Venture Capital Is Broken

Earlier this week I spent several hours in a couple of meetings with Adeo Ressi, the founder of TheFunded. Adeo is a very cool, very smart guy and it was both enlightening and fun meeting with him.

In the first meeting, Adeo was presenting some findings to the finance and entrepreneurship faculty at Harvard Business School.  His message was that venture capital is broken and that the entire system needs to be re-evaluated.  He cited some interesting data (hopefully he'll publish he just published his slides which are after the jump) such as:

• For first time ever, less money is coming out of VC via exits than is being invested (actually a lot less).
• A handful of deals (Google, Ebay, etc.) account for 25% of total VC returns over the past 20 years.
• Deal structure is incredibly non-transparent (he posed a funny question, "if you own 2% of the Common stock of a company that sold for $100MM, how much do you get?"  The answer, of course, is you have no idea, but probably little or nothing).

Later, we were talking about a post on TheFunded ironically describing the type of company that VC funds invest in ($100MM year 5 revenue, $5MM series A, etc.).  Then, almost as a joke, I saw a post on a VC blog explaining why they only invest in companies that can achieve $100MM of year 5 revenue.  It all reminded me of a paper I read by Bain Capital and described in this MIT Sloan Management Review :

In "Building a Great Software Business in Booms and Busts Alike: An Empirical Analysis of the Operational Performance of Formative Stage Companies, " Bain Capital Ventures professional Jeffrey Crisan and managing director James Nahirny analyzed financial results from 1990 through 1998 for 304 publicly held software companies.  Their baseline criterion for labeling a company as successful is what they call the "Rule of 126"–that is, these software companies achieved $100 million in revenue and earnings before interest and taxes (EBIT) margins of 20% within 6 years after company formation.  Companies were considered failures if they had never had a profitable year and had never reached $40 million in revenue.

According to the Bain Capital authors, there were about 60 of these successful companies in the 8 year period they looked at. Last I checked, there are at least 4,000 venture capital funds, that in chasing these "successful" companies, invest in thousands of companies each year (in the US over 1000 last quarter alone). 

A couple of months ago I wrote about how most venture funds are set up to chase these big deals (they are large funds over $100MM with a several partners and they look to invest $10MM+ into each company they fund) and can't manage smaller companies.  So it's not surprising that a lot of "unsuccessful" companies get funded (false positives) and a lot of "successful" companies get passed over (false negatives).

So what's the conclusion?  Well, as Adeo said, "I'm just the canary in the coal mine."  There is a lot that's going right with venture capital, but there too is a lot that is broken.  To fix it takes some real innovation and critical thinking.  All of us (entrepreneurs, VCs, limited partners, service providers, academia, et al) have a part to play.  If there is any lesson to learn from the current financial crisis it is that we should act soon to fix venture capital and not wait for the bottom to completely fall out before doing something.