Don't Blame Venture Woes on the Economy; It's the VCs' Fault

After a period of “looking inward,” venture firms are ready to start putting money to work during the second half of this year, according to Terry McGuire. The co-founder and managing general partner at Polaris Venture Partners spoke on a conference call today detailing the state of the global venture capital industry — a state that isn’t rosy, even if the folks on the call tried hard to avoid saying that. The call, sponsored by the National Venture Capital Association and Deloitte, highlighted a survey of 725 venture capitalists around the world that determined that the economic downturn has made Asia a more attractive market for venture firms, and that larger venture firms are more likely to focus on late-stage investing and decrease their investments in new companies overall.

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In a series of charts, Mark Heesen, president of the NVCA, showed how now is a terrible time for early-stage companies looking for venture capital. The presentation also made me wonder if greed and complacency have broken the industry by allowing too much capital to flow into it. Generally, the larger and more established the firm, the less interest it had in early stage investing, partially because larger firms have a large portfolio of existing companies to deal with, but also because it’s easier in tough times to make safer investments in more established companies. However, early stage investments are where the big returns are, so it’s hard to believe that firms that abandon that for any length of time will be able to weather the bigger changes buffeting the industry.

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Plus, since it’s the larger firms that are proving to be less agile, it seems obvious that venture investing doesn’t scale well (a point made by Heesen in the call). So why did some VCs turn into such lumbering giants ill-suited to adapting to risk and economic change? Greed played a role as new money poured into funds run by these firms during, and even after, the dot-com boom. The more money under management, the more a venture capital firm earns in fees. The world of startup investing has also changed in the last few years, and several firms either missed it or just decided not to adapt to it.

Companies could be started for less and sold more quickly — but also for less money. As it became tougher to take companies public and deliver outsized returns, some VCs started thinking about how to deliver decent returns even if the IPO market never returned to previous highs. Some, such as First Round Capital and Union Square Ventures, raised smaller funds. Others couldn’t figure it out. When I talked to partners at Sevin Rosen back in 2006 about its future, they couldn’t see where to put large amounts of money and make great returns. So they decided to quit raising another fund — effectively shutting down a venerable player in the industry.

But many in the industry kept going along with huge funds and expectations that the venture investing would return to a level of normal that preceded the bubble. And they’re willing to ask the government to help make it happen. They latched onto clean technology as an industry that would require access to their large capital base and would deliver huge returns. It might, but the fact that 63 percent of VCs are planning to increase their investment in cleantech, while substantially decreasing investments in other sectors, makes me think of several thousand people on a sinking ship rushing to grab a place on 10 lifeboats. That kind of group-think isn’t going to get LPs excited about investing, and it certainly isn’t going to boost returns.

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