Is it possible to have too much of a good thing? That’s a question venture investors need to ask themselves, because all available evidence suggests the industry is suffering from a dramatic oversupply of capital.
Ordinarily, capital is the lifeblood of the venture business. Capital exists in such enormous quantities these days that I worry it may start to become toxic — harming entrepreneurs and investors and threatening the very innovation that powers the United States economy.
Last year was one of the busiest for the venture industry, with more than $84 billion invested, the most since the dot-com era.
Many people welcome that inflow of capital, believing it will lead to the creation of many more promising companies. Unfortunately, the opposite is occurring: There’s been more than a 22% decline in the number of investments in the last two years; the value of individual investments, however, has increased over the same period.
Meanwhile, the portion of all venture dollars in 2017 that was invested in first rounds has fallen off steadily since 2012, according to our analysis of the data from Venture Monitor and the National Venture Capital Association (NVCA). The total number of first-round deals has declined considerably too.
What’s happening is that VC firms, having raised ever-larger funds, can no longer afford to make the sorts of early-stage investments that have been their legacy. Having bigger funds to deploy, they’re forced to make bigger bets on more established, late-stage companies. The well-publicized multibillion-dollar late-stage investments in the likes of Uber and Airbnb are emblematic of this trend.
I understand why firms are chasing the big fish, but I think it’s ultimately bad for everyone.
For one thing, it’s long been established that the bigger the VC fund, the harder it is for it to deliver exceptional returns. The Kauffman Foundation found in 2012 (download required) that only four of 30 funds with committed capital exceeding $400 million were able to outperform a simple index fund of small-cap stocks. Furthermore, the study shows that smaller funds outperform bigger funds and that none of the billion-dollar-plus funds it examined returned more than two times the investment.
This is simply the financial world’s version of the law of physics. The larger the fund, the more you’re fighting gravity to deliver the sort of performance limited partners are paying for and expecting given the level of risk.
Another problem is that by continually shoveling dollars at companies, VCs may be distracting entrepreneurs from attaining the operating-model discipline necessary to become stable public companies.
Still-private tech companies post year after year of red ink, usually because of increasing customer acquisition costs as they prioritize growth over profitability. Sometimes, though, a path to profitability isn’t at all obvious. With VCs willing to subsidize them with successive late-stage funding rounds, these companies have little incentive to rethink their strategies.
This problem is exacerbated by the relatively new phenomenon of semi-public markets being created for the trading of still-private company shares. Now, founders, employees and investors don’t need to wait for an IPO to achieve some liquidity. They can cash out without the company ever needing to prove itself in public markets or become an attractive strategic acquisition.
The consequences are dramatic: Over the past three years, the number of exits for VC-backed companies has dropped by nearly a third.
With VCs slowly abandoning their traditional role as early stage underwriters, there’s a risk that the innovation that’s been the hallmark of the U.S. economy could begin to atrophy. The tech world is pulsing now with exciting new technologies: everything from artificial intelligence to blockchain to the intersection of engineering and biology. This is the sort of environment that in prior eras would have led to scores of small teams — the proverbial two founders in a garage — looking to start the next Google or Facebook and calling on venture firms to be partners in that journey.
What will happen when they find their pitch decks go unread because VCs are spending all of their resources trying to crowd their way into another late-stage investment? Innovation will suffer, with undesirable consequences for the long-term health of the tech ecosystem.
So what should VCs do? In my opinion, we should get back to basics.
For one thing, we should think about limiting the size of early-stage funds we raise, as it will increase our ability to provide meaningful returns in the long run.
We should also refocus on being early-stage investors — after all, this is what most of the world associates venture capitalists with in the first place. Doing so will foster more startup activity, put more people in business and give us a better shot at creating more breakthrough companies.
Originally published at www.forbes.com on May 7, 2018.