Venture capital’s new normal

In many ways, 2010 was an incredibly surprising year for the VC industry. The pace of investment activity picked up considerably following the economic turmoil in 2008 and 2009. The number of companies started, investment valuations and the speed at which financings were completed all increased dramatically relative to the prior two years. At the same time, the long awaited restructuring of the VC industry started to become reality with fewer traditional funds being raised, more small (angel and micro-VC) funds launching and many VCs leaving the industry for other careers. Finally, the M&A market picked up and the IPO market cracked open a bit, creating more liquidity than the past couple of years.

2011’s even faster start has surprised not only many outside of the VC industry, but also many VC professionals. There has been extensive commentary on what is perceived to be an overheated or irrationally exuberant market, but I believe that we are simply experiencing the “new normal”, at least for the next few years. The reality is that there remains too much investment capital in pursuit of funding the handful of companies started each year that will generate outsized returns for limited partners. VC industry returns have been abysmal for the past decade, so missing out on those winners could mean the inability to raise new funds for many firms. At the same time, the cost of starting companies is lower than ever and angels and funds of all sizes are competing to finance the same, increasingly capital efficient businesses. More sources of abundant capital mean more companies being started and increasingly low odds of predicting which companies will emerge as winners. All of this creates a dynamic in which the first inkling of success for a young company yields multi-million dollar financing offers at seemingly inexplicable valuations ($100 million has become the new $10 million) and proven success generates multi-hundred million dollars financings at unprecedented valuations.

Unfortunately, this is likely to be the difficult reality of the VC industry for at least the next few years. For now, this new normal seems to be limited to the private investing market, not the public market, suggesting that this is not a bubble like the one experienced a decade ago. Further, in the VC market, dollars invested today don’t prove themselves to be ill spent for several years down the road. The repercussions of poor investing take even longer to unfold. The new normal in the private market will not quickly disappear with the bursting of a bubble, but rather slowly give way like an aging balloon bleeding air.

While many VCs will lose playing this new game, the good news is that there has never been a better time to be an entrepreneur, or in all likelihood, a consumer. Capital is freely and cheaply available to those willing to accept the startup challenge, both here in the US and around the globe. The startups that do emerge from the current financing frenzy as market leaders will have created innovative products and services for which consumers will be the ultimate beneficiaries. Those entrepreneurs will have created enormous wealth for themselves. The VCs that supported those entrepreneurs may or may not have generated returns for their investors. Which would you bet on?

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