by Michael S. Malone
Is the venture capital model “broken”?
If so, heaven help us. Because if it is, the recession we’re sliding into will prove to be even deeper and darker than we imagine.
Venture capital’s troubles have become a popular subject of conversation in recent weeks, not least because of the recent announcement that so far in 2008 only six venture-backed companies had managed to “go public” with their first sale of stock. That compares with 86 a year ago, and 265 during 2000, the last dot-com bubble year.
The venture-capital industry has been in trouble for most of this new century, never achieving more than a fraction of its success of the ’90s. But this new figure — and it is unlikely to improve by even a single IPO between now and year’s end — is devastating. And has led to growing speculation that the venture-capital industry, once the pride of American entrepreneurialism, may have reached a tipping point on the way to oblivion
The two most recent advocates of this pessimistic perspective are the Web site VentureBeat, run by the former venture capital industry beat reporter for the San Jose Mercury-News, Matt Marshall, and TheFunded, a site to rate venture capitalists, run by Adeo Ressi.
Ressi apparently stunned, and angered, an audience at Harvard Business School recently with a slide show, “The Canarie is Dead” (see it here), that (bad spelling aside) argued that something is fundamentally wrong … perhaps fatally wrong with the venture-capital industry.
The HBS audience was stunned because Ressi finally said publicly what many in the audience had probably been thinking, and was angered because he claimed one of the causes of the VC’s predicament was the “Old Boy” network that the Harvard Business School specializes in.
Still, there was one devastating slide in Ressi’s presentation that no one could refute. It showed that for the first time in the half-century history of high-tech venture capital, two curves had crossed … and now VCs were taking in more money from investors than they were returning to them. Venture Capital, the jewel of American finance, the dynamo behind the high-tech revolution, had now, shockingly, become a loss leader.
Pretty scary stuff.
Now it was VentureBeat’s turn. Wednesday, Marshall published a story that put it in the simplest terms: “The VC Model is Broken,” the headline read. And although he didn’t agree with many of Ressi’s premises (neither do I), he did agree with the conclusions, and was prepared to take them even further.
Marshall offered three reasons for Venture Capital’s current woes:
1. Early VC successes — Companies like Intel, Cisco and Genentech were so hugely successful that they drew huge sums of money from investors around the world anxious to get into the VC game . . . over-stressing what should have remained a niche industry.
2. Established companies have gotten smarter — Firms like Google and Microsoft snatch up hot new startups before they can become serious competitors, taking them off the market before they go public.
3. “Greed. Pure and simple.” — Those are Marshall’s words, and by them he means that VCs have continued to raise ever-larger funds, even in the face of low returns, because the administrative fees are a major source of revenues to their own firms.
This all sounds reasonable, but I think that Marshall, surprisingly, has it exactly backward. Perhaps it’s because he hasn’t been around long enough to see an earlier slowdown in the Venture Capital industry — and, thus, has no standard by which to compare the current one.
Sure, venture capitalists are greedy — but they always have been. It’s greed that makes them try to make investments with the greatest possible return (and, unfortunately, also makes them sometimes run in blind herds). And, yeah, big companies have gotten smarter about their mergers and acquisitions. But the main reason they are able to snatch up hot young start-ups is because those young firms cface no real alternative but to get bought.
That’s why every business plan in Silicon Valley seems to end with the phrase, “And then we sell to Google.”
What Ressi and Marshall see as a structural failure is, in fact, the result of external forces largely beyond the control of the venture-capital industry. What these two gentlemen don’t realize is that we have seen this happen once before.
During the late ’70s and early ’80s, venture capital in Silicon Valley was also largely frozen. New companies weren’t getting funded and few were able to go public.
Why? One answer was that the VC firms had grown so quickly in the years — and had responded with rapid hiring — that many of the partners and associates were now out of their depth and doing a lousy job of advising the companies in their portfolio. Another reason was that the then-current crop of new companies weren’t that interesting (which would change a few years later with the rise of the Internet).
But the real reason, as I discovered at the time, was that the high capital-gains rate was keeping investors out of VC funds, which, in turn, made venture capitalists more conservative with their investments. When President Reagan cut the cap-gains rate, we had the greatest new business boom in history.
I believe we are seeing the same thing now. We are looking at the current crisis in Venture Capital and assuming that it is self-inflicted. But the more likely reason is that the industry has taken so many external shocks in the past seven years — Sarbanes-Oxley (which has killed new IPOs because of its onerous costs to young companies), full disclosure laws (which have driven smart people away from serving on corporate boards), and options expensing (which has all but erased the prime motive for people to join new start-ups) — that it can’t help but be in bad shape, a once-robust industry reduced to a sick, shrunken shell. [And now, of course, there’s talk of raising the capital-gains tax rate again, which will be the final nail in the coffin of venture capital.]
In their blind frenzy to punish perceived evil-doers of the dot.com bubble seven years ago, government regulators and boards have taken the most efficient new company and wealth-creation process ever devised and set up roadblocks all along its path.
And the biggest roadblock of all is that they have taken away the all-important liquidation event — the IPO — to which VCs, their investors and their companies aspired. With that gone, these players have no choice but to opt for the earlier, and lesser, liquidation event of acquisition.
But if Ressi and Marshall have the causes wrong, they’re dead-on about the consequences. Kill the venture-capital industry and you kill most new company creation (angel investors and corporate capital won’t adequately fill the vacuum). Kill new company creation and you starve the single most important source in the economy for new wealth and new job creation.
And if that new wealth and those new jobs disappear, how are we ever going to cover the credit crunch and pay for all of the new social services promised by Congress and the new president-elect? For that matter, how are we ever going to get out of this global recession?