Stumbling Venture Capital Industry Harms Startups and Innovation

America has lost 8.5 million jobs since December 2007, and the unemployment rate is a high 9.3%. Some hope that new ventures can make up the hiring difference. But given the state of the venture capital (VC) industry that backs startups, those lost jobs aren't coming back anytime soon.

Without capital, companies can't hire people or buy machines. And despite having $200 billion to invest, the VC industry that funds startups is not doing the job. That's because, in the word of Harvard Business School Professor William Sahlman, VC "sucks." Sahlman gave this pithy assessment at AlwaysOn's Venture Capital East conference Tuesday.

Big Proportion of Investments Wiped Out

What ails VC? It's a very risky business, locking up its partners' capital for perhaps a decade to invest in startups. And for the most part, VC deals don't generate sufficient returns to justify further investment. Sahlman presented a chart showing that VC's median investment returns peaked in 1996 at about 45%, and by 2008, those returns were negative 10%.

In fact, Sahlman pointed out that a huge proportion of the capital allocated to VC investments is wiped out completely. He analyzed over 600 VC investments and found that 62.4% were completely lost, while a tiny fraction, 3.1%, of the deals accounted for 53% of the profit from those roughly 600 investments.

VCs get money to invest in businesses from limited partners (LPs), which can include university endowments. And those endowments are generally passing on the "opportunity" to invest in new VC partnerships. At least one of those LPs is fed up with VC -- noting that for the last 13 years, the industry has lost money and lacks accountability.

Peter Dolan, director of private equity for Harvard Management Company, which invests Harvard University's endowment, notes, "When I ask a VC partner to explain a fund's poor performance, he just says: 'Be patient, the cycle will turn.' Society, venture capitalists, and entrepreneurs would all be better off if VCs quit their jobs and started doing something different."

Few Exit Routes

Meanwhile, LPs and VCs don't have a good way of turning their startup shares into cash. The market for initial public offerings (IPOs) is pretty slow -- the 1990s saw about 120 IPOs a year, but the offerings are now down to a trickle. There were six to eight deals in 2009 and slightly more in 2010, according to Paul Deninger, vice chairman of Jefferies & Co.

If there's any good news here, it's that the lack of investor demand for IPOs is forcing investment banks to offer better merchandise. According to Morgan Stanley (MS) Managing Director Edward Liu, during the IPO market's peak, companies could go public with $50 million in revenue despite losing money and get a $300 million market capitalization.

Now a company needs to have $150 million in revenue and generate $60 million in positive cash flow to go public. While the higher standards may be good long-term for the IPO market, the small number of deals doesn't do much to help VCs needing to sell their companies to generate returns for their investors

"Zero Returns for Infinity"?

Another piece of fairly good news is that the 10 largest technology companies have $150 billion in cash that they're using to buy faster-growing startups. A lucky few have been able to sell their companies to these corporate buyers. But very few startups can satisfy the standards of today's IPO investors or corporate acquirers.

This leaves a third way for VCs to turn their investments into cash -- the secondary market, which pays cash for shares of private companies. For the most part, this works for well-established private companies like Facebook when people who leave the company decide they want to cash out their shares. According to Barry Silbert, CEO of SecondMarket, which runs a market for cashing out private shares, a company like Facebook can work with his company to set up a so-called Dutch auction for selling some shares.

While this is interesting, the secondary market is too small to solve the VC's problem. SecondMarket did $300 million in transaction volume in the most recent 12 months.

The cumulative effect of all these problems does not bode well for the future. As Sahlman said, "My forecast for the future of the VC industry is zero returns for infinity."

Where Is Technology's New New Thing?

To his assessment, I would add one important ingredient: The right new technology has been missing for a decade. Since the 1960s, each decade has featured a new productivity-enhancing technology that prompted Corporate America to invest its capital. The first wave was mainframe computers; in the 1970s, companies bought minicomputers; in the 1980s, they purchased PCs; and in the 1990s, businesses invested in the Internet.

No such technology has emerged since 2000. If it did, I believe that a share of what Sahlman called "$200 trillion in capital looking for a home" would become available to finance the startups that supply the productivity-boosting technology. But given all the problems with the current VC model, I doubt much of that capital will come from them.

Instead, it might emerge from "super angels" -- groups of wealthy individuals who work with entrepreneurs to help them build their businesses. According to Ed Sullivan a partner at KPMG, such investors are growing. Between 1999 and 2009, their capital doubled to $30 billion and the number of such funds grew from 100 to 300. These super angels have actual experience running startups, unlike many VC partners, so they actually offer useful advice to startup CEOs.

Wary of Financial Markets

But startups still view going public with trepidation. Ross Goldstein, general partner of VC, DFJ Gotham Ventures, estimates that it costs $3 million for a startup to comply with Sarbanes Oxley requirements. For a typical emerging business, this means it needs to generate an additional $25 million in revenue to comply.

Meanwhile, Silbert argued -- and I agree -- that the public equity markets are now dominated by flash traders who hold stocks for an average of 11 seconds. Given the casino-like nature of the public equity markets, it's no wonder that a startup CEO would be uncomfortable trying to manage a public company.

America's greatest economic strength in the past was its ability to commercialize innovation better than any other nation. If we are to restore that strength, we need to rethink the way we provide capital to our promising startups.