Venture Capital Is Shrinking and/or Growing Rapidly

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On page C1 of today's Wall Street Journal, I learned that venture capital — the industry that exists to give rise to the next generation of hot Internet companies — is dying a slow, sad death.

Venture-capital firms are taking stiff measures to survive a tough fundraising environment and lackluster returns, including gutting their partnerships, slashing their fund sizes and refocusing their investment areas.

But just as I was readying my sympathy bouquet to send to Sand Hill Road, I saw this Breakingviews column about the fact that things for the VC industry have never been better. "Last year, VC outfits raised $20.6 billion of new committed funds, according to the NVCA and Thomson Reuters," Robert Cyran writes. "That’s about 10 percent more than in 2011."

So is venture capital dying or flourishing like never before?

I suspect that both pieces are sort of right and are getting at the same general phenomena. It's well established that venture-capital funds have not done very well relative to other investment types, and investors are becoming increasingly skeptical of the industry. But Breakingviews seems to just lament the gap between venture capital's reputation and its actual performance, whereas the Journal goes out in search of a couple of firms that have downsized their staff and raised smaller funds, stirs in some statistics that support the theory, and then extrapolates to paint a portrait of an entire industry in decline. (See, the Times' Sunday Styles section doesn't have a monopoly on fake-trend stories!)

What is actually happening, I suspect, is that the lower end of the VC industry is starting to struggle, while the higher end is chugging right along. Cyran notes that "a few well connected, marquee VC firms like Andreessen Horowitz still do very well," but the Journal's story points out that not every firm has the luxury of investing in Facebook and Twitter. Without the ability to invest in those household-name companies, low- and middle-tier VC firms are stuck trying to make bets on hundreds of little companies in the hopes that one or two will become huge and pay for the rest many times over.

This is essentially the same business model used in book publishing, where one Fifty Shades can pay for an entire year's worth of flops. And it works as long as investors are willing to keep pouring money into your funds, even if you have a few years without a hit. But now investors are starting to lose patience:

Many venture firms are responding to a higher bar from investors, who have been disenchanted with scant venture returns and are scrutinizing partnerships closely to pick out the stronger versus weaker venture capitalists in a firm.

I met with an editor last week who seemed confident that Silicon Valley was "going to explode" in the near future — that the market would soon come to its senses, that investors would flee from the entire VC-backed tech sector, and that all the Pinterests, Twitters, and Facebooks of the world would go up in flames, just like they did in 2001.

That's certainly possible, but judging from the Journal's article, it's more likely that as tech companies struggle to find big exits and make money for their venture-capital owners, VC investors will simply shift their money from lower-end firms, the ones not making money, to the ones that have recently had big hits.

Another possibility is the so-called "Series A crunch," a phenomenon that is treated with studied reverence by tech reporters, who look everywhere for signs that tech companies are having trouble raising their first post-seed round of funding, known as the Series A. In a Series A crunch, the bottleneck narrows — you have lots of little, brand-new companies raising money, but far fewer established, medium-size companies getting funded. You can see how this would be bad for small and medium-size VC firms, who invest lots of seed money in brand-new companies, only to have them die on the vine later on when they're unable to get bigger investors to sign on.

So yes, something is going on with venture capital. Maybe there will be fewer VC firms a year from now and no companies will be able to get funded, and we'll have 2001 all over again. Or maybe there will just be a consolidation of money and power into a few lucky firms, and the Facebooks of tomorrow will still be able to get plenty of cash in their coffers. The only clear takeaway from today's VC Rashomon is that nobody knows what's happening yet.