Imagine you are an ultra-wealthy individual, or a pension fund manager, or the person in charge of supervising a university’s endowment. You want to put some of your money into venture capital, and ideally reap stellar returns by helping back fast-growing companies.
You call up Paul Ferri, founder of Matrix Partners in Waltham, one of the most successful local venture firms (it funded Apollo, Cascade, Stratus, Apple, Sycamore, and Tivoli, among others). You ask Ferri for his opinion on which firms you should invest your money with. “Let me give you some advice,” Ferri will tell you, as he has told others who’ve sought his counsel. “Do not put money into this industry. You won’t get it back.”
That’s a startling answer from one of the best in the business especially at a time when Google is on the verge of going public in what’s expected to be a pyrotechnic IPO. But to underline his point, Ferri pulls out data showing that from 1990 to 2003, $218 billion was entrusted with US venture capital firms. Only $179 billion was returned via IPOs and acquisitions. “Any other industry, you’d say, `This is a Ponzi scheme.’ “
The central problem, as Ferri and others see it, is a glut of money in the system. Investors pour it into too many venture capital firms, which in turn help start too many companies. Here’s a look at what’s wrong with venture capital obviously not a comprehensive list and what it’ll take to fix it.
1. Investors who put their money into venture capital funds the aforementioned pension fund managers and endowment overseers don’t seem to have been burned by the stock market blowout. In fact, many have now decided that fixed percentages of their total assets ought to go into venture capital, say 5 to 8 percent, despite the sector’s high risk and volatility.
And foreign investors are eager to get into US venture funds, too. If they can’t put their money into the funds that have performed best over time, they often settle for putting it into new-kid-on-the-block funds with little track record of creating successful companies or delivering returns to their investors.
2. If you are a money manager, your job is to put that 5 to 8 percent of your money into venture capital. It’s not an option to say, “Maybe we should put this into bonds instead” or “I couldn’t get into a top-tier fund, so let’s hold off on investing this money for now.”
3. The “fund of funds” industry has grown. Think of this as a sort of mutual fund for venture capital. You invest with a firm like HarbourVest, and they put the money into an array of venture capital funds. But often, their compensation isn’t tied to the performance of the funds they invest in. Instead, it’s tied to total assets under management. That encourages them to raise lots of money from their investors and dole it out, in turn, to lots of venture firms.
4. Venture firms typically take 2 percent management fees out of the money in their fund. That promotes larger, not smaller funds. But larger funds, as Harvard Business School professor Clay Christensen pointed out recently, have trouble making and managing small investments in start-ups, exactly the sort of thing that made venture capital work in the first place. (The very first venture firm, American Research and Development, put $70,000 into Digital Equipment Corp., an investment that grew to be worth $37 million.) When your fund is $500 million, the impulse is to parcel it out to start-ups in $5 million to $20 million chunks.
5. It’s hard to inculcate a sense of fiscal discipline in a start-up when money rains down so plentifully and there’s a sense that with such a big venture firm behind you, there’s always more when you need it.
6. Corporate spending on technology is still pretty stagnant, and tech buyers tend to be reluctant to buy from start-ups that may not be around in five years to provide support for their products. Plus, as Charles Lax says, “The macro situation in the world economy is not good, and I’m not sure it’s getting better.” Lax is the managing general partner of GrandBanks Capital in Newton.
7. Lots of venture firms with lots of money create lots of start-ups. (The firms also bid against one another for the right to invest in certain start-ups, which drives up the company’s valuation and makes it harder for the venture firms to eventually get a good return on their money.)
Bill Seibel, chief executive of the supply chain software firm Demantra in Waltham, estimates that there are nearly 750 companies, most of them small, selling similar software. (To differentiate itself from those 750 competitors, Seibel expanded Demantra’s offerings; the company now helps customers gauge how marketing promotions affect demand for their products.) Venture capitalists have also funded hundreds of anti-spam, security, storage, RFID, Web services, and wireless LAN start-ups.
A surfeit of start-ups in a particular sector makes it tough to get customers’ attention, and hard to negotiate a price that will allow you to make a profit. Ferri says that in 1993, five of his top 10 portfolio companies were profitable; by 2003, because of this intense competition, just one of Matrix’s top 10 is profitable. “There are too many companies doing similar things,” Ferri says. “They’re spending more money more quickly, and they have less pricing power with the customer.”
8. Even if companies are stalled in the marketplace, venture capitalists still seem reluctant to shut them down. “It’s not like you see in the restaurant business, where a bad restaurant tends to go out of business pretty quickly,” says Seibel. Sometimes, they merge them with other companies, hoping that the combination will somehow impart momentum. But writing down the value of a company or writing it off entirely looks bad to a venture firm’s investors.
Tim Barrows, another partner at Matrix, sees evidence of what sounds like grade inflation. “If you compare the way one firm values a [private] company with the way another firm values that same company, you see some pretty surprising differences,” Barrows says. But until a company goes public or gets bought, that valuation is purely imaginary simply a number cooked up to provide a “best guess” as to what a firm’s portfolio of companies is worth. Often, these valuations exceed those of comparable publicly traded competitors.
“There are still a bunch of VC investments that haven’t been written down enough,” says Todd Dagres, who split with Battery Ventures last year, and says he’s exploring the possibility of raising an early-stage fund that would focus on the intersection of technology and media. He says he’s interested in areas that VC firms don’t typically dabble in, like online gaming and computer animation.
9. That imaginary valuation can make the industry look like it’s doing better than it really is. (Ferri points to a Wall Street Journal headline from last month that trumpeted, “Venture capitalists make money again” – a report based entirely on these pretend portfolio valuations having risen 8.1 percent.) That helps venture capitalists go back to their investors and raise money for their next fund.
10. The investors in venture capital firms haven’t yet lost enough money to cause a change in their behavior, and either stop investing with subpar firms or move their money into different asset classes entirely.
How to fix the situation? Google won’t do it alone.
Ferri says that when the investors who support venture capital firms lose enough money, “eventually this business will contract,” and squeeze out the firms that never delivered good returns. But that means a few more years of chaos for venture firms and intense competition for the companies they create.
Dagres would like to see the industry get smaller sooner than that. “We need to reduce the amount of money, the number of firms, and the number of companies competing in a market segment,” he says. “I hate to put it this way, but the VC industry needs an enema.”
