Five Years Too Late

January 8, 2009

The Death of Venture Capital (again)

Filed under: Uncategorized — fiveyearstoolate @ 12:58 pm
Stuart Ellman

Stuart Ellman

Eric Wiesen

Eric Wiesen

In these last months, the drumbeat proclaiming the death of venture capital has grown louder, even becoming mainstream. Some of what’s appeared in the press sparked an interesting conversation amongst us about what all this means for venture capital as an asset class and for the entrepreneurs whose businesses are funded by venture capital. A number of perspectives were shared within RRE, and we collectively agreed that our industry faces some real challenges ahead, and that we want to be as thoughtful as we can about how we as investors face them, so that we can advise our portfolio companies and friends.

One analytical method that has been applied by some is to simply note that Venture Capital as an asset class has not had great returns in the eight-year period since the dot-com crash, then connect the dots toward a conclusion that an asset class with limited liquidity and sub-par returns is doomed. With this model we should expect capital outflows until the industry is essentially gone. This strikes us as a lazy way to think about a complex problem. Had you applied this same method to publicly-traded stocks in 1940 or 1980 you could easily conclude that equities was an asset class whose best days were behind it, and would have then missed two of the greatest bull markets in history. In a more contemporary context, we’re likely to see a moribund real estate market, but that doesn’t mean real estate as an asset class is dead either. Assuming that because something has performed poorly in the past it will continue to perform poorly in the future has rarely proven an effective method of prediction.

One way to more accurately explain the last eight years is with basic economics: what goes up must come down. Returns for venture capital from 1995-2000 were so phenomenally good that the asset class attracted massive amounts of new capital, new players and lots of me-too activity. As in all such episodes throughout history, this influx caused previously good returns to become concomitantly bad. Since the party ended, the VC industry has been slowly unwinding its way out of this overpopulation, but as our colleague Jim Robinson IV noted in a recent interview, the long cycle time of a VC firm (often 10 years) makes this unwinding a slow process. But it has been happening consistently and inexorably since 2001. When the case against Venture Capital is made, it is often mentioned that there are “several thousand” venture capital firms, and that it’s simply too many firms for what was a relatively small industry during its most profitable periods. And that is ultimately true. But there aren’t anywhere near that many venture firms who are genuinely active. If you define active as those firms that have made an investment in the past 12 months, that number is more like 500 than 2500 (Thompson claimed 1700 in 2007 while the National Venture Capital Association is more judicious, calling it 800 in 2006). And let’s be realistic – it’s still trending down and will likely continue to do so for the next couple of years. By the time the full 10 years have passed since the last of the bubble-era funds were raised, the industry will once again be relatively small.

But ultimately all of this is simply Monday-morning quarterbacking. Yes, too many firms were formed during the late 1990’s and too much money was raised. Too many companies were funded without real business models or that couldn’t justify the valuations investors accepted. And the price is still being paid for that excess. But the argument that venture capital is dead in 2009 seems, in our view, to oversimplify and confuse the two major economic collapses of the nascent 21st century: 2001 and 2008.

2001 was all about technology. Our ecosystem ballooned and then popped. Duly noted. But 2008 has nothing to do with technology or venture capital directly. 2008 was a collapse of historic proportions, largely driven by misguided government policy, leverage and a real estate bubble that dwarfed anything we saw in 2000. These factors have little to do with venture capital (which typically is 100% equity and has no leverage) or the companies in which we invest (which also typically use little to no leverage). We aren’t real estate investors and we as an investor group didn’t buy toxic assets. So then the question becomes – will venture capital and the world of technology startups be collateral damage in this collapse? And of course the answer is: yes and no. There’s no question that the broader economy affects startups and VCs alike. These effects have been widely discussed — here and elsewhere — from the slowdown in consumer spending to cutbacks in big company budgets to the challenges of raising VC money and that VCs face with their limited partners.

Some will single out sectors as unusually troublesome (usually advertising-driven web startups or cleantech companies that have high CapEx). In these sectors there are going to be winners and losers just like everywhere else. And sure, some VCs will have a hard time raising their next fund as LPs shy away from all “alternative” assets, resulting from a “Denominator Effect” or other rationales. But while it’s fun to put “the death of Silicon Valley” on the cover or to write a story about how the lack of a robust IPO market will be the end of Venture Capital, in the final analysis the basic rationale for venture capital is as sound now as it has ever been.

