Monday, July 18, 2011

The Coming Brick Wall in Venture Capital & Why This is Good for US Innovation

The author of the below article (see link) argues that the venture capital business itself is going through an even more fundamental change than just the entry of a new category at the earliest stage. That the industry is shrinking back to a mid-90′s level in terms of both dollars and numbers of firms. What do you think of that argument?

Here is a link to the article I am talking about: Brick Wall

A couple of thoughts around that:

1. The economies of starting a company today are different than what they were in the mid-90's. Cost of acquisition is lower and technologies such as cloud computing and methodologies as A/B testing and agile development brought down the cost of development & IT. Given that comparing the total capital available is not necessarily the right metric.

2. Given that economies have change and given that we are starting to see more medium size acquisitions(<$40M) (and sometimes quick talent acquisitions), large funds (north to $150M) are struggling. There are fewer blockbusters and the good deal flow for growth stage rounds is centered about the top 5-6 VC (Accel, Sequoia, DFJ etc.). The rest settle for lower quality deal flow which is expected to impact their ability to achieve target returns and raise another fund.

A $250M VC fund trying to target a 20% IRR in 5 years needs to reach $500M of exits. If they have 20% of each exit then they need to target total exits of $2.5B. If you are invested in Facebook, LinkedIn or GroupOn then you are set. Otherwise it is challenging to meet those returns.

3. Like with any industry, you need to keep an eye on the market and change constantly. The VCs that noticed the change early on (USV, First Round Capital) changed their investment strategy & fund size. The ones that failed to recognize the change, might struggle.

Mark Suster wrote a nice article summarizing these trends: Venture Capital