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Letter from the Editor

Sick Capital

Why it matters that VCs won’t do their jobs.

  • This letter appeared in the March/April 2010 issue.
  • by Jason Pontin
  • February 23, 2010

If venture capital is sickly, does it matter? Put another way: would the startups in the TR50, Technology Review’s new list of the 50 most innovative companies, be more innovative and sustainable, or even different, better ventures altogether, if venture capital were healthier?

Venture capital isn’t what it was. Funds launched in 1996 and 1997 have seen returns of 80 to 100 percent on average, according to Cambridge Associates; those launched in 1999 and 2000 have lost money. Since then, many have returned less than zero, and only recently has the industry showed signs of life. In “What’s Wrong with Venture Capital”, James Surowiecki writes, “As Fred Wilson, a principal at Union Square Ventures, bluntly puts it, ‘Venture capital funds, as a whole, basically made no money the entire decade.’ ” What went wrong? The reasons are summarized by Surowiecki (and by Howard Anderson, cofounder of Battery Ventures, in “Good-Bye to Venture Capital,” June 2005 and at technologyreview.com).

First, the markets for new technology stocks, the most important means by which VCs recover their investments, are nearly frozen, and the valuations of companies that do enjoy public offerings are no longer irrational. In 2009, just 13 venture-backed companies went public, down from 271 in 1999. Worse, as Anderson wrote, “rational markets value companies at two and a half times their sales at an [IPO].” That’s bad for VCs: since most startups fail, a return of 250 percent on those ventures that succeed isn’t that great, considered over the lifetime of the investment (typically, at least five years). Anderson may be forgiven for having written, “We need a little irrationality to earn a living.” VCs once expected that one wonderful success in every 10 of their investments would justify their failures; no longer.

Second, no one buys as much technology as they once did. IT spending by enterprises grew at 15 percent during most of the 1990s but has grown only by single digits for most the last decade. More striking, as Surowiecki points out, “much of the value that new businesses are creating in fields such as social networking is … ‘nonmonetized.’ ” Users think Facebook and Twitter should be free, and there is no reason to think that VCs’ investments in social technologies will be as lucrative as their investments in enterprise software and networking equipment during the 1990s.

Third, there is too much venture capital, but entrepreneurs need less funding. The venture industry now manages about $200 billion, twice what it did in 1998, and invests $20 billion to $30 billion every year; but the cost of launching startups, at least in the software and Internet sectors, has fallen “by at least an order of magnitude,” according to Fred Wilson, because of open-source and outsourced software development and the falling price of processing, storage, and bandwidth. In the absence of an irrational market for technology stocks, there’s no way for venture capitalists to generate handsome profits on $30 billion of what is, we must remember, called “risk capital.”

Does all this matter? Surowiecki writes, “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.”

But the sickliness of venture capital does matter to entrepreneurs, and it should matter to you, too. VCs no longer perform their historical functions: recognizing a few potentially disruptive technologies, finding great entrepreneurs who burn to commercialize those technologies, providing measured seed funding, and worrying startups to profitability. Instead, the partners of the typical fund invest more money, much later, in more companies, selected according to some risk management philosophy.

A well-known Silicon Valley investor (who asked that I not name him, lest he offend his partners) expressed the consequences: “VCs spread themselves over six to 12 portfolio companies, often spending as little as a day a month on each. This is terrible for both entrepreneurs and the country.” There’s research to back him up: Josh Lerner, a professor at Harvard Business School, has shown that the advice of VCs is an important reason why venture dollars are “three to four times as potent” as corporate R&D in spurring innovation. (Read why Lerner thinks governments are so bad at encouraging entrepreneurs.)

Past venture capitalists funded the technology companies that became the engines of the world’s economic growth: Intel, Microsoft, Genentech, Compaq, Apple, Cisco. But there have been just two really transformative venture-backed companies in the last decade: Facebook and Twitter.

Might Twitter have sooner answered the question that we pose in the article “Can Twitter Earn Money?”, had its VCs been more like their predecessors? My unnameable investor told me: “I wish the VCs on the board at Twitter would drop everything else and help Twitter build the solid business that the service so richly deserves. In the past, they would have.” Write and tell me what you think at jason.pontin@technologyreview.com.

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