Venture Capital's Hidden Calamity

A closer look at otherwise strong investment growth shows many firms are getting all the drawbacks of a hot market, with few of the benefits

This is a bad time to be a venture capitalist. Anyone who says different is raising a new fund—or works at one of the few firms having a good year.

Sure, the numbers look great on the surface. The value of deals rose a solid, yet not bubbly, 8% in the second quarter, with investors pumping $7.4 billion into emerging companies, according to Dow Jones VentureOne. And the money is funding some legitimately exciting frontiers, including Web 2.0, which attracted $500 million in the first half. Companies specializing in clean tech got $1.1 billion in the same period.

Initial public offerings are up for the year, too. In the second quarter, venture-backed companies tapped the public markets for $2.73 billion, the most raised in a three-month period since the go-go days of 2000. And researchers expect the current period to be another banner quarter, with a whopping 46 companies looking to file.

IPOs and Acquisitions Tell a Different Story

But a closer look at the numbers reveals some disturbing trends. Consider IPOs. Most of the initial share sales getting done are mainly one-off companies that were founded years ago and have slogged away at building solid businesses for a half-decade or more. This year's biggest hits were MetroPCS (PCS) of Dallas and EMC's (EMC) spin-out of VMware (VMW)—hardly your classic Silicon Valley startups. There's simply no big overall tech movement getting Wall Street revved up, and among entrepreneurs, the feeling is mutual. Sarbanes Oxley and other regulations have made the prospect of going public far less appealing.

The picture looks worse among acquisitions. Sure, the usually sleepy third quarter saw $10 billion come in acquisition proceeds, but that was spread among 90 deals. Companies like TellMe, the voice recognition software company founded in the late 1990s that snagged $800 million from Microsoft (MSFT), are in the minority this year. Far more common is the tech company that plodded along for more than six years, chewing through some $30 million in venture cash to eventually get bought for $50 million or so. Indeed, the median length of time it took companies to get bought was the longest Dow Jones VentureOne has seen since it started measuring the industry 20 years ago. Meanwhile, valuations keep rising, as billions of dollars in VCs’ coffers fight to get in what few great companies are out there.

Upheaval Ahead

It's not that venture firms are destitute. They've got plenty of base hits. But the home runs are increasingly elusive. And venture capital is a home-run business, where the top 10% firms make up nearly 80% of the returns.

Internally, many investors are worried that only a handful of firms will break even on the current crop of funds, much less post stellar returns. In hushed conversations over breakfasts at Buck's and lunches at the Sundeck, VC veterans are wondering aloud whether they should get out, or, after years of playing boardroom quarterback, whether they've still got the chops to actually build a startup.

However you slice it, unless something changes, venture capital is in for upheaval. Some venture capitalists are going to find themselves out of a job. Overall, the industry may become more the font of outsourced research and development for big firms and less the breeding ground for the next great tech powerhouse. And returns will be lackluster for the majority of firms left out of the best deals.

Smaller Stakes

The current calamity has been a long time in the making. After the NASDAQ party ended, firms learned the hard way that you could no longer take companies from idea to public in 18 months. Not only is it a business of building companies, it's a business about people, gut calls, and the art of building a portfolio one deal at a time. That's why scores of firms that had raised $1 billion-plus funds wound up returning hundreds of millions in uninvested money back in the early '00s.

But even as many firms were voluntarily downsizing, those investing in the venture industry as a whole—the world's largest pension funds and institutions—only wanted to invest in venture firms more. Money wanted to get into a shrinking business, giving marginal firms another shot and keeping any Darwinian shakeout at bay. "Venture capitalists are still living in 1999," says Peter Thiel, former PayPal Chief executive and founder of hedge fund Clarium Capital and venture fund The Founders Fund.

The fallout is still being felt, even in what are considered hot sectors. Take Web 2.0, where exactly one company, YouTube, had a $1 billion-plus outcome when it was purchased by Google (GOOG). Only a handful has sold in the hundreds of millions. And because the costs of starting these businesses are so low, venture investors own smaller stakes than they did in the last Web bubble.

Paper Gains

Clean-tech companies have seen a few exits, with two IPOs this year and three in registration. Still, the deals have been small. Most of the Clean-tech market is still experimental, in both technology and market opportunity.

Meanwhile, venture investors are paying more to get into the best deals. A recent study by Valley law firm Fenwick & West showed that valuations are on the rise. Valuations are an important barometer of who holds more power at any given point in the Silicon Valley economic cycle. The higher a valuation, the fewer shares a VC's dollar buys, and the more leverage entrepreneurs have.

High valuations aren't all bad news for the venture set. Step-ups in valuations between rounds, for instance, mean that on paper, early-stage investors are showing gains. But so far, that's just on paper. Typically, valuations are driven up by the prospect of a big acquisition or IPO. Now, they're mostly being driven up by the piles of money looking for the next hot deal. Venture investors are getting all the drawbacks of a hot market, with competition to get in on deals and high prices, without the benefits—a rash of blockbuster IPOs and acquisitions.

Oodles of Cash

Heading into this year, a study by the National Venture Capital Assn. found that almost half of venture investors surveyed predicted a decrease in the number of VC firms even as returns improve overall. "The pundits were correct about the reduction in venture capital firms—they were just a few years too early," Mark Heesen, head of the NVCA, said at the time of the survey.

Indeed, other studies have shown that terms between venture guys and their investors are getting harsher, as limited partners increasingly demand lower management fees and so-called "key man" provisions, which give investors an out if certain rock-star partners leave a firm. The most staggering example of the tension was the recent news of Yale getting kicked out of top Valley firm Sequoia Capital's newest fund after refusing to invest in the firm's less-proven overseas and late-stage funds.

There is a bright side. With so much cash floating around the Valley, entrepreneurs have never had it so good. Sure, a lot of dumb ideas are getting funded, but nearly any great idea has a good chance of getting funded, too. There is likely a trove of new experiments being started on the sly. And ultimately, VCs will fund these deals, and that top 10% will continue to have huge hits with returns that the NASDAQ, bond markets, and even buyout firms can't match.

The question is, in an industry that has gotten this big and this bloated, how long do the other 90% and their investors keep hoping for the next winning lottery ticket?

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