The average return on venture capital investments for the year ending June 30, 2009, was -17 percent, according to figures released by the National Venture Capital Association in October. The 3-year return was +1.3 percent, the 5-year return was +5.7 percent, and the 10-year return was +14.3 percent. Over all of these time frames, venture funds have performed significantly better than public market averages like the Dow-Jones, the NASDAQ, and the S&P 500. Still, even a 14 percent return isn’t exactly the kind of stellar performance that the term “venture,” with its air of high risk and high reward, once connoted.
And the picture is about to get much worse. As Kaufmann Foundation fellow Paul Kedrosky has pointed out here, the 10-year returns from venture funds will go negative in 2010 after the last of the dot-com exits drop from the rolls. All this has left plenty of room for sniping, from both insiders and outside observers, that the venture model itself is broken (or at least decrepit, as Xconomist Daphne Zohar puts it).
But if venture is broken, then what about it needs to be fixed? Pundits have offered any number of vague solutions. But if you talk to the partners at Charles River Ventures in Waltham, MA, you’ll get a single, definite answer. They’ll tell you that the problem is that there’s too much venture money chasing a finite number of good ideas. The solution? Venture funds themselves should be smaller—and there should be fewer of them.
“The number of great entrepreneurs and innovative products does not scale with more capital,” says Jon Auerbach, a general partner at CRV. “You cannot invest 10 times the capital into 10 times the number of startups and hope for 10 times the results.”
Auerbach has only been with CRV since 2007—he spent seven years before that as a general partner at Lexington, MA-based Highland Capital Partners—but this is actually an argument that the firm has been making since 2001. That was when the firm’s general partners suffered a drastic change of heart about the $1.25 billion fund they had just raised and gave $800 million of it back to the limited partners (LPs). Ever since, CRV partners have preached whenever offered the opportunity about the need to “right-size” the venture business and about the virtues of limiting each fund to roughly $250 to $300 million.
And many other voices are now joining the chorus. Back in April, Fred Wilson at Union Square Ventures wrote that the venture math just doesn’t work. LPs are putting about $25 billion into venture funds each year, but portfolio companies are only producing about $100 billion per year in exits, which, after venture funds’ fees and carry (the profits kept by general partners) are subtracted, translates into annual returns for investors of about 10 percent—far less than most LPs expect from venture funds as an asset class. Working backward from recent data on exits, Wilson suggested that venture firms should raise only $15 billion to $17 billion each year in total if they want to offer admirable, sustainable returns.
If you take Wilson’s math further and divide $17 billion by the number of truly active funds—which Auerbach estimates is around 400—then it becomes apparent that each active fund should only be raising about $43 million a year, or $212 million every five years. That’s not far off from CRV’s $250 million sweet spot.
So maybe the industry is moving in the right direction. Or maybe it’s still heading for a huge shakeout. Zohar says it’s time to end practices such as tranched funding and liquidation preference multiples that favor VCs over entrepreneurs, while Kedrosky argues that LPs should “force change on a broken industry” by demanding lower fees and more favorable repayment terms from venture partners. But what if there are many venture firms that should simply go out of business? If “the right number” of venture firms in today’s economy is around 400, as Auerbach asserts, that means another 400 firms classified as active by the NVCA should be shut down.
In a long conversation with Auerbach in early November, I asked why CRV is so adamant about the dangers of overfunding and overpopulation in the venture industry; how the firm’s own awakening to those dangers came about back in 2001; and how the venture industry needs to adapt going forward. I also asked him whether he feels entrepreneurs need to adjust to the idea that capital will be scarcer. “I’m not saying entrepreneurs should scale back their expectations,” he answered. But at the same time, he said that the venture business would be far better off funding just two or three companies in each market niche—not nine or ten, as we’re still seeing in sectors like networking hardware, database software, social media, or mobile advertising.
Xconomy: What’s the basic argument you’re making about the size of venture funds?
Jon Auerbach: As a firm with 39 years of experience investing in early stage startups, if there is one thing that we’ve learned, it’s that the industry functions best when it is a small, constrained industry. We fundamentally do not believe that there is scale in the venture capital industry. Unlike private equity or buyouts, which is really a science, venture capital is an art. It has a lot to do with people and judgment, a lot to do with
