Is the Venture Capital Business Broken?

This past summer we surveyed over 1,000 venture capitalists, and asked them a simple yes or no question: “Is the Venture Capital Business Broken?” Over 53% of the respondents said “yes.” This triggered a lot of conversation in the blogosphere and in the VC community.

It got me thinking about what exactly is going on and made me want to do a deeper dive. As a result, late in the fourth quarter I reached out to 50 general partners of venture funds across the country in Silicon Valley, Austin, Dallas, Tysons Corner, New York and Boston to gauge their sentiments about the state of the venture business.

Not surprisingly, a wide-range of insights and comments resulted from those conversations. I started those dicussions by asking: “How does the venture business look on January 1, 2010, when the industry can no longer drag around the 1999 returns in a trailing 10 year average?” The best response I received was that on that date that the industry would go to a 12-year trailing average!

In no particular order here are some of the interesting responses:

1. Building great companies vs. building products that can be sold. There seems to be an ongoing debate about whether or not venture capitalists should be trying to build great companies or build products that can be sold. This tended to be somewhat of a regional phenomenon, where VCs on the West Coast talk more about building great companies and VCs on the East Coast talked about the realities of having to manage their portfolio which forced them to build products rather than companies; investing $5M to get something to $20M of revenue and hoping to sell it for $100M. The West Coast guys talked about “swinging for the fences and building the next Apple, Google, or eBay”.

2. M&A over IPO. The pipeline for money going in and coming out clearly has challenges. It is very difficult after the economic meltdown we have had for a pension fund, a fund-of-funds or an endowment to make a commitment to the “asset class” of venture capital. Public equities have been relatively cheap for some period of time and offer immediate liquidity, something not available in a venture capital partnership and returns have been weak. So there will be less money going into the system; no surprise here. Because it takes longer to get money out of the system, the overwhelming majority of venture capitalists that I spoke to felt that M&A would be the inevitable outcome rather than an IPO. Exits in early 2010 will be critical for fundraising to start later in the year.

3. Resistance to innovation. I heard a lot about and agree with the premise that innovation capital is vital to our economy. Start-ups create more jobs in America than anything else and we need the innovation machine that the venture capital industry represents. Although in one conversation, one of the partners shared with me an ironic observation – he works in an industry that preaches innovation and it is all about creating new businesses and investing in new ideas, but the venture industry itself – doesn’t want to change! It is barely a 30 year old industry but slow to change, almost institutional in its view of itself as it relates to structure, fees, compensation, succession planning, etc.

4. Size of funds will decrease. Several venture capitalists talked about that when funds do get raised they will be smaller, which is not a surprise. But I was surprised at how small! They felt the ideal size fund to invest in early stage technology ventures was probably less than $150M with only three or four really good investing partners and limited or no leverage – a hands-on model. The days of 12+ guys around the table trying to put $1B into the system won’t work.

5. Industry in need of a major reset. Another topic that seemed to get uniform agreement was that the industry is going to have to go through a major “reset”. If there were 800 firms two years ago doing early stage tech investing it would not surprise this group if there might only be 400 firms two years from now.

6. Trend toward pay-for-performance. Surprisingly, a lot of the venture capitalists felt that the compensation that they earned needed to be aligned more with results. While the size of funds has been large and the management fees have provided significant ordinary income, several of the venture capitalists felt that it is was too much relative to the amount of work that they actually do!

7. Return to apprenticeship model. I heard a bit about returning to the apprenticeship model that historically was the way that a venture capitalist was developed. Bring in bright young talented people out of the university, marry them up to a senior person and inculcate them with values and hands-on experience that results in a good investor in seven years versus the direct entry hiring that we saw at the top of the bubble, when the money had to be moved and put to work faster.

8. Increasing fund raising internationally. On the topic of fund raising, interestingly, I received several comments that “there is always new money out there and that American venture capital is viewed as a status symbol by the newly wealthy in other parts of the world”. Fund raising will likely move to other parts of the world where new family money is created as billionaires produce goods and services in low labor cost geographies.

9. Concern over strength of syndicates. I heard a healthy degree of cynicism or concern about the strength of syndicates and venture guys are being very careful about who they invest with. They are inclined not to take new people into a deal preferring the safety of “familiarity” over working with strangers. They are also looking at how strong the partnerships are and which specific partner within the firm looks like he has longevity and will be with the organization for several funds.

10. Age gap. I found an interesting age issue in that many of the older venture capitalists, meaning 50 or older have very different views than the guys in their 30s. The guys in their 50’s want it be like it was 10 years ago and the guys in their 30’s are disappointed that the great promises of success and wealth have not developed and here they are 10 years later working hard without the great wealth creation they hoped for, albeit though well paid. The young guys want change and they want it now.

11. Pockets of optimism. I found many pockets of optimism. A belief that the right-sizing of the industry is good and that innovation and investing will continue to create businesses and jobs. Those opportunities will come in areas aligned with the obvious: health-care technology, environmental improvements in conservation/renewables/efficiency, tech-enabled services, consumer, mobility, and gaming.

All of the venture capitalists like and want to keep their jobs. All of them were promised anonymity in exchange for frankness of their conversations with me.

So my conclusion is that while the survey may have said 53% felt that the industry was broken, I know it had a lot to do with the timing of the survey in mid Q2 2009 and the self-selection nature of those who chose to respond.

I have been and will continue to be optimistic about the future of venture capital as a profession and more importantly about the benefits of investing in innovation: job creation, problem solving, wealth creation for founders and investors and maintaining our competitive position in the ever-increasingly smaller global economy.

Here’s to a great 2010!

Charley Polachi is founder of Polachi & Co., a provider of executive search services to high-tech companies and their investors. You can read his past peHUB posts here