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Good-Bye to Venture Capital

Technology finance has turned rational – so I’m outta here.

Good-bye! We venture capitalists like to think of ourselves as giants striding across the technology landscape, showering money on terrific young entrepreneurs, adding value, creating jobs, nurturing real companies. We are financial samurai. But I am giving it up. Why?

First, technology supply is bloated. Innovation is not dead, but demand for new technologies is moribund and will continue to be weak for at least the next five years. During the boom times, VCs financed more than 5,000 new companies a year in information technology, communications, biotechnology, and the Internet. The problem is that the buyers of new technology cannot possibly utilize all this stuff. There is a very real limit to what can usefully be deployed. IT and communications spending is no longer growing at 15 percent per year; growth will be in the middle single digits for at least the next five years. Therefore, few software and communications companies will enjoy the double-digit growth that inflames company valuations and makes VCs rich.

Second, there’s a good reason why technology spending is stagnant. The hype machine is broken. For years, technologists told the world that “information is strategic”; we said that if companies didn’t overspend to protect against Y2K they were committing corporate hara-kiri. Executives spent like crazy people. No longer. Their new mantra: spend no more than last year.

Third, the financial markets for technology companies are no longer exuberantly irrational. VCs hate rational markets: rational markets value companies at two and a half times their sales at an initial public offering or one and a half times their sales at a merger. We need a little irrationality to earn a living – but the total capitalization for the leading technology companies is now one-sixth of what it was five years ago.

Fourth, these changes in venture funding are structural, not cyclical. VCs actually like cyclical markets; we can buy in cheaply and wait for exuberance to bail us out. Traditionally, we knew that if we picked the right sector we could make 10 times our money. In fact, we knew if we picked the best two or three companies in that sector, we could make 50 times our money – but you get my point. But those days are, regrettably, over.

Here’s why: it takes about $30 million to get a startup software company to break even – and even great software companies rarely grow more than 100 percent a year. In irrational times, a software company with $30 million in sales would have been worth $180 million, or 600 percent of a VC’s investment. Which is good, but not great. Unfortunately, in rational times, the company would be worth $47 million to the investors, or only 157 percent of their investment. But that’s over five years! Per year, it’s a return of only 11 percent – and that’s for a winner. Remember: in venture funds, only 20 percent of investments are winners. Forty percent are in the middle, 20 percent are losers, and another 20 percent are write-offs.

Venture funds all strive to rank in the top quartile. But the returns of the top-quartile funds depend on when they were launched. Take a look at these numbers for venture capital returns from Cambridge Associates:

Year Percentage increase
1984 12.9
1988 22.7
1994 49.6
1997 67.5
1999 -8.7
2000 -8.3

If you were a VC between 1994 and 1997, you couldn’t help but make money. But by 2000, you were underwater.

Finally, it’s not just supply of new technology that is too abundant. Ten years ago there were 240 member firms in the National Venture Capital Association. Today, that membership has nearly doubled, and our fund size under management has increased eightfold. There’s too much venture money pursuing too many deals. There’s nowhere for all that money to go: we can’t spend the money we’ve raised.

Venture capitalists view themselves as pragmatists, but if they think the dynamics of the business haven’t changed, they’re as self-deluding as the next person.

Ever wonder what we did for a living in early-stage venture funding? I bet you think we spent the day searching for the next insanely great company. But we spent most of our lives in endless meetings with people who were lying to us: scientists who swore that their patents were solid and entrepreneurs who insisted that they had no competition. We lied right back at them: said our money was different.

That was the old way, and it was tons of fun, and we all made too much money. I’ll miss it. But now the markets are too rational, and the returns are too small and uncertain. So, time to leave.

Howard Anderson is the William Porter Distinguished Lecturer at MIT’s Sloan School of Management, where he teaches courses on early-stage companies. He founded the Yankee Group and cofounded YankeeTek Ventures and Battery Ventures. He plans to raise no new monies for his venture funds.

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