Earlier this week at the AlwaysOn Venture Summit East, Harvard Business School Professor Bill Sahlman declared that the "Median rate of return on VC will be 0% for the rest of eternity". For those of us who have been in the industry for a while, this is not a new statement from Professor Sahlman, although the qualifier "to eternity" certainly is a new time frame for this claim (and for those of you keeping track at home, eternity likely exceeds the length of my investment horizon). Rather than debate his point of view, when I heard this I sent out a tweet saying simply "I hope he is wrong". Soon thereafter I got a reply, which I have heard from several entrepreneurs before, that went something like this: "Don't you hope he's right? We want entrepreneurs to get at bats, and the current model makes that possible".
I was tempted to reply back quickly with the the short answer of No, but thought this topic may deserve more than 140 characters. So here is the the longer answer. In the short term, venture capital that is willing to be invested at a 0% expected rate of return is on the margin good for entrepreneurs in that it helps get companies funded and maybe some of these companies will emerge as real businesses and many entrepreneurs will indeed get their at bat. In the longer term, however, it is unsustainable and bad for entrepreneurs for two reasons. The first reason is that the abundance of capital leads to too many companies being funded in any given sector, with the net result being that interesting sectors that can support maybe 5 companies now have 20+ companies pursuing the same customers, partners, and employees and each company is weaker as a result of the level of competitive intensity for scarce resources. The second reason is that venture capital as a "asset class" competes for capital from investors and if the returns are not interesting, capital will go elsewhere where the expected risk adjusted returns are higher. Further, venture capital is an inherently illiquid investment and, because of the illiquidity, our investors look for a premium return when they can not access their capital for longer periods of time, just as you get (and demand) a higher interest rate from your bank when you commit to a 3 year CD versus the interest rate you get in your always accessible checking account. The general rule of thumb is that venture capital needs to generate returns that are 500-1000 basis points greater on a per annum basis than a similar equity investment, say the S&P 500 or the Nasdaq 100. As a result, unless you are expecting the broader public stock markets to decline by 5-10% per year, a 0% rate of return in venture capital is not sustainable and the industry as a whole will contract, resulting in less capital for the industry and entrepreneurial ventures. So while it may seem appealing on the face of it to have the industry run for the broader good of innovation, in the end we – meaning entrepreneurs and venture capitalists together – need to earn our keep every day to ensure that capital remains available for great people and ideas.