Editors Note: Jim Verdonik is a principal in the Research Triangle Park law firm of Daniels Daniels & Verdonik, P.A.Remember the Good Old Days of venture capital . . . before there was too much venture capital?
No, I’m not crazy.
Yes, I know it’s difficult to raise venture capital.
That doesn’t change the fact that our biggest problem with venture capital is there is too much of it.
Believe it or not, too much venture capital money is worse than not enough. Shortages can be eliminated much more quickly than surpluses. It’s generally easier to raise more money than it is to turn down money.
Bear with me and I’ll explain.
A little historical perspective is useful.
What were the “good old days” of venture capital?
No, it wasn’t the Internet bubble days, when VCs were throwing money at companies as fast as they could.
It was before the middle 1990s, when venture capital first made the leap from being a cottage industry to an integral part of the national financial industry.
Yes, venture capital industry as we know it today, really is only about 10 years old.
I know. Some VC groups have been around for over 30 years. The industry didn’t just pop up ten years ago, but in the mid-1990s major structural changes occurred.
Major Changes to VC industry
What was the biggest change to venture capital during the 1990s? That’s easy to answer: the size of the industry. In part, there were more venture funds, but that was a relatively minor change. More importantly, the average amount of capital VC funds raised increased substantially. This growth didn’t merely produce a bigger version of the same thing. Instead, it substantially changed the nature of the industry.
While the increase in average amount of funds under management appears to be permanentm, there has been substantial consolidation in the VC industry, resulting in a decrease in the number of active funds–but the amount of money the surviving VC funds manage remains high.
Why is the average amount of capital under management a more significant trend than the increase in the number of venture funds? Because it drives the investment decisions VC funds make.
Let’s take another look at the Internet bubble as an example of how this works. VC funds, swollen with dollars to invest, were putting $10 million, $20 million or more into companies with no revenue, no intellectual property and no commercialization plan other than “Build it and they will come.”
Much of the discussion by analysts about the reasons for the Internet bubble focuses on the exciting nature of the Internet and the great opportunity it seemed to offer. Under this analysis, the bubble was driven primarily by VCs falling in love with a new sector and not seeing its dangers.
While that is true in some cases, it is no coincidence that large investments started flowing so freely into very early-stage companies only after the amounts of capital managed by VCs substantially increased during the mid-1990s.
Was the bubble driven by the blindness of VCs to the risks of investing in companies with so little intellectual capital or operating experience, or was that blindness driven by the sudden pressure on VCs to invest more money for high returns, because they were managing so much more money than they had ever managed before?
My bet is that the increase in capital to invest was the driving factor and the initial lure of the Internet was only the scene of the accident. All that money had to be invested somewhere. The Internet happened to be there at the right time for VCs to find a place to invest large amounts of money.
The lesson VCs have taken from the Internet bubble is that investing large amounts in very early-stage companies is dangerous. Fair enough, but VCs always knew that. They didn’t develop a case of collective amnesia about the risks of giving too much capital to very early-stage companies until the late 1990s, after their supply of capital had increased substantially.
So, are VCs managing less money these days? In a word, “no.”
Yes, some VCs made headlines by terminating the capital call obligations of some of their investors. On the whole, however, the average amount managed by VCs is still substantially higher than in past decades. Given the choice between (1) downsizing the size of their funds and investing smaller amounts in early-stage companies or (2) having lager funds and investing more money in later-stage companies, VCs generally have chosen to have larger funds and invest more money at a later stage.
So, why did VCs suddenly get so much more money in the 1990s? One primary reason is that money managers at pension funds, insurance companies and other financial institutions with the really big bucks to invest changed their asset allocation formulas to require investing a certain percentage of their money in venture capital. The percentage is relatively small, but a single institutional investor may have tens of billions of dollars to invest. Five percent of that amount is a very big number.
It took a long time for many institutional investors to build venture capital into their normal asset allocation strategies. It will probably take a long time for them to change their asset allocations to substantially reduce the amount allocated to venture capital.
Will the big money managers invest smaller amounts in each venture capital fund? Probably not.
