Perspectives on entrepreneurship, startups and venture capital from K9 Ventures.

A Time for Change in Venture Capital

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In my previous post, I talked about some of the reasons I felt that the venture industry was broken and needed reform. This has been something that I’ve been thinking about for a long time now (~1.5 years or more) and became the basis for me starting K9 Ventures. The logic there was that instead of just identifying a problem, do something to solve it. In the words of Mahatma Gandhi: “You must be the change you seek in the world.”

However, before I start writing about how I would want to change things, it is necessary to address the current economic climate. The bottomline is that this is the worst time in history for the venture capital industry. The stories of doom and gloom in the venture business are everywhere. Here are just a couple that I’ve come across recently:

If that isn’t enough doom and gloom so far, I’m sure you can dig up a lot more. There are several reasons for all this doom and gloom. I’ll try to list at least some of them here:

  • Lack of IPO and M&A exits: Q2 2008 was the first quarter in 30 years in which not a single venture backed company exited via an IPO (see NY Times article). The blame is attributed to adverse incentives of legislation like Sarbanes Oxley and the bad financial markets. Mergers and acquisitions have also been down, especially the large deals. What does this mean? Well, VC firms have not been able to get exits; money that was invested in venture capital is locked up in illiquid private investments in portfolio companies and cannot be returned to Limited Partners.
  • The Denominator Effect: The big endowments, pension and retirement funds, charitable organizations, family offices and high net-worth individuals who are the Limited Partners in venture funds have all seen their portfolios take a severe hit. Several of these funding sources have managed asset allocations, meaning that their investments in venture capital are supposed to be a certain percentage of their portfolio. However, when the value of the overall portfolio (the denominator) decreases, the percentage of the portfolio allocated to venture capital increases. The commitments to venture capital are therefore now a much higher percentage of their total portfolio than they originally started with.
  • Deferred/Unmet Capital Calls: Portfolios have taken a beating in this market. For any LPs that were not sitting on cash, and few were, a capital call in this market would typically require them to create liquidity by selling some of their holdings. However, with the market this depressed, no one really wants to sell in the down market. Therefore, several of the large LPs have advised their venture funds that they really don’t want to see any capital calls in the near future. This ties the hands of venture firms. To make sure they have enough money for their existing portfolio companies, they first start reducing any new investments. In some cases, LPs have actually defaulted (see WaMu) on their capital calls.
  • Venture Asset Class Performance: Venture capital as a asset class has produced disappointing returns. In fact, most venture firms actually lose money! It is only the top tier venture firms that are able to maintain good returns year over year. And in the current climate, even that is suspect. But, venture is a long term play. LPs have to give it at least 10-15 years to see see what the returns on venture will be like. Well, a lot of LPs have now been in the business that long and they’re not happy with the high-risk low-return performance of venture capital. To the extent that several LPs are considering pulling out of venture capital altogether.
  • Stock Market vs Venture Capital: If you’re sitting on a pile of cash right now, would you rather invest it in the depressed stock market, where several publicly traded companies look like they’re in the bargain basement, OR would you rather invest it in a highly risky, completely illiquid venture investment in a private company? The stock market is liquid, typically less risky than a startup (though some would argue that) and if and when we pull out of this recession, the returns from the stock market may be even better that most venture investments. This applies both to angels and to the big money LPs.
  • The Trickle-Down Effect: The total venture investment in 2007 was around $29B dollars. If the stock market has declined over 40% in the current year, and if we hold the asset allocation numbers constant, then next year the total money going into venture capital will be down by at least 40%. Add to that that several LPs are pulling out of venture capital altogether, it means that the total money in venture capital will be reduced even more. Without doing a full scientific analysis, I’d say a 50% reduction is not inconceivable. That equates to hundreds, if not thousands, of startups that will no longer be funded simply because of the effect of trickle-down economics.

So where does this leave us? Well, lets just say things are not looking good for the startup funding environment in the near future. The venture capital industry is getting beaten from all sides. Projections say that several venture funds (presumably the non-Tier 1 venture funds) will actually start shuttering their doors in the near future. Even the top funds are having to rethink their strategies and especially their headcounts. The “layoffs” in venture happen quietly — but they can, will and are happening in these times.

I’m going to make some bold and (I hope) controversial statements: Venture Capital is a people business in every sense of the word. It is therefore a boutique industry and it cannot scale. In my humble opinion, it doesn’t make sense for LPs to be funding multi-hundred million dollar funds and sometimes even billion dollar funds that claim to be “early stage” venture capital funds. The word early-stage has been misused to such an extent that it’s hard to even say what it means any more.

For small upstarts like K9 Ventures this is a bitter-sweet time. On one hand the macro-climate will certainly make things harder in the venture industry for the foreseeable future. On the other hand, such industry-wide disruptions are the best time to try something different. Without abusing an already overused line for 2008 I’ll say: It’s a time for change — even in the venture capital industry.

  • Alan

    This is a very well written, assessment of the VC industry as a whole, but I think there is one factor you are not emphasizing enough: Fund Size – A large fund’s GP’s interests are far from aligned with the interests of the LP’s. Take your typical, run of the mill $500M fund that charges the industry standard annual 2% management fee. The GPs are guaranteed a $10M per year management fee to use at their discretion. Multiply that over a handful of funds and you can see why large fund’s GPs don’t necessarily have the LP’s interests in mind.

    A change MUST come to this industry or we’re going to see a very nasty fall out once the current funds expire.

    • @Alan: Thanks for your comments. I agree 100%. The only reason I didn’t mention fund sizes in this post is because I have written about precisely that in the previous post: The Venture Spiral. A more recent post: Thoughts on “Another View: V.C. Investing Not Dead, Just Different” also touches on this topic.

      I strongly believe that smaller fund sizes will be essential to getting early stage venture capital investing restarted. However, not all the major established funds are going to cut their fund sizes to be a fraction of what they were. Instead, this will happen by new funds emerging to fill the gap. The catch is that since venture moves at such a slow pace (to raise capital, to establish a track record, to establish a reputation and a brand) the process will take some time. It has already started, with some great funds like First Round Capital, Maples Investments and Softech VC for example.

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  • I totally agree with your perspective. I think that the conditions you describe make it an opportune time for early stage VCs and Angels to carefully evaluate and select investment opportunities, that don’t require the “homerun” type of returns that larger VCs need and look for due to the size of their funds, management fees, etc.

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  • good post, but that’s not why i’m commenting.

    i just wanted to say, “i love this color theme”.

  • Great post Manu. It is really thought provoking.