Hazard Lights

Bill Gurley recently had an excellent post on the state of
the venture capital industry, with an emphasis on how Limited Partners think
about the asset class.  I generally
agree with his primary thesis that: 1) the industry will be smaller and raise
less capital and 2) this is net healthy for entrepreneurship given that fewer
companies will be funded in what would otherwise be overcrowded sectors.  That said, I am not sure the metaphor he
used – a picture suggesting all the industry needs to do is go on a diet to
lose some weight – is right. 
Instead, I think the more appropriate metaphor is what went two weeks
ago in the NFL: teams cutting players to have appropriate sized rosters.

Here’s how I see it: If venture capital funds typically have
4-year investment period, over the course of that time period most firms would
need to raise a new fund.  As a
result, if we look at the four years from 2005 to 2008, when the industry as a
whole raised $125 billion across 952 funds, we have a rough approximation of
the size of the industry on a run-rate basis prior to the recent economic
turmoil.  During this time, it is
estimated by the NVCA that there were approximately 7,500 practicing venture
capital professionals, or $16-17 million of capital to invest per
professional.  If going forward,
the industry raises more like $15 billion per year, or $60 Billion over four
years, at the same ratio of capital per investment professional, the industry
can support only 3,600.

As a result, much as NFL teams need to cut back to get to 53
players on their roster, venture capital firms will need to cut back investment
personnel to reflect the reality of the current funding environment.  I don’t think this change will happen
over night, nor do I believe the industry will actually get to this level of
professionals (about where the industry was when I first joined in the early
90s), but directionally I think this change needs to, and will, happen (and
already is happening).

What does this mean for entrepreneurs?  First, be sure to spend some time
thinking through whether the particular partner you are working with is likely
to be on the team going forward. 
If they have not made an investment in the past couple of years, are working
with a only a small number of portfolio companies, or are focused in an area
(industry, geography or stage) that the firm seems to be de-emphasizing, they
are potentially at risk.  Further,
the firms that are likely to see the greatest cutbacks will be at both ends of
the size spectrum.  The larger
firms that have added significant staff over the last 10 years will likely trim
more than those that have stable sized partnerships and conversely, the smallest
of firms in the industry will be at risk as they just wont have the fee income
to support their organization and accompanying overhead.

Second, the reduced size of the venture capital industry
will result in fewer companies getting funded.  Each one of the venture capital professionals in the industry
today is out trying to make investments, so if there are approximately half the
number of participants, it stands to reason there will be approximately half
the number of companies funded (if all the industry did was diet and have less
capital with the same number of participants, as Gurley’s image implies, one might
incorrectly infer that the same number of companies might get funded just with
less capital each).  While this
certainly raises the bar on the quality of the team, idea and market
opportunity for entrepreneurs, it importantly will result in a significantly
healthier market environment for those companies that do receive capital.  We all have been part of companies that
were pursuing a good idea and market opportunity, only to see a dozen companies
created in that space, with the net result being a bar room brawl in which only
one or two players emerge from the saloon bloody, bruised and vulnerable to
another fight.

So just as cut day in the NFL is not fun, this process in
the venture capital industry will not be easy or painless, but will net result
in stronger teams and a more healthy environment for the industry and
entrepreneurship as a whole.