The VC Market: An Adaptive System

To most, the world of venture capital appears to be in the midst of chaos. Poor 10-year returns. Many bloated GPs. The super angel/micro VC “phenomenon” (if it can be called that). Rumors of collusion. A largely closed IPO market. Stock market uncertainty. An uncertain regulatory climate. And on and on. A crazy time to be a venture capitalist, right? Well…

I contend that venture capital, like every other asset class, moves in cycles. It’s only that most of our perspectives are so short that we tend to lose sight of the fact that what appears to be “historic” is, well, ordinary when viewed through a longitudinal prism. But as is the case with self-correcting systems, it will, in fact, correct (and likely overshoot as trend-shifts generally do).

Poor 10-year returns make raising funds more difficult as LPs get skittish. This is both a function of most institutions looking in the rear-view mirror as it relates to asset allocation and the PR risks of maintaining large exposures to a current downtrodden asset class. This is exacerbated by the liquidity problems of many institutions who over-weighted alternatives without really modeling cash needs in an Armageddon scenario (like the one we had). The data bears this out. As capital flows out of the asset class (notwithstanding all the hubbub about angel financing), those with the intestinal fortitude and the discipline to stay in the game have the opportunity to enjoy out-sized returns. So to be in the game now with dry powder is a good place to be if your investment selection is good and you possess the ability to maintain and perhaps increase ownership over time.

The class of large, unwieldy VCs who raised funds I-III during heady times and are now trying to raise fund IV without a history of exits will get flushed out. Some may try and re-tool to be able to invest in seed stage deals, but poor legacy performance will render them toothless in today’s super competitive fund-raising world. If you’re Foundry, USV or First Round Capital, you can snap your fingers and existing LPs will re-up – and perhaps compete for additional capacity (it is interesting to note that these three firms have applied strict discipline to avoid becoming too big and balky). For others, well, it will be a tougher if not impossible slog. And this is ok. Performers will attract assets for fresh funds and laggards who grew fat during the easy-money days will be disbanded.

The emergence of the super angel/micro VC segment of venture is really not that big a deal. Btw, if you run LP money you are a VC, not an angel. The super angel moniker simply makes no sense. I was an angel investor for five years and have been a VC for almost one. VCs have fiduciary responsibilities as it relates to due diligence, portfolio management, record-keeping, Board seats, etc. Not a trifling matter. These new small VCs are generally leveraging the cheap costs of compute and storage to inexpensively test ideas and validate business hypotheses. This is something truly new that has evolved rapidly over the past five years. But its effect on the venture investment landscape has been blown totally out of proportion. While the cost to validate/invalidate nascent businesses has without question plummeted, the cost to build out and scale these businesses are as high as ever. Twitter. Facebook. Zynga. Etsy. It doesn’t matter. Most successful web businesses take substantial amounts of capital to grow, and it is a total myth that VCs as capital providers and business builders are obsolete. In fact, they are more necessary than ever as deal velocity has increased as more successful ideas can be validated at a more rapid rate.

AngelGate barely warrants mention. Seed-stage venture capital is neither a duopoly nor an oligopoly. No two firms – nor 20 firms, for that matter – have enough market power to influence who gets what deal at what price and at what terms. Capital is fungible. Excellent investors exist well outside the confines of Silicon Valley, ready, willing and able to compete with the Valley for the plum deals. If deal prices and structures have truly gotten too heady, then it will be so not only in the Valley but in NYC, Boston, London and elsewhere, and prices and structures will be adjusted. It’s as simple as that. The collusion argument is a red herring, and defensiveness around the issue is unnecessary. What irks me is hearing that certain early-stage investors whom I know and respect are now spooked to be seen in a group with other early-stage investors because of perceptions of collusion. It is time to bring back rational thought and reason to the dialogue and stop all this inane and theoretically (and practically) irrational talk.

The difficult IPO environment has certainly cast a pall upon the industry, but I’ve recently seen signs of innovation and practice that are helping the path to liquidity: the rise of secondary markets in privately-held businesses and the appetite of growth equity firms to provide capital not only for growth but to partially cash out founders and early investors. Are either of these a substitute for a robust IPO market? No. But they can certainly help bridge the gap between where we are today and what a healthy venture-backed IPO market might look like. Most importantly, this avenue can help get founders a measure of liquidity that will enable them to have peace-of-mind (kids education and house paid for, etc.) and go FTW. And isn’t that what we venture investors want, anyway? Rational exit decisions based not on fear but on exit environment, exit multiples and the probability of achieving key business milestones?

The challenging environment in the “real economy” certainly impacts the perception of venture risk. But the small amount of capital required to validate many ideas together with the cost saving/revenue enhancing nature of many start-ups places the venture economy on a materially different plane than the real economy, at least in the short run. The early-stage venture investing environment has been very robust notwithstanding the public-market headwinds. This performance has been even more impressive in light of the uncertain regulatory environment (Accredited Investor rules, tax treatment of carried interest, etc.). Bottom line, the NPV of future cash flows are perceived to be more valuable than the drag of both the public markets and potential SEC and tax policies enacted by Congress. If this isn’t incredibly validating of today’s early-stage venture environment I don’t know what else to say.

Venture capital is alive and well in Q4 2010. It’s not without its challenges but it is active, thriving and creating jobs every day. We are in a complicated time in the VC industry’s evolution, but it is merely a cyclical phenomenon. None of the issues present today are unique to the industry: they’ve been seen before. It is time we moved beyond the “This has never happened before” phase towards the “Let’s make the most of this environment and make money for our LPs and ourselves.” Because the time is right and we owe our LPs this measure of focus, passion and stewardship.

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