The venture capital industry needs shave about $13 billion a year from its investments in startup companies, writes Paul Kedrosky in a research paper released today by the Kaufman Foundation. The report not only offers data showing how the U.S. venture capital industry is too big, but links such size to depressed returns. It’s a data-rich, authoritative look at the issues I wrote about yesterday after the NVCA released a survey that shows how ill-adapted many venture firms are to the changed world of technology investing.
Those changes include a less forgiving initial public offering market, lower capital requirements for certain types of startups and more firms flinging more capital around. Kedrosky’s data suggests that the U.S. venture industry should shrink to less than 0.1 percent of the GDP (it currently stands at around 0.19 percent of GDP) — to roughly $12 billion. He pushes for smaller funds and investments, especially in mature areas such as information technology. He also recognizes that venture firms are reluctant to make this shift. From his paper:
It seems inevitable that venture capital must shrink considerably. While there is no question that venture capital can facilitate some forms of high-growth entrepreneurial firms, its poor returns make the asset class uncompetitive and at risk of very large declines in capital commitments as investors flee this under performing asset. While any estimate is subject to much uncertainty, it seems reasonable—based on returns, GDP, and exits—to expect the pace of investing to shrink by half in the coming years. We should also expect a continuing sharp decline in the amount of money invested in information technology, a maturing sector with declining capital requirements in its remaining innovative segments.
The question is how to shave $13 billion from the industry. Venture firms are already thinning their ranks and trying out smaller funds. But Kedrosky suggests another key element to making this culling less difficult: moving away from the idea that venture capital is a “necessary and sufficient” ingredient for growing entrepreneurial companies. I touched on that debate after sitting in on a panel at South by Southwest and talking to Mike Maples Sr., a Texas angel investor and former Microsoft executive. There is a definite perception that true tech startups raise venture capital rather than bootstrap or grow through other types of financing such as angels. Changing that perception may change the overall demand for venture capital dollars from startups and even governments.