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VC discipline

I've written many times about the size of the VC industry.  There is lots of data to show that the returns don't justify the current size of the industry.  Too much capital in the hands of VCs have led to companies being overfunded, which lowers the returns.

The latest data set comes from Paul Kedrosky of the Kauffman Foundation.  Paul confirms some of the thoughts above, and postulates that the core business that has driven venture capital, information technology, may have matured too much to justify so much VC investment going forward.  New sectors need to be exploited.  Perhaps clean energy is one of them.  The challenge is that the investment models in new sectors are not was well known, and there will invevitably be some trial-and-error until it is figured out.

PEHub wrote about this today, with an interesting example.  They used the comparison of three companies in the same space to illustrate what happens when a niche gets overfunded.

[Note that my former firm, Venrock, was an investor in Vontu (but in a fund that was invested before my time there).]

PEHub suggests that the Vontu syndicate did well and, therefore, the other two companies shouldn't have been funded.  But, the real problem in this chart isn't the existence of the other two companies but the amount of capital poured into them.  Obviously, Vontu could justify significant investment given the size of the outcome.  If somehow they could have gotten there with less capital, everyone would have done even better.

But, the other two companies were way overfunded.  They were all probably optimistic at the start of the investment.  Perhaps they had to keep up with Vontu.  But, the VCs who kept putting money into those companies were only focused on trying to get a big win and not protecting their downside.  I don't know anything about the operations of these other two companies, but you almost always know that you aren't heading for a big outcome long before it happens.  If the VCs had the discipline to turn off the flow of capital and push the company to an exit, they may have done better in the case of Reconnex and could have limited their losses in the case of Tablus.

It's the lack of discipline in the business that is causing the problems.  VCs have big funds which generate big fees.  Therefore, they are motivated to deploy large amounts of capital in hopes for a big win (with little regard for the losses).  And, in the Don Valentine quote in the PEHub article,

Don Valentine asked his limited partners why they invested in other venture firms they knew were unlikely to make money and came back with a candid assessment, recorded in the book Done Deals: “They think it’s fun.”

I don't think that LPs think it's "fun" now to over-invest in venture capital due to the low returns this decade.  Maybe, with the fun now over, some discipline will return.  And, LPs will also start to look for some more innovative models as ways to make some money.

The last thing that has to happen is for VC compensation to get more aligned with their investors making money.  The 2% fee and 20% carry model can provide too much current income for VCs with little regard to capital loss.  That doesn't work for LPs except for well-established funds that have a high likelihood of doing well.  In addition to looking for some unique investment strategies, LPs should also look for some innovative compensation models from their venture funds that align everyone's interests more directly.


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