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

[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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