Paul Kedrosky just did a new report for the Kauffman Foundation entitled “Right-Sizing the U.S. Venture Capital Industry.” Paul’s main point—the VC industry needs to shrink to match the pool of opportunities:
It seems inevitable that venture capital must shrink considerably. While there is no question that venture capital can facilitate some forms of high-growth entrepreneurial firms, its poor returns make the asset class uncompetitive and at risk of very large declines in capital commitments as investors flee this underperforming asset. While any estimate is subject to much uncertainty, it seems reasonable—based on returns, GDP, and exits—to expect the pace of investing to shrink by half in the coming years. We should also expect a continuing sharp decline in the amount of money invested in information technology, a maturing sector with declining capital requirements in its remaining innovative segments. Capital will continue to grow in other areas, including clean technology, but the sector must shrink its way back to health if venture capital is to provide competitive returns and secure its own future as a credible asset class and economic force.
Paul (who runs the immensely successful Infectious Greed blog) points out, quite correctly, that
ten-year venture performance will almost certainly turn negative at the end of this year when the bubble venture exits of 1999 are excluded. As a result, the venture industry’s current returns are already challenged and set to become considerably worse.
The question is why. Paul gives several reasons, including:
the venture business itself might be structurally flawed, with the core markets that made it successful—information technology and telecommunications—now mature and delivering sub-standard returns, while new venture-ready markets have not emerged.
I would go even further. I think the disastrous ten-year stretch for venture capital closely reflects the innovation shortfall. The VCs did precisely what they were supposed to: Invest in high-risk technologies which were supposed to pay off in the 5-7 year time window, such as biotech, MEMs, fuel cells, and so forth. Unfortunately, they ran into a giant negative coin flip—everything was delayed a lot longer than they expected. Thus all the money-eating startups, and the general reluctance of VCs to stick their neck out.
But this explanation for the VC lost decade opens up another question: Do we need less venture capital, as Paul suggests, or do we need more? Or do we need another type of innovation funding, better suited for businesses which still need to do a lot of cutting-edge research?
“Venture capital never designed to take a company ten years into the future,” Gary Pisano of Harvard Business School told me a few weeks ago. Pisano makes a distinction between engineering-oriented high tech, like information technology, and science-oriented high tech, like biotech. Venture capital works well for the first type, because the difficult science has already been done and the time to market may be a few years. But biotech companies are still doing research, with a much longer time to market.
Pisano suggests that we set up the equivalent of a minor league for public companies, like the NASDAQ used to be before it got big. “It’s almost as if we need a quasi-public equity market which is regulated differently,” says Pisano.
Not an easy question.