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Summary:

New data just released by National Venture Capital Association (NVCA) and Thomson Reuters shows that the VC industry is starting to shrink with some rapidity. In Q2 of 2010, new money committed to venture funds plunged 49 percent from Q1.

The VC industry is starting to shrink with some rapidity, according to data released today by National Venture Capital Association (NVCA) and Thomson Reuters. The trend, which first started in 2008, has only accelerated. During the second quarter of 2010, new money committed to venture funds plunged 49 percent from the previous quarter and 57 percent from the same period a year ago. NVCA believes the soft economic environment is to blame for much of the recent decline in new funds.

The latest quarter saw 38 funds raise $1.91 billion — the lowest level since the third quarter of 2003. There were 26 follow-on funds and 12 new funds raised in the second quarter of 2010, NVCA noted. These included new funds by Polaris Venture Partners and Venrock Associates.

venturefunds.gifIf you look at the accompanying graphic, you can see that the total amounts being raised by venture capital firms are decreasing, and 2010 isn’t looking particularly attractive. I think the data (and financing trends) has some near- and long-term implications for entrepreneurs.

I don’t think the early stage startups, especially those who are focusing on the consumer web and mobile applications, are going to be much impacted by the shrinking VC industry. The startups of today are much more capital efficient and need a lot less money to grow in the early phase of their life. The rise of the new angel investors is only helping the startups, who are taking small amounts of funding to prove their ideas before hitting up venture capitalists for more dollars.

While fewer VCs would mean fewer dollars, it would also mean less funding for multiple competitors, a problem that reared its ugly head during the 1990s and then in mid-2000s, coinciding with a big upswing in VC fundraising.

However, if there is any good news for the VC sector, it is on the exit side of the equation. According to NVCA, during Q2 2010, there were 17 venture-backed IPOs that were valued at $1.3 billion and included Gaithersberg, Maryland–based Broadsoft, Inc, a developer of voice-over information technology, which raised $67.5 million and Tesla Motors, which raised $226 million. During the quarter, 92 venture-backed M&A deals were reported. The information technology sector saw 78 deals with a disclosed total dollar value of $2.4 billion, including Google’s $750 million acquisition of Admob.

These exits can only help the industry, which has struggled to show any meaningful returns that would convince investors to come back and up their commitments to venture funds, especially those who are looking to raise funds in 2011. It is clear that the true test of the industry is going to come next year, and we can (and should) expect some kind of a shakeout.

Related GigaOM Pro Content (sub req’d): What the VC Industry Upheaval Means for Startups

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By Om Malik

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  1. Is it fair to say that for the most part, a shrinking VC industry, is healthy for everyone? Did it not become bloated? Also why is “fewer VCs would mean fewer dollars” and thus “less funding for multiple competitors” really all that bad? Unless you mean that more competition in a free market system is a good thing (even if there are several losers after the dust has settled)?

    1. Eddie

      I don’t think it is a bad thing that there are a fewer copy cats being funded. It was a mere observation that such a development might happen and startups should be aware of it.

  2. Dave Asprey Monday, July 12, 2010

    I was lucky enough to spend some time as an Entrepreneur in Residence with Trinity Ventures, one of the funds which was able to recently raise a new fund. Being an EIR is great because you not only get to meet with all the new startups, but you get to go up and down Sand Hill Road talking with other VC firms.

    Based on that experience, I think Om is right-on in the analysis above. The NVCA numbers don’t lie. In addition, one long-time VC who I very much respect recently told me over lunch, “Dave, look up and down the street [Sand Hill] and count how many partners are getting paid anything beyond their salary plus bonus. I’ll bet you that less than 1 in 100 of them is taking home a significant carry [percentage of profits], and that’s how venture capital partners make the real money.”

    So it follows that some VC partners will look for greener pastures, but those who stick around will tweak the model to find a way to make it work again. In raising money for my startup {PulseTracer.com), it’s rare to come across a venture firm without a newly-formed seed capital program. Larger VCs mostly steered clear of seed rounds because of concern about the amount of time a board seat requires vs the small amount of capital per investment. A partner who is on 9 boards or so is so busy that other VC tasks like finding deals and raising new funds fall apart.

    If the average investment per seed is $500k, that means one partner can only manage about $4.5 million before he runs out of time. With a fully deployed $300m fund, that means you’d need about 66 partners. Assume each makes about $450k/year, and that fund would be spending approximately 10% of the entire fund per year on salary, not counting fundraising or new deals! Normally VCs take 2% of the fund size per year for expenses.

