This suggests that the industry as a whole still has at least a few years of underperformance ahead. Although that’s not good news for venture capital investors, it’s not clear that it’s a problem for the economy. What’s peculiar about the debate over the brokenness of the venture capital model is that it isn’t really a debate about whether it’s important to have early-stage funding for innovative companies: everyone believes that. Nor is it an argument about whether venture capitalists add value: the complaints of many entrepreneurs notwithstanding, the historical evidence suggests that venture capital has played a key role in fostering innovation. In a study of Silicon Valley firms, for instance, academics Thomas Hellmann and Manju Puri found that venture-backed firms were significantly quicker than others to bring products to market and were more likely to pursue what they call an “innovator strategy.” And in a study of patent data, Josh Lerner found that venture dollars were “three to four times as potent” as corporate R&D in encouraging innovation.
If venture capital is both necessary and useful, then, why does it matter, from a societal point of view, if it’s oversupplied? What we care about, after all, is not whether investors get good returns or VCs are well paid. We care about whether new companies are getting started and innovations are being funded. One of the fundamental truths of profitable innovation is that it is hard, if not impossible, to identify in advance. (That’s why the familiar venture capital model depends on having a couple of huge hits in a portfolio to outweigh all the mediocre results and outright misses.) So while the shakeout will be welcome, it may actually be more important for the well-being of the industry than for the rest of us. As Tim Draper says, “There are never enough VCs or entrepreneurs or money for new efforts.” After all, even though venture investors undoubtedly put too much money into me-too software companies and clean-tech firms that never panned out, would we really have preferred that money to have gone into some bank’s collateralized debt obligation instead?
Probably, no. But there are reasons to think that a too-flush venture capital industry isn’t a good thing. First of all, since VCs get a percentage of assets under management, having tens of billions come into the industry every year makes it possible for a venture capitalist to make a good living even from investments that go nowhere. That’s not a recipe for creating focused VCs. And the “muscle-bound” problem is real, too: to the extent that having too much money means venture capitalists wait to enter until later rounds of financing, the value that they add is reduced. It’s also likely that because the size of these funds has required VCs to spread their investments across more companies, their effectiveness as monitors of corporate performance has been diminished. To many entrepreneurs, this may not sound so bad, but Lerner’s research, at least, suggests that the guidance and monitoring VCs provide is an important part of why VC-backed firms have historically done better at sparking innovation. It may be a coincidence that the oversupply of venture capital has coincided with an era that produced, arguably, just two transformative venture-funded startups: Facebook and Twitter (for an analysis of Twitter’s business, see “Can Twitter Make Money?”). But it may also be that the industry as a whole just got a little too comfortable.
That’s changing, for the good: VC funding was just $17.7 billion last year, down 40 percent from the year before. And although it will be painful, the industry needs investors to leave if it’s going to return to a more rational size. It is highly unlikely that the pendulum will swing back too far–that venture capital will become underfunded. The allure of huge profits is not going to vanish. And the activities of venture capitalists are still associated more with hugely profitable investments like Juniper (and, before it, Cisco, Apple, and Digital Equipment Corporation) than with ventures like Procket.
Venture capitalists, like entrepreneurs, are overconfident: they believe they can identify and exploit profit opportunities that others are missing. If this may not be a great thing for them or their investors, it’s a good thing for the rest of us, since it guarantees a constant flow of new money into new businesses. Venture capital needs to become a more rational business. But not too rational.
James Surowiecki writes “The Financial Page” for The New Yorker.