The people who manage ten of billions of dollars of capital need to do it efficiently by investing it in big chunks. They have the same problem large VC funds have, except their time management problems are even bigger. They can’t efficiently identify and manage small investments in hundreds of VC funds.
What does this mean for the venture capital industry and companies seeking to raise venture capital in the future?
(1) Early-stage companies that don’t need, and can’t efficiently deploy, 10 or 20 million dollars of capital will continue to have substantial difficulty raising venture capital. Large VC funds cannot invest small amounts at the time these companies most need capital, because it’s not an efficient use of the VC’s time. It takes at least twice as much time for a VC to manage a $1 million investment in an early-stage company than a $10 million investment in a later-stage company.
(2) Later-stage companies seeking large amounts of capital are going to be in a much better bargaining position than in the past. VCs are creating a future shortage of later-stage companies, because they are investing in fewer early-stage companies. There are fewer early-stage companies in the pipeline, but later-stage VCs still have piles of money to invest. Over the next few years, therefore, more and more money will be chasing fewer and fewer later-stage companies. Valuations for later stage companies should increase as a result.
(3) Returns on investments by the many later-stage venture funds will decrease compared to historic rates of return, because VCs will be paying higher prices for investments in later-stage companies. This will be partially off-set by higher valuations when VCs exit portfolio companies on IPO or sale, because the number of good VC-backed companies will have decreased, thereby creating more interest by purchasers and public markets in those VC backed companies that are up for sale or are closing IPOs.
(4) When later-stage VCs return less to their investors, institutional investors seek ways to increase their rates of return. Some will invest less money in venture capital. Others will turn to different forms of venture capital.
(5) Institutional investors will increasingly use middlemen to handle their venture capital investments. One type of middleman is a “fund of funds,” which is a venture capital fund that primarily invests in other venture capital funds, rather than making direct investments in portfolio companies. We are already beginning to see this trend develop with more people seeking to launch “funds of funds.” Institutional investors will increasingly delegate their VC investments to “funds of funds,” because these middlemen will specialize in identifying and managing a large portfolio of smaller VC funds that institutional money managers don’t have time to track.
(7) These new smaller VC funds will be able to invest smaller amounts in early-stage companies. When that happens, early-stage companies will find it easier to raise capital.
(8) The VC industry will split in two very different pieces; smaller VC funds dedicated to early-stage investments and large funds dedicated to later-stage investments. Larger funds will obtain capital primarily directly from institutional money managers and smaller funds will obtain much of their money from intermediaries, like a fund of funds.
Return of the good old days
At that point the VC industry will have returned to the “good old days” with a healthy cadre of VCs that regularly invest in early-stage companies and a separate cadre of mezzanine funds. The big question is, how long will this process take?
Unfortunately, this scenario will probably develop slowly. Large numbers of venture capital investors, who are good at doing early-stage investments, cannot be instantly mass manufactured. Handing out MBAs won’t do it. Early-stage VCs need a lot of experience in different areas of business to handle the challenges of investing in early-stage companies. It will take time for the next generation to develop that experience.
Of course, we had a whole generation of VCs with early-stage investment expertise. Don’t hold your breath waiting for large numbers of these VCs to move from larger funds back into small funds. VCs with larger funds generate substantially larger annual management fees than VCs with smaller funds. Going back to smaller funds would result in a substantial downward adjustment in cash flow for most VCs.
The current mantra entrepreneurs hear from VCs these days is that positive cash flow is the Holy Grail. Yes, some existing VCs will sacrifice near term cash flow for the potential upside of higher capital gains from early-stage investments, but what’s the likelihood a large number of VCs will suddenly abandon the cash flow “goddess” they’ve been telling entrepreneurs to worship?
Remember, you heard it here first.
Daniels Daniels & Verdonik, P.A. has been serving the legal needs of entrepreneurial and high technology clients for more than 20 years. Jim Verdonink concentrates his practice in the representation of technology companies and investors in venture capital, securities and other corporate matters. He founded and operates two websites with business and legal resources www.BoardStrategies.com and www.TecCoach.com. Questions or Comments can be sent to email@example.com.