venture capital, return, private equity, Toby Elwin, Harvard Business Review

Venture Capital and the descent into irrelevance

Toby Elwin, VC Quarterly Return Rates, 1981-2009, source Cambridge Associates, LLC U.S. Venture Capital Index

The bigger the risk, the bigger the reward. Elemental finance: you assume the amount of risk suitable for an expected payoff. You assume bigger risk and its bigger payoff with the full caveat that there is an equally big downside loss that could happen.

Invest in a money market and get slow, steady, decimal-point-% returns; you sleep well knowing your risk is low and what to expect.

Invest in emerging markets, a start up, or unproven technology with wildly fluctuating uncertainty and huge range of possible returns; you get potential sleepless nights worrying about losing your entire investment or planning a safe harbor for your potential windfall.

If venture capital (VC) is to assume its traditional place as the fuel for innovation than a 2% average quarterly return from 1981-2009, as well as a glut of investor money sitting around without a home, will have to change.

VCs believe they seek and back promising entrepreneurs. VCs believe they spark innovation. VCs believe they have an other-worldly sense for picking the right talent with the right product for the next market.

The reality has not caught on. This month’s Harvard Business Review has an article called The VC Shakeout that looks into this misalignment and possible contraction of the VC space in detail.  For example, investments in VC portfolio firms did not outperform investments in other NASDAQ stocks during the boom period of the 1990s.

Toby Elwin, Harvard Business Review The VC Shakeout Few Deals

In a post I wrote for nowEurope on the state of US venture capital, lengthening time to liquidity from 5 years to 7 – 9 years is almost a new expectation. However, the returns are not matching the risk and investors have far better options. “Venture capital hasn’t worked for a decade and must be radically restructured if it’s going to influence innovation – and make solid returns to investors” by Joseph Ghalbouni and Dominique Rouzies*

Harvard Business Review The VC Shakeout No Exits graph

There are more investments in more opportunities, there are not enough sound opportunities, and the liquidity deals have, logically, dried up. This is a trend not a blip. This results: time-lines for potential liquidity is extending further, thereby leaving all the risk on the portfolio investor and the VC’s balance sheet.

Toby Elwin, Harvard Business Review The VC Shakeout Long Waits graph

Lengthen time = increase risk. “That means VCs are now in the unenviable position of offering investors high-risk, lower-yield investment opportunities.” Or as the story points alludes:

  • Few Deals + No Exits + Long Waits = bloated balance sheets

“Every VC I know thinks there are too many VCs, too much dumb money, too many people bidding up valuations and reducing returns for the top guys. Too many–except, of course, themselves!”

Entrepreneurs are turning toward angel investors for their needs. The VCs have turned increasingly desperate in attracting entrepreneurs. Because at the element level the investment is an investment in a relationship. If either side is not getting their needs met, then it is not much of a relationship, it is more like a shotgun marriage.

“What’s more, VCs are losing their ability to attract the entrepreneurs that will generate better returns.  They’ve fallen short in marketing their relevance to entrepreneurs who don’t need capital as much as they need guidance.  Instead of marketing their operational expertise, their well-developed network of experts, and the personalized attention they can offer, many VC firms have resorted to peddling wildly attractive financing options.”*

The VC world needs to return roots that spawned many of the incredible innovations we’ve seen from biotechnology, silicon, software: “When we enter an investment, we don’t think about how to sell it…[w]e think about how to help th entrepreneur build a great company.” Bernard Liautaud, Balderton Capital

“…experts who see a ‘shrinking role for venture capitalists in seeking and backing promising young entrepreneurs,’ as alternatives including angel investors gain favor. Fresh research by Josh Lerner and William Kerr of Harvard Business School bolsters this argument with evidence that entrepreneurs who obtain angel investing are more likely to survive at least four years and show improved performance.”**

Great insights, but am I led to believe relationships are now retro? So, if entrepreneurs are looking for relationships, they now find better relationships with angel investors over VCs.  Sounds like a great start for VCs to gain relevance:  the relationship.

If VCs have a hard enough time evaluating the market for deals, then evaluating relationships presents a far bigger challenge.

So many of today’s internet companies don’t need much capital and if angel investors are covering the financing as well as the relationships – what’s a VC to offer?

*The VC Shakeout – Harvard Business Review

**The Rise of the Fleet-Footed Start-Up – New York Times

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