I have been catching up on some data and news stories about the beleagured venture capital industry. A continuing shakeout in the industry means that fewer venture-capital firms are in the market with less money, meaning tougher terms for startups. Unfortunately, it doesn’t look like this will change any time soon unless we get some gigantic IPOs to pay back all the funds.
Yes, you can read some success stories about M&A and wins from a few of the major, top-tier firms. But that’s just a small percentage of the industry. In sum total, most venture capital funds have had crappy performance over the last 10 years and many of them are shutting down. According to this Wall Street Journal article, the number of venture-capital firms shrunk from 1,023 to 794 from 2005 to 2009. And they’re raising less money. 125 venture funds in the U.S. collected $13.6 billion last year, down from 203 funds that raised $28.7 billion in 2008, according to the Journal.
Why the lack of enthusiasm for the industry? Exits. And for big exits, you need big IPOs. As the chart below has shown the dead markets mean we’ve been in an IPO draught for 2 years. If the market can continue to rally, you will see an increase in IPOs in 2010. But I am skeptical that you can get back to the healthy levels of 2006-2007 in the next year. I think it’s going to take much longer.
That doesn’t mean it’s necessarily a bad time to be an entrepreneur or for a startup. There’s less competition, and stuff is cheap. It just means it’s harder to get venture capital money. Venture capital can be a perverse business. So much money and energy piled into the space during the tech bubble that the investors had no hope of making their money back. The flood of money pushed valuations into the stratosphere and meant that all of the little, “me-too” firms that sprung up were, in theory, pumping dumb money into startups at the top of the market.
Now, of course, the tech bubble was 10 years ago. But because venture-capital funds have such a long time horizon — five or six years in many cases — the unwinding of this industry is taking longer than it would take, say, in the stock market. The underperformers are being flushed out very, very slowly.
So what does it mean going forward? Well, unless the M&A market roars back or the IPO market blossoms in 2010, this trend will continue. We’ll see fewer VC firms in the next 1-3 years. And they will have less money. Which will make them even more prickly with entrepreneurs.
Of course, I’m not saying this is good for the economy: Venture capital is actually great for the economy because it encourages risk-taking and moves capital toward some of the world’s most creative entrepreneurs. But sometimes you can’t overcome structural problems.
Unfortunately, the money in the VC market isn’t much different than the stock market: Investors are overeager when valuations are high, and they are reticent when times are tough. That’s why I think right now might be exactly the time to be betting on startups! They’re having a hell of a time raising money. The problem is not bad ideas, it’s bad industry dynamics and sentiment in the venuture-capital industry itself.