more than 6,000 companies funded in 2000. That trend has since reversed, and in 2009-2010 the market is tracking to about 2,500 companies per year.
2. Too much capital invested per company. The average capital invested in venture-backed companies acquired in the mid to late ’90s was around $10M – $20M. This has grown to $40M – $50M in recent years (nearly $60M for 2010 M&A exits). Even though exit valuations have risen, the amount of capital deployed prior to exits has climbed even more rapidly.
It’s simple math to see that returns will lag if there are three times more companies chasing the same volume of exits and if the average capital invested in a company is rising more rapidly than exit valuations.
Bursting the Bubble
Many things contributed to the imbalance, but one of the biggest culprits was the massive, bubble-fueled influx of capital into VC funds.
Leading venture firms in the mid-’90s managed funds typically in the range of $100M – $200M, and many of those funds did phenomenally well. With that success came the opportunity to access greater amounts of capital, leading many venture firms to scale their funds to sizes of $1B and beyond.
Predictable consequences resulted:
• Start-ups were encouraged to take more capital than they needed and to spend aggressively in anticipation of potential growth.
• Strong competitive bidding for deals led to inflated pre-money valuations, which left little room for capital appreciation.
• Numerous “me too” companies were funded—all chasing after the same bounded market opportunities.
These factors served to degrade the investment returns of venture funds over the last decade. While weak returns can’t be blamed entirely on the overabundance of capital, the need to put excess capital to work from oversized funds certainly contributed to the problem.
For the firms that continued to embrace a more traditional approach to venture capital with properly sized funds, the results were far more successful. SVB Capital recently published a report analyzing the performance of more than 850 venture funds over the last couple of decades. The study found that a “higher portion of smaller-size funds have achieved significant returns…relative to large funds across most vintage years.”
VC on the Rebound
The venture model isn’t broken; it just failed to scale. Many of the venture firms that formed during the Internet bubble aren’t around today, and many firms with decades of investing are downsizing recently raised funds in an effort to regain the strong returns delivered in the past.
These trends will bring the venture market back into balance, and the venture industry will once again deliver the outsized returns that are expected by institutional investors. Innovation and entrepreneurship continue to accelerate, and venture firms can and will continue to play an important role in bringing that innovation to market. This is especially true in Massachusetts, where the country’s second-most-active cluster of venture capitalists is still counted on to create—and fund—competitive advantage in the local innovation economy.
