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.