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Still too much baggage for the trip

Hypothetical scenario: Say, 15 years ago, an investor group looks to widgets as a high growth opportunity, sees widgets taking off, and allocates $10 to a variety of widget startups. As the industry grows and opportunities multiply, this investor base increases its annual allocations to $30, $40, or more, until one day, 15 years later, the group realizes that $30, $40 per year has been too much, that the widget boom was great but didn’t justify this level of infusion for so many years, and that an adequate return can’t possibly be realized at this pace. In short, the investor base had overextended itself. This group, therefore, retreats to an annual clip of $20, which it considers to be a more defensible target in the realm of widgets, as manifested in the 15-year period ended. And then, the context changes: the tremendous widget inventiveness and disruption declines, not due to less capital, but just so.

There were mixed news in the latest PWC “Money Tree” report on venture capital investing for 2009, which showed a pull-back of some 50% from recent norms. Concerned entrepreneurs and many venture capitalists, who would like to see more money in the system, voiced displeasure over the deterioration. By historical standards, they argued, $17 billion for the year is a pittance, although the optimists were quick to point to a pick-up in 4th quarter activity that would have brought the aggregate to a $20 billion annualized amount.

Then there was the flip-side of the case, put forth in this blog by Fred Wilson, who made note that $17 billion is a move in the right direction for a segment in which capital invested and returns on investment are in inverse relation, and who saw the late-year pick-up as negative. This argument ties back to Fred’s original post about the VC math problem in early 2009, to which I have referred in this space before. By this calculation, in which certain assumptions were made about transaction amounts and net VC proceeds at the time of exit, a sustainable venture capital rate of investment in any given year should be around $15 billion. This presupposes a future exit valuation environment of $100 billion per year, so that the money invested can create adequate return.

Now, this analysis was based on historical experience during a time of enormous innovation. This was the time when the Internet was born and its enabling technologies blossomed. There is no need to list out specifics because we all remember the worlds of 15 years ago and again the past decade, and the extent to which these have led us to today. Suffice to say that Google did not exist at this time in 1998, and exists all over the place now. The question is this, and it is a question with repercussions on many economic levels: Was the historically unprecedented environment of disruption sustainable? And if the VC industry has been overcapitalized based on that same level of activity that gave rise to Google, where does the industry really stand if this rate should (perhaps substantially) decline?

As I tried to argue in a post a few weeks back, the coming era may prove more evolutionary than revolutionary, the Apple tablet notwithstanding, and we are more apt to see the likes of Lala being acquired for millions of dollars in order to add to a technical portfolio and staff, than a new platform emerging from nowhere to become the next Google. If this sweeping generalization proves true – and it will not necessarily be negated by Facebook’s $10 billion valuation or Twitter’s $1 billion, the home-runs du jour – then even $15 billion is no longer reasonable as an annual level for venture capital investing.

Then again, entrepreneurs don’t need that much these days to be successful, and the widgets they create don’t have to be sold for billions to produce a good investment return. 

Disclosure: No positions