Why the Shrinking Venture Capital Market Matters

Editor's note: This is the second column in a new series that challenges commonly held myths about entrepreneurship.

Myth: The shrinking venture capital market will be replaced with another market.

Reality: These days, few venture capitalists are making good money. According to a recent study by Paul Kedrosky, a senior fellow at the Kauffman Foundation, the average financial return in the venture capital industry has been negative over the past nine years.

Successful exits from venture capital investments are now far below the level at which they once occurred. In the heyday of the late 1990s, for instance, venture capital-backed mergers and acquisitions were as much as 30% of the number of companies backed by VCs five years earlier, but in 2009, that number looks closer to 11%.

The numbers for initial public offerings are even worse. After achieving an IPO rate in the 1990s of 25% of the companies financed five years before, that rate fell to a paltry 0.3% in 2008.

Perhaps because of its poor performance over the past decade, the venture capital industry has been shrinking. Total capital under management (in real dollar terms), the number of active VC firms, and average fund size are down to levels last seen in the late 1990s.

Moreover, we may only be part way through the consolidation of the venture capital industry. Kedrosky predicts the industry will shrink an additional 50% from current levels.

A Flock of Angels Would Be Needed Does the poor performance and consolidation of the venture capital industry matter to anyone other than the VCs themselves and their investors? To some observers the answer is no. Because relatively few high-growth companies receive venture capital funding, these observers argue, we can have the same number of high-growth companies even if the venture capital industry shrinks substantially. Other sources of capital, "ranging from banks to angels," Kedrosky explains, can substitute for venture capital, providing startups with the funding they need.

Perhaps, but I don't think so. For a 50% reduction in venture capital not to affect entrepreneurs looking for money would require a lot of substitution by other capital sources. And there's little evidence that other sources can really substitute for venture capital investments, which are large and take the form of equity.

Last year's PricewaterhouseCoopers MoneyTree Report shows that the average venture capital deal size in 2008 was $7.4 million, virtually all of it taking the form of equity. Who else can provide companies with equity investments of roughly $7.4 million?

Kedrosky suggests angels can, but that's unlikely. As I report in my book Fool's Gold, the median angel investment in the U.S. is only $10,000 (the average is only $77,000).

Even the average investment by angel groups is small. According to the Angel Capital Assn., a trade association of angel groups, the average group investment is less than $250,000. At the average venture capital deal size, it would take close to 30 angel groups to replace a single VC deal. At this rate, replacing half of the 3,808 VC deals reported in 2008 would require an increase in the number of angel group deals by 57,000. That's a huge increase over the 947 angel group deals reported by the ACA in the U.S. in 2006.

Moreover, a lot of angel group investors make investments with the hope that VCs will follow on and make investments in the same companies at a later round. If VCs are cutting back on their investments, these types of angels would need to cut back as well.

Banks, Private Equity: Not True Substitutes Banks and other sources of debt financing, like trade financiers and credit-card companies, are also unlikely substitutes for venture capital. Because of the risk of investing in startup companies, it's not unusual for an early-stage venture capital firm to seek an internal rate of return in excess of 50% per year. Efforts to generate those rates of return through debt would violate usury laws.

Private equity companies have money, but they normally look for older companies in trouble or where they think sufficient value isn't being realized. They don't invest in enough young companies to substitute for venture capitalists.

The bottom line is the venture capital industry is performing poorly and is consolidating. According to the National Venture Capital Assn., there were 1,366 active funds in 2008, down from 1,883 in 2001. That decline should be troubling to entrepreneurs seeking to build high-potential businesses and the policymakers who have come to rely on venture capital-backed startups to generate wealth and create jobs.

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