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The VC Industry Is Too Fat and the Exits Are Too Thin

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[qi:115] The venture model is ailing, and folks in the industry are promoting two different diagnoses for the sickness. One group says the industry needs more exits and should promote the return of smaller initial public offerings, while the other says the industry has grown too big in terms of the money it raises and needs to shrink. Both are probably right, but I think firms adjusting for a smaller overall industry will be likelier to succeed.

NVCA: Will work for more exits
In the first camp is the National Venture Capital Association, which today offered a four-point plan designed to solve the problem of there being too few exits. The NVCA thinks there need to be more sub-$50 million initial public offerings, so it wants encourage those IPOs through two actions taken on the industry side and two requiring government help.

On the industry side, it wants more boutique investment banks and accounting firms involved in taking companies public, presumably because they are willing to take on smaller IPOs than larger firms. NVCA also wants to boost liquidity options for venture capital firms either in the public market or while keeping firms private.

To encourage liquidity on the public market through IPOs, venture firms may accept longer lock-in periods — holding on to their stock longer — and get banks to boost analyst coverage so companies with smaller market share still have information circulated about them from an independent source. These steps could reassure buyers that VC-backed IPOs are quality goods. For liquidity pre-IPO, VCs are calling for a secondary market with companies like SecondMarket and Xchange to connect buyers of private stock.

The other two pillars require the government to review and change regulations such as Sarbanes-Oxley and to offer better tax incentives by adjusting the capital gains tax and/or creating tax breaks for investors in IPOs.

More money, more problems
Among those in the latter camp is Fred Wilson, a principal with Union Square Ventures, who outlined what he dubs “The Venture Capital Math Problem.” With some back-of-the-envelope math, he calculates the current flow of money into the venture industry is depressing returns. His conclusion is that the venture industry doesn’t scale. Fred Wang, over at Trinity Ventures, shares this outlook, and he estimates that venture capital firms ought to raise $15 billion a year, rather than $25 billion.

Both camps are right, but the NVCA is facing an uphill battle in its attempts to solve the problem of fewer small IPOs. Given that this plan requires regulatory changes plus an overhaul of the venture ecosystem, it’s a lot more difficult and risky than adapting to a smaller overall venture pie. Sure, no one likes the idea of a smaller pie, but if returns continue to stagnate either because there’s too much money, or no liquidity, the limited partners who invest in venture capital will make the decision to pull their money anyhow.

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15 Responses to “The VC Industry Is Too Fat and the Exits Are Too Thin”

  1. This is starting to look like the Newspaper industry. IE.

    “old ways” -> the bigger the better, with limited pipes of distribution, where limited group of people decides
    “what is news”. -> and then those news are distributed to public audience.

    “new way” more channels to choose from, (blogs), more people deciding “whats news” and public selecting the channels they like to follow.

    Now. Please tell me what works better for you?

    Trust me when I say, that all models that are structured on top of limited channels/pipes, limited transparency and choices made by small group of people to cater to masses, will eventually disappear.

    It’s just time for VC industry to wake up and face it, something fundamentally different is needed… and that’s what we are doing at

  2. Actually, the costs of SOX compliance have dropped dramatically, as various vendors have entered the fray to help smaller businesses with the compliance piece. Far more problematic are the economics of the sell side investment banking model, which have been radically changed. The compression of regular way commission business and the proliferation of alternative trading venues for the buy side have rendered the traditional cash equities model obsolete. Since the commissions generated by large buy side clients flipping out of intentionally under priced IPOs and the ongoing flow of buy side commissions can no longer support the sell side research analysts/cheerleaders, the boutiques can no longer offer a credible underwriting option. At the same time, the larger banks cannot justify the relatively tiny fees that they receive on sub $100m IPOs.

  3. Regarding the eco-system,the genie is out of the bottle. It’s very hard to justify bringing companies to market sooner when you consider the post IPO bubble carnage. The venture capital model, with 10 year partnerships that lock both investors and managers into relationships that are out of synch with how long it takes to build an outstanding company will need to change. More thoughts here:

  4. How about both options?

    Longer lock-ins will only enable more abuse, as VCs will gin up mini-IPOs to unload dogs, then calculate their carry while distributing doomed, locked equity. By the time LPs liquidate, share values will have crashed, helping to speed the industry toward Option 2.

    Option 2 is inevitable anyway, as pension funds and endowments realize that it is stupid to give money to Joe’s House of Venture Capital and Tire Sales just to meet some theoretical asset allocation target, and as all investors raise their illiquidity premium. Unlike with other asset classes, it’s not worth investing with any but the top 25 or so funds, and the top funds tend to stay at the top of the pack. So probably half of all VCs will wink out after their current funds expire.

  5. primate

    Aren’t the accounting costs of SOX compliance too high to allow for $50mm IPO companies? Maybe we pay our accounting firms too much, but I thought that the minimum yearly revenue for a public company should be >$50mm in order to absorb SOX… Also, perhaps I’m just working in an industry where the profit margins aren’t high enough…

    • Stacey Higginbotham

      SOX is the biggest culprit behind the death of the sub-$50M IPO, but it’s not the only one. There’s also less coverage of small companies, which makes them less visible to potential buyers. Small public comapnies may also be too small to attract institutional fund buyers. A couple of years after SOX the idea seemed to be that you had to achieve a $100M market cap to be public and now it seems to be around $300M.

      • Yes, this coverage threshold should only increase as financial institutions cut analysts. There is some Indian company trying to commoditize analyst coverage, starting with corporate bond analysis. If they can do what they say, and find a sustainable business model, they’ll have a huge market opportunity as more and more equity issues go uncovered.