The venture capital bubble has burst. The New York Times reports that the venture capital industry is shrinking on two fronts: the number of venture firms, and the total amount of investment in venture funds. As many as half of all venture firms could shut down because of poor financial performance. In 2008, venture capitalists returned on average a mediocre 6% to investors. That's compared to 48% return in 2000. The inflow of money into venture funds fell from $7.1 billion in the first quarter of 2008 to $4.3 billion in the first quarter of 2009.
What Downsizing Means for VCs
For venture capitalists, the rubber will hit the road.
1. Those who can add value through operational and managerial skill will survive. Those who overmanage or fail to manage will have a hard time generating returns sufficient to please investors. VCs will need to strike the right balance between merely montoring and being hands on.
2. Further, these changes will test the ability to VCs to find high potential ventures can be grown into successful companies. There will be fewer bets to place, and each bet will matter more. Those who place bets on subpar, marginal startups will be exposed even further than the economic downturn has already done.
3. With the IPO market looking dry for the foreseeable future, VCs will have to build sustainable businesses that are attractive to potential acquirers.
4. VCs will still face stiff competition for funds and for promising companies, since the venture industry becomes increasingly global. But it is important to remember that the way VC operates worldwide differs from VC in the US. Exit vehicles, including IPO markets, work differently and investors have different expectations from and relationships with VCs. Moreover, many US based funds are hesistant to invest in foreign startups.
5. The smartest money will win.
What Downsizing Means For Entrepreneurs And Startups
1. From my vantage point, the number of startups in Silicon Valley is booming because engineers and others cannot find jobs with companies. These entrepreneurs are chasing a shrinking pie.
2. As the number and size of VCs shrinks, Startup founders will face a higher bar for funding as VCs become more selective. There will be fewer VCs to invest in subpar, marginal startups. Entrepreneurs will have fewer opportunities to pitch.
3. Startups with high capital requirements, for example, cleantech ventures, will have more difficulty raising sufficient funds or will have to do more with less.
4. Entrepreneurs will need to look to alternative funding strategies, such as bootstrapping and angel investors.
What Downsizing Means For Investors
1. Fewer and smaller venture funds means investors will have to find other vehicles to park their money. Even now, investors are shifting their money to private equity funds. At the same time, this one of the forces behind the downsizing of the venture capital industry. Andreesen Horowitz, which just raised $300 million, is an exception to the downsizing trend. As the ecpm blog notes, Andreesen Horowitz does not solve of the problem of too much money in the industry.
2. As the shakeout continues, investors can have greater confidence that their money is in capable hands. The smartest money will win.
Douglas Y. Park
Twitter: @DougYPark
