Venture Capital Comes Back from the Brink

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Venture Capital Comes Back from the Brink

William Sahlman, a highly respected Harvard Business School professor, recently told a crowd at the AlwaysOn Venture Capital East conference that, today, venture capital "sucks."1 

Sahlman cited the disappointment of the last decade to explain why some $200 billion in venture capital is just sitting there waiting for investments worthy of funding — and he is not alone in his frustration with the state of the industry.

Why all this pessimism?

For one thing, venture capital is a high-risk business that's supposed to also create high returns over time.  It requires that you commit large amounts of money for many years and, sometimes, even for decades. 

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The return on venture capital investments was at its highest in 1996 during the tech boom IPO wave.  But, most recently, the industry average return was minus 10 percent.  In more than 60 percent of VC investments, the principal is lost altogether. 

Another way of looking at the risk is this:  Just three percent of all VC investments account for more than half of all the profits made by venture capitalists.

These statistics aren't being ignored by the people from whom venture capitalists get their money; limited partners, which are often the endowment funds for big universities. 

The major universities have great pools of cash to invest on behalf of the school, and in the past, they have turned to venture capitalists to help them invest.  Today, these fund managers have turned sour on VC due to poor performance.

Historically, the way this business worked was that limited partners gave cash to the venture capitalists, who in turn gave it to someone who was starting a new business.  Once the business got on its feet, there would be an initial public offering of stock, and everyone would happily cash out as investors rushed to get in on the next big thing. 

But IPOs are becoming increasingly rare.  For example, in the 1990s, there were about 120 IPOs each year.  In 2009, there were only eight.

Fund-raising for venture capitalists is at a five-year low, following a 68 percent decline to just $95.8 billion in 2009.

Of course, the '90s were hardly what we would call a normal market.  At the peak of the tech boom, companies with only $50 million in revenues could launch an IPO and get $300 million back from investors, even if they had showed no profit. 

The investment banks that broker these deals now require that a company have revenues of at least $150 million, and be able to channel at least $50 million into free cash flow, before they'll consider an IPO...

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