    There are only two solutions I see. The first is for the VCs to “outsource” the early stage investments, which is the path most seem to choose, forging tight relationships with super angels like Jeff Clavier and early stage firms like Andreessen Horowitz or even Ycombinator. In my opinion, this is a band-aid approach that leads to disruption of the venture industry as we know it. When the super-angels have enough big exits, they will find they are on equal footing with the older VCs, but have a more capital efficient operating model. Clayton Christiansen

    The other path requires VCs to roll of their sleeves and get more involved while keeping capital efficient. How? By bringing in seasoned operating entrepreneurs at a reasonably low salary (say $150k) who each run their own mini portfolio of seed deals, say up to 15 each, but with a sizeable bonus based on the success of the deals. Call this new guy a “VC in Residence” (VIR) or something. As the succesful deals mature to become A round investments, they leave the VIR’s portfolio and go to a partner at the venture fund. Make it a 3 year VIR program – the expectation is that over the course of the 3 years, one of three things will happen. Either the VIR gets so excited he joins one of his portfolio companies, or he proves himself so well that he is invited to become a VC partner, or he just isn’t good at this kind of work and goes off to some other thing.

    What would a VIR program do? It would insource the seed investing program, prevent disruption, keep costs low, and most importantly, it would breed for and filter the next generation of venture capitalists.

    But hey, even though I’ve been advising VCs for a long time, I was only an EIR for 3 months, and there’s lots I don’t know about the inner workings of the industry. Nonetheless, my disruption radar has a long history of being accurate, and I can see it starting here.

    However it turns out, I can’t wait to read what the business case tells the MBA class of 2020. :)

    1. Dave

      Great response. Your arguments about outsourcing to folks such as Clavier and YCombinator are spot on, though it seems Jeff is already big enough to command his own fund, especially if you see his success rate.

      Regardless, the argument you make about seed deals and too many board seats actually holds true of angels as well. At some point, too much is too much. I guess the solution is to not take board seats and instead have informally formal relationships with the company. I mean how/why does a company with mere $500K in seed and an early idea going to benefit from a board. That is the time when the startup needs to focus all its energies on building and proving its product and not spend time preparing for a board meeting every month.

      THanks said, your VIR idea does sound clever.

  3. Tamza Kilam Monday, July 12, 2010

    We need to go back to the pre-bubble phase to find out what worked. Even there we must look at the stage of cycle the US was then vs. now. VCs were supposed to be risk takers and innovators, they have increasingly turned into ‘bankers’ looking for the big hit and the high personal compensations. The share of carry that these guys have been getting was a loophole they have milked, it should be taxed as ordinary income .. it is NOT capital gains. An EIR or VIR is indeed a good, hey even great, idea IF the VCs will see it fit to share the fame and wealth. My experience with the VC world is that they are (like many bankers) super prima donnas … Get down to earth, WORK, take some risks with seeding $, and be willing to take reasonable returns .. you will do sustainably well, try to stick with the old ways and $ expectations, and you will kill the goose.

  4. Sanjay Maharaj Monday, July 12, 2010

    As the VC market tightens, it will pose a challenge to startups in finding venture capital but I see this as a positive in that some real niche and tangible ideas will emerge and only those with an excellent value proposition and monitization plans will get funded.
    This however is not unexpected as in every industry especially after the financial crisis there has a lot of consilidation and house cleaning. Liek you say startups will have to funds themsleves and prove the idea before they can rasie their first round through VC’s, it’s as simple as that.
    Will this stifle innovation is the questions, personally I don’t think so although it may slow it but there are a lot of innovators out there thinking about the next big idea which will eventually get funded if the idea is not only brilliant but proven concept.

  5. Harry DeMott Tuesday, July 13, 2010

    It is like food going through a snake. Given the capital light model that seems to have become prevalent over the past few years – those funds raised in 05-10 were raised with 2003 economics in mind not 2010 economics in mind – so you are going to just have to wait till the investment period on these funds has waned. Yes too many competitors or fast followers get funded – but ultimately that should be good for the survivors who had to iterate so much faster than they would have otherwise. Who said $30B is the right number? Maybe it is $10B – $15B. Seems like the internet is doing to VC what it has done to every other industry in the world – flatten the return profile for participants.

    1. Harry

      You make great points. I think the bigger issue right now is that the amount of funds in the hands of VC firms is so huge that it needs some creative and risky investing. It cannot all be consumer web companies and they have to fund companies that develop or have deep technology ideas.

      I don’t mean that everyone needs to fund a server company or whatever. What I mean is backing companies like SIRI (acquired by Apple) that are doing fundamentally difficult technology versus say a GroupOn clone. There are fewer and fewer such fundings.

      On your observation about the internet and its impact to VCs, well, it is not that off the mark.

  6. Failure to Launch?

    What concerns me in particular about this data is not so much the impact on the early stage companies because they tended to be oriented towards bootstrapping and angels. What’s of concern is the later stage companies that, due to a soft IPO market and economic climate, are needing to be under the financial wing of their VC’s for longer. This means more follow on money than would have been the case previously and potentially more than originally allocated from each fund. As these funds are stretched, this puts these later stage and higher cash burn companies into a precarious place, and one consequence is the need to find a new sugar daddy which often is an acquirer. With this dynamic, its not surprising that we’re seeing acquisitions occurring rapidly.

    Its somewhat like a congested airport with too many planes waiting to jump onto the runway – we need the IPO market to open up to bring improved returns to funds, and allow those companies that have a failure to launch to take off or we’ll continue to see more acquisitions and slow institutional support for new funds.

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