The economist Herbert Stein famously said, “trends that can’t continue, won’t.” That admonition is often ignored, however, in the sunny and magical precincts of Silicon Valley. After all, it can be hard to believe that trees do not grow to infinity when our redwoods fight a daily skirmish against the clouds for dominance of the skies.
Yet the inexorable pull of gravity never fails to exert itself and, perhaps, one such falling-to-earth moment seems to be at hand. For several years now, fundraising by venture capital firms has lagged the amount of capital that has been invested into start-up companies. Summarizing data from the National Venture Capital Association’s fundraising surveys and Price Waterhouse Coopers’ Money Tree Report, the chart below shows that for the last several years, capital deployment has far outpaced funds raised by venture capital firms.
To be sure, fundraising and deployment do not represent an entirely closed system, as angels, corporate funds, strategic investors, governments, investment banks, and other entities often augment the money invested in start-up companies by pure venture capitalists. Yet, a longer view, visualized in the following chart, supports the notion that VC fundraising and capital deployment typically exist in a rough equilibrium.
In fact, since 1995, in fact, the amount of capital raised by start-ups has exceeded the amount raised by venture firms by only 13.9%. By contrast, since the beginning of 2009, companies have raised fully 50% more dollars than the venture capital funds that are their primary backers. Of course, some of this over-deployment can be accounted for by the whittling away of a modest surplus built up during the 2005-2007 timeframe, but ultimately the industry cannot live beyond its means for very long, as the appetite of outside (non VC-fund) funding sources to fund innovation can be fickle. And unlike the Federal Government, which can print money to satisfy a proclivity for spending more than it earns, the VC industry is limited in its investing by its fundraising.
Indeed, the Lehman-induced financial crash of 2008 was a watershed event, as fundraising became considerably more difficult for venture firms; new fund formation has slowed to a trickle and many established funds are worried about whether they will be able to ever raise a new fund. This slowness in VC fundraising is putting a damper on the otherwise buoyant mood here in Silicon Valley. The double-whammy of a challenging overall fundraising market coupled with the concentration of capital in fewer hands has conspired to make many firms particularly thrifty as their fundraising efforts languish and they worry about their next investment being their last. Some estimate that the number of “active” firms is below 100 today, a small fraction of the typical number of firms making investments. Additionally, this year is also an important one in that those funds that were last able to raise during the relatively flush times of 2007 and 2008 will find themselves at the end of the five year investment periods during which they might make new investments. We expect a dislocation over the next 12 to 18 months as the investing window for funds closes and their management fees start to step down. As one General Partner recently asserted, “it feels like the Zombie Apocalypse has started and I’ve only got two bullets left in my gun . . .”
Of course, an optimist might take comfort from the old claim that, “value-added investing works best when capital is expensive and time is cheap while bubbles are marked by cheap capital and expensive time.” And, indeed, faced with a robust opportunity set and scarce (and thus dear) capital, VCs seem to be working as hard as we’ve seen them in recent memory. There’s a palpable anxiety in the air, though, that contrasts with the casual insouciance that people typically ascribe to Silicon Valley. The perennial gales of creative destruction continue to blow here, but in addition to the typical Eucalyptus and Jasmine aromas carried on those breezes, one can also smell a hint of fear, a scent not as frequently perceived here.