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VC can't bail us out

Starting with a Tom Friedman op-ed piece in the New York Times on Saturday, there have been a steady stream of VC bloggers who have pointed out why Tom's suggestion of the government pouring $20B into venture capital is a bad idea.  I agree.  Here are thoughts from Fred Wilson, Don Dodge, and Jeff Bussgang.

Venture capital is a business that can't scale with more dollars.  No matter how vibrant our economy is, there are only so many ideas that are worth funding each year.  Having more money available doesn't mean that more ideas are worth funding.  Quite the opposite:  having second and third-tier ideas funded as well as top-tier ideas dilutes the market opportunity for everyone.  It forces every start-up to raise more capital in order to compete.  It lowers the financial return for the entrepreneurs and for the investors.  And, as venture returns are lowered, limited partners begin to scale back their commitment to venture capital for the long-term.  So, a flood of government venture money in the short-term can lead to a scarcity of private venture money in the long-term.

Most top VCs will agree that there is too much money in the industry.  If you look at venture returns, you'd conclude that perhaps half of all venture funds should go away.  So, putting more money into venture capital clearly isn't necessary.  And, although Tom Friedman points out that some of the institutional investors who invest in venture capital are short on cash, you can be sure that there is no shortage of funds available for any top or second quartile VCs who are raising money.  The cash crunch is much more likely to begin the squeezing out of some of the poorer performing venture funds.  But, because of the huge amount of capital still out there and the long time constant on venture funds (funds are committed for 10 years, typically), any venture scale back will take a long time.

So, can the government do anything to help new technology business grow?  Well, I don't think that real early stage businesses can bail us out in the short-term.  This shouldn't be considered part of an economic stimulus, but, instead, part of a longer-term plan to build new industries.  In this light, the government has a great role as a funder of primary research.  Clean energy is one obvious place for this type of funding, but it can be done across many sectors.  It was government funding that got the Internet started (with our without Al Gore).  Government funding through organizations like the NIH still fund many of the initial developments in biotech.

Only the government can justify the initial research funding that may have no economic return.  This investment will instead help create research positions at our universities and will, ultimately, lead to companies spinning out of those schools.  I'm actively involved in the Deshpande Center at MIT, and that's a great model for assisting the most commercially viable research projects move toward becoming companies.

If you think of the funnel of potential businesses, I think that the bottom of the funnel (venture funding) works pretty well and is probably over funded.  Where we should be spending more resources is in testing out new ideas at the top of the funnel.  Although the government needs a good system of evaluating the ideas it funds (perhaps modeled on DARPA, but without the millitary ties), I wouldn't mind some overspending on basic research that may lead to the next big thing.

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