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Summary:

For the past couple of decades, venture capitalists have had the upper hand. They’ve had the funding and most of the power in the startup ecosystem. But, said venture capitalist Fred Wilson, as that balance of power shifts, VCs need to rethink their role.

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For the past couple of decades, venture capitalists have had the upper hand. They’ve had the funding and, traditionally, they’ve held most of the power in the startup ecosystem. But, Fred Wilson, managing partner of Union Square Ventures (and beloved blogger), believes that balance of power is shifting (As noted in Stacey’s take on a similar notion advanced by the Kauffman Foundation earlier Tuesday.) And as it does, venture capitalists themselves must rethink their role.

Speaking to a crowd of entrepreneurs at the Grind work space in New York this morning, Wilson said that since the mid-1990s institutional investors have poured $30 billion into the venture capitalist business every year, but venture capitalists have only been able to figure out how to generate good returns on half of it. (Actually, venture capitalists haven’t seen that much money flowing in since 2007, according to the National Venture Capital Association, which notes the recession dramatically lowered investment.)

“There’s two times as much capital in the venture capital business today than we, the professional investors who make up the venture business, can actually put to work intelligently,” he said. As an asset class, venture capital has not beat the public markets on a consistent basis since the mid-1990s, he added.

Mo’ money, mo’ problems

That underperformance alone has given VCs reason to stop and think about their position, but he emphasized that the recent influx of new sources of capital has exacerbated the need for reflection. (The Kauffman Foundation report referenced in Stacey’s post on the “broken” VC industry outlines even more reasons why venture capitalists need to adapt to the times.)

In the past five years, the amount of angel investment has grown fivefold and more international funding is also entering the startup sector, particularly from Russia and the Middle East, Wilson said. The growth of crowdfunding (made possible by the recently-passed JOBS Act) will further flood the startup market with new capital. If every American family gave just one percent of their investable assets to crowdfunding, he said, $300 billion – or ten times the current amount invested in the sector – would come barreling into venture capital. (That seems to be a pretty big assumption but, regardless, the point is well taken: crowdfunding stands to dump a huge amount of new money into startups.)

“This is, I think bad news for the venture capital industry, but terrific news for the entrepreneurs,” Wilson said, adding that over the past two decades, “it’s been an inexorable march from an industry that was very much skewed towards institutional VCs to an industry very much in favor of the entrepreneurs and it’s just going to get more and more and more that way.”

So, what’s a professional venture capitalist to do?

The new venture capitalist.

Given all the new pools of funding, he said, it doesn’t make sense for VCs to continue aggregating capital. And considering the industry’s inability to generate returns on more than half of the current investment in venture capital, he added that the allocation aspect is another area ripe for rethinking.

Still, he continued, VCs, can keep on adding value as board members, advisors and resources on exits and governance.

Going forward, VCs have a few options on the table, including becoming more selective, shrinking, halting investment of instutional capital or taking more equity for the governance and advisor services they provide, Wilson said.

But one of the more compelling ideas he floated was building a business on top of crowdfunding.

“If these crowdfunding markets really do develop into these vibrant markets… maybe the answer is to leverage that capital and do something interesting there as opposed to going out and raising money from the institutions,” he said.

A possible model could be a scenario in which a VC spots an interesting deal in the crowfunding market and offers to sponsor the deal with one-tenth of a $1 million round, he said, potentially making it easier  for the startup to raise the remaining $900,000. The hypothetical VC could also join the board and get added equity for the expertise.

Of course, if nothing else, there’s always blogging – “a pretty good gig if you can get it,” he said.

And, as a last resort? Quipped Wilson, “We can just retire.”

Fred Willson will be interviewed by GigaOM’s Mathew Ingram at paidContent 2012, May 23 at the TimesCenter in New York. Register here.

  1. Let’s put this in context: Fred Wilson is a consumer Internet VC. Consumer Internet, mobile apps are probably well suited to crowdfunding.

    At VentureDeal, we track 41 industries that are funded by technology VCs in the US and the vast majority of them are probably not suitable for the crowd funding approach. Most obviously, the life sciences of biotechnology/pharmaceutical/medical devices, which require extremely patient and deep-pocketed investors.

    Other “hard” technology sectors such as security, IT, wireless, networking, semiconductors… the list goes on and on of industries that require long periods of incubation and extremely knowledgeable, value add investors.

    I believe that a large majority of industries that are funded by the standard VC model will be untouched by crowdfunding in any significant way.

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    1. Sasa Marinic Tuesday, May 8, 2012

      Hi Don,

      I somewhat disagree with the point you are making. I believe that industries like pharma are perfect for the crowdfunding. The solely importance and impact of new medicine are more than enough to attract the crowd and capital. I don’t think that crowdfunding is about making short term profit. If that is the case than one should trade shares on nasdaq. on the other hand if you are investing / crowdfunding 100$ and it triples value in a year (and that is much) it is still 300$ and not a “live changing” amount.

      the truth is that existing companies are not likely going to adopt crowdfunding as a way to raise capital.

