VC Markets: No Easy Answers

The venture capital industry has been a slow-moving train wreck for much of the past decade. And one of the more radical steps aimed at avoiding disaster may only hasten it.

To recap, there's more money going in every year than can be invested properly, especially with Sarbanes-Oxley regulations discouraging smaller companies from going public. There are few areas of true high growth in the U.S., now that industries like chips and enterprise software have matured. And the recent Web 2.0 and clean tech darlings are not much help, either. Many Web companies don't need enough capital for VCs to take meaningful stakes, while the more ambitious clean tech gambits arguably need more capital than VCs can dole out.

I've long argued that a shakeout is inevitable. While some people claimed I was being hyperbolic, the disastrous returns of the past few quarters (following lackluster returns over the past nine years) validate my concerns.

Four-Point Plan Proposed The realization is spreading that VC is in dire need of a fix. The National Venture Capital Assn. has proposed a four-point plan. VC Fred Wilson is saying venture math is irreparably broken. Super-angel investor and entrepreneur Reid Hoffman has even proposed that government money prop up worried VCs and encourage them to start investing again.

Amid the handwringing, the drumbeat is growing louder for a new solution, the creation of a secondary market. This would let anyone holding a private stock to sell it for a fair market rate, without having to wait for an acquisition or an initial share sale. A secondary market essentially makes an illiquid stock liquid. Proponents say it would ease the venture-returns gridlock and get innovation flowing again. But it would also change the venture capital economy in some radical—and in my view, undesirable—ways.

To be clear, some of the changes would be good. I've long been in favor of so-called "partial liquidations" that allow founders to cash out part of their stakes. In August, Facebook started letting employees sell up to 20% of their stakes at a $4 billion valuation. Entrepreneurs working day and night to build their dreams should be allowed to cash out a tiny percentage of ownership.

Good Times Will Come Back But a full-fledged secondary market is a totally different matter. The lack of returns is a symptom of a larger disease that needs to be cured, not sidestepped. Put bluntly, VCs need to do better deals if they want better returns. The limited partners that park their funds in VC need to do the responsible thing and invest less in the asset class if they want the math to work again. Then good returns will come back.

Good idea or no, secondary markets will soon be put to the test, thanks to a new company appropriately called SecondaryMarket, as well as a handful of other players.

This may come as good news for VCs and entrepreneurs in the short term, I also see two big unintended consequences that aren't work the risk.

Valuations on Paper Only The first is for the buyers of these newly liquid securities. Haven't we learned enough about engineering new "creative" securities? There are protections and limits for who can invest in venture capital for a reason; when companies get overvalued and the market gets frothy, the damage is limited to founders and venture investors who have greater insight into the company's finances and are in the business of taking risk in the first place. At least theoretically, by the time of an initial public offering, the company is vetted enough that it can make a successful debut. The dot-com bubble was so disastrous in part because illiquid startups became liquid public before they were ready, and everyday people invested in companies that weren't mature.

By contrast, the collapse of more recent Web 2.0 valuations didn't have anywhere near as big an impact because it was contained amid professional VCs. Valuations were still essentially all on paper.

Sometimes markets need to take a hit. Because the industry moves so slowly and returns are measured over a multiyear horizon, the impact of the excesses of 1999-2000 is only now being played out. We need to let market forces correct overinvestment, not provide artificial means of putting off that correction further.

Motivated by Love, Not Money The second and more important concern is cultural. Silicon Valley has given rise to so many great companies in large part because of its culture of risk-taking. When you remove the risk from starting a company, you erode that culture and rob Silicon Valley of its greatest assets.

The culture has already changed dramatically over the last few decades as the venture industry has become bigger and more institutional. Entrepreneurs today rarely build full companies in garages. They no longer have to go into debt, take a second mortgage, or deplete their savings to build a company. If they have a good idea, there's more than enough angel funding and venture capital to go around, and there's a very set path for how you build that company out. That's already given rise to myriad poseurs who decide they want to be entrepreneurs first, then think about the actual company they're going to start second.

Sometimes that works. But most of the multibillion-dollar companies were started because a half-crazed founder couldn't get the concept out of his head—put another way, they were started for love, not money.

Shouldn't Be Any Guarantees But the secondary market takes this de-risking too far. There shouldn't be a guarantee that you can cash out, whether you're an entrepreneur or an investor.

There is a reason the best companies are built in downturns. Only the most die-hard entrepreneurs have the stomach to do business then. Some of the biggest successes of recent years—including Facebook, Six Apart, News Corp.'s (NWS) MySpace, Yahoo's (YHOO) Flickr, and Google's (GOOG) YouTube—were all started in the years after the dot-com bust, but before Web 2.0 became sexy. At the time, the very idea of funding consumer Internet companies again seemed foolhardy.

Wilson and others point to successes in the ad hoc secondary market; it already exists, so why not take pains to make it better, or so the argument runs. That it has worked for a handful of companies that are doing well hardly justifies unleashing this Pandora's box on thousands of startups with far more uncertain futures.

Feel the Pain I sympathize with VC and startup boosters who argue a decade of little to no liquidity brought on by poorly drafted Sarbanes-Oxley legislation and the excesses of Wall Street has unfairly punished entrepreneurs and robbed the marketplace of innovation.

I'll go further and say it may have denied our next-generation mass employers and billion-dollar powerhouses too. The fact is, many companies solve IPO challenges by selling too early. But VC shouldn't follow the example of other industries in this bailout-happy, quick-fix economy. Venture capitalists should incur their share of pain while market forces are allowed to do their work.

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