Macro VC Math
Fred Wilson wrote a great post today that summarizes, at a macro level, the VC Math Problem. If you are interested in the math behind venture returns, read this whole post, including the slew of comments. Great stuff.
I could quibble with some of Fred's assumptions, but the fundamental message is right on. He describes the likely distribution of exits of technology companies (Fred says that this is about $100B of exit value in a year). If you crunch through the numbers through how much of this VCs end up with, net out their fees and carried interest, it shows that this is sufficient to justify something like $16B of venture investment in a year. That's about 60% of what is raised in recently times, providing more evidence that the venture business must shrink. More money doesn't create more exits.
One of the comments to Fred's post ask if there was a limit on entrepreneurship in the same way that Fred argues there is a limit on venture math. I think that the venture limit derives from our economy's ability to absorb new technology offerings. As the economy grows (or returns to growing some day soon!), we can absorb slightly more new technology. I think that this does impose a limit on the technology entrepreneurship we can justify in this country, at least the type of entrepreneurship that is aimed at getting some sort of venture return. But, there are many types of entrepreneurship that are really aimed at having a business throw off enough cash to pay all the employees a healthy wage. Those are sustainable businesses that may never exit. And, they are great. I don't see a similar limit on these, many of which are service businesses.
All of these macro approaches are somewhat flawed. I think that it is mostly important to look at them as directional, rather than precise. Whether you think we can justify $15B or $20B of VC investment, it's hard to look at the NVCA returns and think that investors will feel that these are strong enough to justify the risk. And, eventually, those investors will move away from VC, hopefully rightsizing the amount of capital available.