I completely agree with Steve King of Small Business Labs, in Is the Venture Capital Industry Broken? He says:
The news here isn’t that the VC industry is broken. This has been actively discussed for years. The news is who’s saying it’s broken.
Which is, in the flap this month, the Kauffman Foundation.
The Kauffman Foundation has long been a close friend of the VC industry. In addition to investing many millions of dollars with VCs, Kauffman’s mission of supporting entrepreneurs and high growth companies has resulted in them closely collaborating with the VC industry.
The foundation recently published We Have Met the Enemy and He is Us, a blistering critique of venture capital and its role in startups.
Here’s the problem in one simple business line chart (why I like business charts). It shows how the rate of return on venture capital looked great during the first big Internet boom. It’s not a pretty picture.
On the other hand, those low points in the last few years aren’t uncommon, are they? How is your industry doing since the great recession? The chart shows pretty much what Steve summarizes as follows:
Kauffman has many reasons why the industry is broken. But the quick summary is the industry simply hasn’t performed well. Only 38% of the funds Kauffman invested in over the last couple of decades beat public market small cap indexes. This is primary due to the expensive fees VC firms charge.
So does this mean hard times for startups? I doubt it. I see is a shift towards smaller seed rounds and more angel investment as a web and software technology have reduced the capital needed by the average high-end web startup to get from nowhere to proof of concept and validation. In an oversimplified general sense, what took $2.5 million in 1998 takes probably $250,000 today.
Business comes in cycles. Suppose the huge camelback hump in returns in the late 1990s (the boom) were a temporary aberration. The hard times afterwards (the crash) are probably a temporary aberration too.
Steve recommends this story in GigaOm and this one by Fred Wilson of AVC for further reflections on the Kauffman findings.
[…] Entrepreneur, that appeared on TechCrunch about a week ago. Post author Rip Empson digs into the recent Kaufmann data on venture capital, adds some analysis by Fred Wilson, Chris Dixon, and others, and comes out with […]
I disagree with the idea, “the days of big investments yielding big returns are mostly over.” We are still seeing startups providing hyper-returns today. Investors need to do their due diligence.
When an investor is looking at using a VC Firm or invest directly, they need to do their homework. What is the teams experience? What is the investors experience in the space they are investing in? Consulting someone who is an expert in the space is always a good idea.
It’s not hard to find young startups with great ideas. There are local startup incubation hubs in most major cities. But investors need to do their research, ultimately an idea may be great, but if the team hasn’t delivered a successful idea yet, that’s a concern. If none of the founders have a technical background, that’s a concern.
The biggest issues as I see it for start ups and the ecosystem being built up around it, specifically angel funds, can be broken up into three separate concerns:
Lack of Access: How does the average retail investor get access to the great successful funds? The barriers of entry are too high and conversely the successful funds don’t need capital from the small guy.
Lack of Transparency: There is a huge pent up demand to invest in start ups by individual investors. They search and scour for local angel funds, invest their money blindly and hope and pray they are part of a fund that has invested in the next great exit. Not a wise investment strategy.
Lack of Liquidity: The retail investor gets invested in the angel fund and then for whatever reason he wishes to cash in or redeem his investment. Dream on again. In most of these angel funds you are buried for years to come.
The Solution: The first publicly traded seed stage investment company – DTI Ventures- Democratizing Technology Investment.
Investors have access,transparency and most importantly liquidity.
The Kaufmann Fund analysis is inspiring, almost like the post-epiphany missive in Jerry Maguire. As the POGO-like report title suggests, investors are their own problem. For returns better than the Russell 2000, there needs to be more courage and less haste. In fact, the paper shares begrudging admiration for the VCs at least optimizing their own pay.
Any predictions on whether investors will step up demands of VCs to “show me the money?”
I think part of it is also the scale of the Internet and the type of things going to market today. Software takes some skill to write, but it’s not especially expensive. And then you have to take into consideration that a lot of people are doing it just to do it. When they look for funding it’s to create a foundation, not sell a product outright. And even then you have open source toolkits like Drupal, Joomla, JQuery, and a host of others to do a lot of the heavy lifting for you. Today a lot of hardware is built around system-on-a-chip kits like Gumstix or BeagleBoard, and you can do inexpensive 3D plastic printing with RepRap.
The scale of investment has dropped so far that the need for venture capital is changing. As people pursue what are essentially hobbies the scale for return is also much different. I think the days of big investments yielding big returns are mostly over.