      Traditional VC have two goals. 1 raising funds and 2 investing the raised funds in as safe and as profitable way as possible. This causes a lot of start-ups not being able to raise any capital just because they are too much of a risk for the liking of a VC. When this risk is shared by many small investors it becomes neglectable for each individual.

      What this article misses a bit is consideration of macro-economic financial situation. There were times (not that long ago) that VC’s had so much funds they didn’t know where to invest it. Some of them have lost money because of the wrong investments and are now more defensive with their investments. This influences the graph very much.

      Sasa

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      1. Peter Frykman Thursday, May 10, 2012

        Sasa,

        It’s a great point that individuals “investing” $100 or less have a different risk tolerance than VC’s. But even more important is that individuals may have entirely different set of goals than VC’s with their investment. You point this out briefly and I’d like to take it further.

        Not every organization or initiative is a VC-fundable enterprise, especially at inception. A crowdfunded organization may create different value beyond simply the prospective financial return required by VC’s.

        As the Founder and CEO of a for-profit social enterprise focused on rural small-holder farmers (www.driptech.com), I know that there are investors who value social impact in addition to financial impact. This is often easier for individual investors, who don’t have an explicit profit-maximizing investment mandate like VC’s. Much of our early funding came from such individual “Angel” social investors. Now our investors include both Vinod Khosla and a publicly-listed corporation. Crowdfunding can take early-stage social impact investing one step further.

        The most exciting thing about crowdfunding is the opportunity that it presents to individuals to invest directly according to their personal interests and motivations, which could be a combination of profit, social impact, or something else. This specific, personal involvement is one of the reasons that Kiva.org has attracted so many individual lenders in the microfinance space. Now anyone can be personally connected to the excitement of a startup, even if they only have a few hundred dollars to invest.

        Peter

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    2. Don Jones you surely are in denial. Curly of the 3 Stooges just gave you the eye poke and nyuk nyuk nyuk!

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    3. Ki Mae Heussner Tuesday, May 8, 2012

      Don, I see your point that consumer Internet companies might seem more accessible to the average consumer who would invest via crowdfunding platforms. But communities like Petridish.org (which Fred actually mentioned in his talk) are already getting the general public to invest in the hard sciences. Donorschoose.org (another great organization he referenced) lets people crowdfund education projects. One could imagine that other similar communities could pop up around other industries.

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    4. Brandon Marker Wednesday, May 9, 2012

      I have seen a TON of biotechnology/pharmaceutical/medical devices attempting to leverage crowdfunding. Not sure it is a good fit, but they are trying to make it a fit.

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  2. Sasa Marinic Tuesday, May 8, 2012

    Reblogged this on Sasa Marinic and commented:
    Fred Wilson: what crowdfunding means for the VC business

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  3. Steve Ardire Tuesday, May 8, 2012

    >“This is, I think bad news for the venture capital industry, but terrific news for the entrepreneurs,” Wilson said, adding that over the past two decades, “it’s been an inexorable march from an industry that was very much skewed towards institutional VCs to an industry very much in favor of the entrepreneurs and it’s just going to get more and more and more that way.”

    Nicely stated Fred !

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  4. Another problem with crowd funding:

    Since attracting talent is the hardest and most critical tasks for early-stage startups to do, how many top-tier researchers do you think a startup CEO will attract by saying “we’re crowdfunded” vs. “we’re backed by Accel Partners”?

    Crowdfunding has all the earmarks of becoming a “financing backalley” for anything other than consumer products/Internet, mobile apps or games, or where the only thing the startup really needs is “dumb money”.

    But for sophisticated, high technology applications or products requiring long periods of steady, large investment and support, crowdfunders might just as well become “crowdgamblers”.

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    1. Maurice Lopes Tuesday, May 8, 2012

      I believe Fred hit it right on the nail, i have been advocating VC’s to co-invest in crowdfunding deals, we even built this feature into our Platform 3 months ago. Don while you are correct, in saying that if im a high-end talent and I’m choosing between 2 companies, one is VC backed and one is crowd-backed it might be more interesting to go to the VC (only for the reason that its pro later stage). Which is what i think everyone is missing here Crowdfunding solves a problem $150K to $500K is not VC sweet spot, this is were Crowdfunding will be most usefull, to help entrepreneurs get the traction a VC needs.
      Maurice Lopes – http://EarlyShares.com

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    2. It’s not either/or. As he said, you could have Accel Partners providing a leveraged amount supplemented via crowd funding.

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  5. Calvin Bhai Tuesday, May 8, 2012

    Am i the only one, thinking that crowd funding could be a boon to ‘shoot in the dark’ VCs? Let the market decide which ones are worthwhile, and then pump own money into that company/product

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  6. The idea of crowdfunding sounds good.. but it will definitely require significant tweaking to achieve any significant impact.