There are only a few ways to grow the economy: more inputs (natural resources, labor) or higher productivity (which introduces a multiplier to the foregoing). And higher productivity typically comes from innovation. Venture capital is in the business of funding companies who will go after opportunities that established players can’t or won’t pursue. And in this day and age this rationale is more important than ever. Will capital be harder to come by to fund these companies, on both the startup and VC sides? Probably. A bad economy with damaged financial markets will do that. Will some startups manage to fund themselves to a quick exit without raising any money? Sure. It’s definitely cheaper to build a company now than it was ten years ago. Is there an argument to be made that we’re in the middle of a slow-rise period of incremental, rather than disruptive innovation? I think there is. But based on what we’re seeing, there are a lot of interesting companies being started, and most of them can use both capital and guidance. Ultimately those are the two commodities venture capital provides.

We know this is a challenging time, and it’s going to continue to be. But as things get better, innovation, new technology and new ideas will be a big part of it. We believe venture capital continues to be an important ingredient, and there’s no obvious substitute.

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  1. “There’s always been too much money in venture capital. It doesn’t mean you can’t make… money in venture capital.” – Tom Kleiner,

    Comment by Nivi — January 8, 2009 @ 4:21 pm

  2. Great post, Stu and Eric. Careful investors have the most opportunity in times like these. I get scared when “the market is good.”

    Comment by Tom Loverro — January 8, 2009 @ 6:10 pm

  3. @ Nivi – pretty sure that was Tom Perkins or Eugene Kleiner, but not Tom Kleiner (note: it was Tom Perkins).

    @ Tom – Agreed. Being a contrarian is (much) easier said than done, but it’s usually how money is made.

    Comment by fiveyearstoolate — January 9, 2009 @ 10:59 am

  4. […] not the same argument as “VC is dead”, which we’ve addressed a couple of times in this space, but another common theme emerging out of the discussion around startups and […]

    Pingback by Bootstrap ‘n Flip? « Five Years Too late — January 23, 2009 @ 2:13 pm

  5. […] closed routes for IPOs, the slump in overpriced acquisitions, the “death” of venture capital or the lack of disruptive thinking and actions by the new venture […]

    Pingback by Unordered Thoughts | Unstructured Thoughts by Taylor Davidson — February 14, 2009 @ 5:26 pm

  6. Venture Capital has always mostly been “Hype Capital”, that is few of the companies the VCs ever invested in were really ever profitable, based on true accounting and cash-flow. Most VCs were simply in the business of “manufacturing / manipulating” high tech companies with close to copycat technologies, in order to have Wall St. firms foist them on the public at higher prices (or as one VC once confided to me years ago “put tits on them and take them public / IPOs”). The problem is the VC firms and Wall St. firms ripped off the American StockMarket Public Investors so often for so long, that no-one’s buying IPOs anymore. The ones who bought lost their money in the Tech-Wreck of 2000 and earlier lesser tech-wrecks.

    The reality is there were and are very few VC created tech. companies that ever really made it big, without hundreds of millions of dumb public money later invested at much higher prices. How many really endured in past 30 years (Apple, Google … actually Apple wasn’t founded by VCs). For every computer and high tech firm that made it big, there are 20 that failed or used up more capital than they ever created.

    There’s still way too much capital in VC funds even now, vs. the real few opportunities out there, that big corporations themselves won’t fund with lower costs of capital.

    Comment by Drew — October 5, 2009 @ 5:35 am

  7. […] Finally, an investment firm along the lines outlined above is consistent with modern economic theory.  Schumpter, Solow, Romer and other economists have shown that innovation is the only way in which per capita income growth is possible.  Having legal title to innovation is the only method to capitalize or collateralize  innovation.  The hunter gather age was followed by agricultural age, which was followed by the manufacturing age.  The future is the information age.  An IPVC (merchant bank, private equity fund, etc) is on the side of economics and history. [1] […]

    Pingback by Intellectual Property Venture Capital « State of Innovation — November 3, 2009 @ 11:21 am

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