Raj Kapoor Speaks out on State of VC Industry

Raj Kapoor Speaks out on State of VC Industry

IMAGINE that Bob Dylan decides to call it quits, declaring that the music business is finished. Plenty of other rockers might snicker: Finished for you, perhaps.

That is a bit like what happened in the venture capital world recently when Sevin Rosen, a successful 25-year-old firm, declared that the industry's business model was broken. Sevin Rosen announced that it would return more than $250 million in commitments from investors who were eager to be part of a new fund.

''The model may be broken for them,'' said George Zachary, a partner at Charles River Ventures.

It didn't help that Sevin Rosen's decision became public just two days before a rival, Sequoia Capital, hit pay dirt again when Google announced it would buy YouTube for $1.65 billion in stock. In less than 12 months, Sequoia, whose early bets on Apple, Cisco, Yahoo and Google itself have long placed it near the very top of the venture capital food chain, turned an investment of about $11.5 million in YouTube into several hundred million Google shares.

''Sevin Rosen? Meet Sequoia,'' read the headline of a fairly typical online sneer by Paul Kedrosky, a venture capitalist, and author of the blog Infectious Greed.

Mr. Zachary added, ''There clearly are people making money.''

Exactly who is making money in the venture industry, and how much, is hard to ascertain. Yet many of the same VC's who were quick to dismiss the suggestion that the industry could be broken, acknowledge that there is more than a bit of truth in Sevin Rosen's analysis of the venture world.

There are too many venture capitalists with too much money chasing too few worthy companies. Compound that with the fact that public offerings of venture-backed companies are nowhere near what they were in the mid-1990's, and the venture capital world looks like a market with too much money going in and not enough coming out.

Indeed, the business, once a relatively small, clubby industry, was flooded with cash and newcomers during the Internet boom -- and not much has changed since. Despite years of poor returns since the collapse of Nasdaq, the number of venture firms has declined only slightly, to 866 last year from 943 in 2001. The amount of capital under management was $261 billion last year, a record, according to the National Venture Capital Association.

And just this week, the association reported that Internet companies received $1.1 billion in the third quarter of 2006, a four-year high. Clearly the hope of being an early investor in the next Google, YouTube or Skype has not faded.
But venture capitalists will tell you it is not just the hope of getting lucky that keeps them in the game. It is the confidence that they have the right strategy to navigate a more challenging industry, be it by investing in a neglected sector or in a promising new industry, by seeking deals in China or India or Israel, or by emphasizing early-stage over late-stage investments -- or vice versa.

''There is a huge amount of money chasing few deals,'' said Raj Kapoor, a managing director at Mayfield Fund. But Mr. Kapoor predicted that firms like his would do just fine because they would continue to get access to the most coveted, and potentially rewarding, deals.

''Is it a model that works for new entrants? No.'' said Mr. Kapoor, himself a relatively new entrant, having become a venture capitalist in 2005. ''Is it broken for top-tier firms? No.''

In a blog posting, Peter Rip, a managing director at Leapfrog Ventures, said that the industry faced real challenges and that successful investors had to become more nimble to fend off competition from angel investors on one end and from hedge funds on the other.

''I think everyone sees that there are problems and that it's more difficult now than it was,'' Mr. Rip said. ''The number of firms that are going to survive over a long period is diminishing.''

Mr. Zachary, for his part, described the problem in Hollywood terms. ''The venture business is becoming more like the movie business where a small number of hits are generating the majority of the return,'' he said. The hope, of course, is that his firm will be among those scoring some of the outsize hits.

That is not good news for the average venture investor.

''There is a tremendous concentration of success,'' said William A. Sahlman, a professor of entrepreneurial finance at Harvard Business School. Mr. Sahlman cited research showing that from 1986 to 1999, a mere 29 venture firms delivered more than half of the industry's total returns. ''I do not see the opportunity set shifting in a meaningful way so that a large proportion of the current venture capitalists can earn a good rate of return,'' he said.

At Sevin Rosen, a partner, Steve Dow, readily admitted that its most recent funds were underwater. But so are most funds that began investing around 2000 or later, Mr. Dow said. Mr. Dow also said that none of the firm's critics had disputed his contention -- based on data not publicly available -- that in aggregate, the industry has not produced meaningful positive returns since 1997. The industry, he said, is suffering from a Lake Wobegon mentality.
''I've never met a venture capitalist who wasn't in the upper quartile,'' Mr. Dow said.

Sevin Rosen, he said, is evaluating new investment strategies. But it is possible that the firm will conclude that the only strategy is to continue to be selective and pick the right deals.

If so, it, too, will be aiming to be in the Lake Wobegon of venture investing.