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Nonetheless, it would be a mistake to assume that the industry’s problems will vanish once the economy picks up. Instead, it seems clear that at least some of the factors that have made huge returns rare are the result of structural–not cyclical–shifts, and that venture capitalists will need to adapt.

To begin with, the costs of starting companies and of making companies profitable in sectors like information technology have fallen dramatically thanks to open-source software, the globalization of engineering, the commodification of bandwidth and infrastructure, and other factors. Wilson, for instance, estimates that costs have fallen “at least an order of magnitude” in the past decade. That’s given entrepreneurs more leverage, since they’re less desperate for capital. At the same time, sectors where venture capital has traditionally made a huge impact, like IT and telecommunications, are no longer growing as fast as they once did. And much of the value that new businesses are creating in fields such as social networking is, at least for the moment, “nonmonetized”–the benefits that users get don’t translate into dollars. There is now a generation on the Net whose governing assumption is that things should be free. Any assumption that they will be as lucrative a group of customers as corporate IT departments may be mistaken.

Finally, it’s an open question whether IPOs will again become the gold mine they were for venture capitalists in the past. Just 13 venture-­backed firms went public in 2009–down from 94 in 2004 and 271 at the height of the boom, in 1999. In an earlier era, Facebook and even Twitter would almost certainly have gone public. Yet neither company seems all that anxious to do so. The problem is on both sides: entrepreneurs don’t yearn to take their companies public as they once did, and investors aren’t clamoring for more public offerings. Running a public company is more difficult than ever: there are more rules to comply with, more pressure from shareholders, and, at least lately, more volatility. More important, IPO pricing is more rational than it once was. That is crucial, since turning startups into public companies has been the way venture capitalists made most of their money. Anderson, for one, thinks saner valuation is at the heart of the industry’s problem. “The entire market has become more mature,” he says. “This is not a bad thing in general, but it’s not good for venture capitalists, because we love irrational markets. They make it much easier to have the outrageous winners you need in order to make the economics of the business work.” Exceptions exist–battery maker A123 Systems (which ­Anderson invested in) raised $380 million when it went public last fall–but they have been rare.

There are some signs of adaptation. Tim Draper of Draper Fisher Jurvetson (DFJ), for instance, argues that “the next eight to 10 years are going to be the greatest venture capital years in the history of the world.” But he believes that the drivers of future innovation aren’t in traditional locations: in addition to Silicon Valley, DFJ is investing in China, India, and Vietnam. Meanwhile, even if, as Paul Kedrosky of the Ewing Kauffman Foundation argues, “too many venture partnerships [are] continuing to invest in information technology because they always have,” many VCs have begun funding companies in industries like media, education, and even finance, where technological change is creating disruptive innovations and, therefore, opportunities for profit.

But it won’t be enough for VCs simply to change what they invest in and where they invest. The real problem is not complex: there’s too much venture capital, and there are too many venture capitalists, for the industry to be really profitable. The industry as a whole now has about $200 billion under management, more than twice what it did in 1998, and venture funds invested $20 billion to $30 billion a year for most of the past decade. And on the level of individual funds, huge amounts of capital combined with falling startup costs have, in ­Anderson’s words, made funds “muscle­bound”: a $500 million fund can’t make too many small investments, even if that’s what would make economic sense, because the partners don’t have the time to supervise hundreds of companies. (This is one reason, along with the desire to limit risk, that many VCs have started to wait until later rounds to invest.) In the absence of another bubble, there’s no way for new companies to generate profits big enough to provide a reasonable return on $20 billion to $30 billion a year. Kedrosky, for one, argues that for the industry to consistently generate competitive returns, annual investment and money under management need to fall by more than half. And while Wilson describes himself as “very optimistic” about the coming decade, he says that the industry “needs to return to the size and shape it was in the late ’80s and early ’90s.”

The interesting thing is that this diagnosis is not especially controversial. Most people in the industry think there’s too much money. It’s like traffic, though: everyone thinks there’s too much of that, but no one wants to take public transportation. And while in most businesses competition takes care of the problem by forcing the losers out, here winnowing takes much longer, because venture capital isn’t like the stock market: if you get disillusioned, you can’t just pull your money out of it. The limited partners who invest in venture capital funds make long-term, binding commitments to meet the “capital calls” of the general partners who manage the funds and make investments. This is, from the perspective of innovation, venture capital’s great strength: instead of needing a quick return, it can afford to build companies. Nonetheless, it creates what Wilson calls “a huge amount of latency in the system.” So even though the industry has been moving toward a more sensible balance between money under management and potential returns, it takes a long time to push underperformers out.

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