The Dea(r)th of Venture Capitalism ?

Techmeme loves a good bitchmeme, and financiers of all stripes right now are an easy target for those looking at gaining karma, kudos and book kontrakts. Todays "VCs are dead" episode was sparked off by a presentation by TheFunded CEO laying out the problems with VC's (see below).



VentureBeat summarises the issues in debate:

Most daunting is that there’s more money being invested into venture firms than those same VC firms are generating from their investments in start-ups — in other words, Ressi argues, they’re now having a net negative affect on the economy. You’d expect this lopsided dynamic to exist temporarily in a downturn. But the worrying thing is that this state of affairs may last for quite some time.

I’m not sure how long this negative balance will last, but for now it certainly contradicts the message traditionally propagated by the VC industry — that it, that VC is a net creator of value, namely of stock market growth and job creation. That positive impact was indisputable — until now.

There are a number of key reasons why things are so ugly:

1. The early successes in the valley (Intel, Cisco, Genentech, etc) attracted so much venture capital after the late 1990s that VC became an official asset class that money investors around the world sought to get a portion of. However, this is a niche industry, and should have stayed that way. Too much money has swept in, with too few deals to accommodate it. This has distorted the economics badly. Valuations are driven up for the good companies, making it prohibitively expensive for VCs to invest. Everyone loses.

2. Others have become smarter. Larger companies put start-ups on their radar much earlier. Yahoo, Microsoft, Google, Cisco have acquired start-ups very early in their life, taking them off the market for tens or hundreds of millions of dollars — but potentially keeping some start-ups from becoming billion-dollar companies. Amazon famously balked at buying Google for about $1 billion back in 2000. That may not happen today.

3. Greed. Pure and simple. Good venture capitalists have an incentive to raise ever larger funds, because the 2 percent they get in fees on the funds can bring them millions of dollars in cushy salary and expense accounts (including private jets, at least in the good old days). But to put all that money to work, the investor can’t focus on early-stage companies, because those small companies can’t absorb enough dollars. So greedy VCs turn to invest tens or even hundreds of millions of dollars into each company. That’s why there was this rush to invest at the lastest stage possible, namely private equity.

Financiers acting irrationally and allowing greed to override caution, and then herd-rushing to fund stuff they barely understand - knowing their own personal risk is low in the case of losing their investors' money. Who'd a thunk it, given the well known probity of the profession? But to worry about the antics of a tiny part of the Capitalist System when the whole frigging thing is going to hell in a handbasket is - well, its missing the point, really. Of course the VC industry as it is is f*cked, of course it will restructure, of course there will be casualties (not necessarily the ones who f*cked up most, of course - c'est la vie) - but of course there will also be a new VC industry, because rich people lending money at exhorbitant rates to help others build their personal dreams is part of the human condition.

(Update - what do I mean, f*cked? Its simply that in this coming downturn, all the old rules will go away - the Limited Partners will start to pull out of theirobligations, the exit opportunities for many of the currently funded companies will disappear, and since much of the stuff funded in the last 2 or so years is based on selling to companies who themselves are finding money tightening, and based on FreeConomic chimerae and/or the (eventual) hope of (declining) Ad funding, its going to be very tough.)

Actually, I'm with a VC - Fred Wilson in this case - when he notes that:

LPs have been telling me that the VC industry has been cash flow negative for years.

Clearly there is too much money and there are too many firms in the venture capital business. The same is true of every asset class I follow. I was at a hedge fund annual meeting yesterday and they predicted a huge number of hedge funds will go out of business in the next 12 months. I think the same will be true of private equity, real estate, and a number of other asset classes.

Right said, Fred* - this is not new news, its good old Greedonomics, as is the predictable outcome that a tiny number of VC's cleaned up nearly all the value from just a tiny number of deals. The long, unprofitable tail will wither away.

But, if you read the presentation above there is a worryingly contradictory set of demands for VC 2.0 - that there must be fewer, better funds, but that 25% rather than 10% of companies out there get funded. As Fred notes:

But be careful what you wish for. We will get a better, more efficient venture capital industry that produces better returns for investors from all these changes. But we may also get less capital for entrepreneurs. Just like there aren't thousands of great VCs, there aren't thousands of great venture capital investment opportunities. When the industry is flush with cash, entrepreneurs are the beneficiary. When it is not flush with cash, entrepreneurs will feel it too.

That was my thought exactly. That net-cash-negative industry story means that it has been very successful at parting rich, (sometimes) smart people from their money, to blow it on experiments that will mainly fail. As a recipe for innovation in the big picture (Darwinian Evolution of the fittest technologies) isn't that a good thing overall - that's a success isn't it?

*I had to do that