    I spent some time on the website “petridish.org” the other day (the website was also mentioned by Fred and another commenter here). Based on the info provided, I cannot help but think that projects are getting funded based on the “catchy-ness” of the title and picture. Not-surprisingly, maximum number of donations fall in the $25-50 category. It is more of a “donation” of a cause concept rather than an investment/funding at the moment.

    The participation of a VC in the process will definitely help in vetting of ideas, pruning and tuning of business plans, executive leadership, attraction of top talent, contacts, networks, exit strategy etc.. all of which are eventually the most important factors in the ultimate success of a startup (rather than the original attractive idea itself).

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  7. Crowdfunding is a nice idea, but it will definitely require significant tweaking for it to be effective/useful.

    I spent some time on the website “petridish.org” (mentioned by Fred and another commenter here). Based on the info provided, I cant help but think that the success of various projects in raising funds largely depends on the “catchy-ness” of the title and picture. At this point, it is more like a “donation for a cause” (save the vampire bat!) rather than any form of investment/funding.

    The participation of a VC in the process will help in vetting of ideas, tuning and pruning of business plans, executive leadership, contacts and networks, exist strategies etc .. the most important things in the ultimate success of a startup (rather than the original idea itself).

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    1. There likely will be a lot of flops. OTOH there may emerge leadership investors within petridish that others follow because of their smart choices. It’s not unlike the old Chicago Board of Trade, where well-known traders had “shadow traders” who would just watch what they did and mimic their trades.

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  8. Christopher Reim Wednesday, May 9, 2012

    This was a thought provoking article, thank you – and I want to add to Don’s comments to the article. As a former venture capitalist and now working in a nonprofit that directs risk equity to community development (finding the high growth companies in troubled communities that desperately need jib growth, wage gains and capacity building), I believe that crowdfunding does have significant potential IF properly organized. I support don’s comments that, like all forms of capital sourcing, crowdfunding does have its more natural sectors where it can be of most use. More relevant still, crowdfunding is valuable to those entreprepreneurs who do not have personal money or friends and family to lean upon. In my view, (1) new job growth, (2) “incremental innovation,” and (3) a new generation of entrepreneurship, can be borne from crowdfunding. This will be effective primarily to young ideas that need between $50,000 and $1 million to prove that the concept is credible to more sophisticated investors. For community development projects, many of these businesses will not be the type to need numerous follow-on rounds; so crowdfunding offers the hope to get the business started – and get jobs moving in these communities. The discussion of crowdfunding is still in its infancy – if we are not careful, too many regular people-turned-venture-investors will get burned and the benefit of crowdfunding will be lost.

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  9. Mark Addison Wednesday, May 9, 2012

    @Don — Couldn’t one of Accel Partners’ LPs invest in a company directly, via a crowdfunding model? Why do they become ‘dumb money’ the moment you disintermediate the VC and their 2% and their carried interest? What the brand-name VCs have right now is a lock on the good deal-flow, but crowdfunding will soon chip away at that.

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  10. Cyril Demaria Monday, May 14, 2012

    Strange logic…

    So, “… venture capitalists have only been able to figure out how to generate good returns on half of it.” These are professional, full-time, experienced people and they failed 50% of the time to make money (which is not so bad, actually, as statistically, in a portfolio, it’s more 20 to 30% of investments making money and the rest, not). And now, Mr & Mrs Smith who barely understand what is the stock exchange, what is a mortgage (otherwise, there would not have been a sub-prime mortgage bubble), or a bank statement, will be able to make money out of start-ups? That’s quite strange. Maybe Mr & Mrs Smith should also do their own surgery, because after all, they do not need these surgeons, who (by the way) sometimes fail to cure their patients?

    So excessive cash available is good for entrepreneurs? Since when? When does the principle of lean start-ups and cash-starved business pushing everyone to be the most efficient possible stopped to apply? Does it sound 1999 or 2000 again? Or is any entrepreneur fool enough to believe that it’s only about money?

    I happen to have invested as a professional VC in a previously crowdfunded company. What a chaos! Nobody was really seating at the Board, doing the job of a professional investor: questioning, advising, challenging, bringing contacts and networks and basically adding value. The shareholder’s agreement was a mess and guess what? It was impossible to renegotiate as it was signed by xxx shareholders who could not give a damn about it to amend it! Good luck with that! (we had to go sign loads of side letters with the founders to basically recreate a small round with them only).

    Finally, the problem of entrepreneurship financing is not that VCs are stupid, or entrepeneurs are greedy, or anything close to that… It’s that there is too much money for a given number of quality opportunities per year. Valuations are regularly too high, entrepreneurs regularly raise too much money and the result is depressed returns.

    So crowdfunding is just the sign of yet another bubble which, by the way, will probably as soon as it burst keep the masses away from VC, start-ups and everything close to that for one or two generations.

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