There is Too Much Venture Capital…Not Too Little

Over the weekend I saw a report from the NVCA about the amount of money US venture funds had invested in the first quarter which Adeo at TheFunded summarized well.  The bottom line is that VC funds invested a total of $3 billion in startups which is the lowest amount since at least 1998 and significantly lower than after the dot-com crash.  The knee jerk reaction would be to conclude that the credit crunch has made its way to the private equity asset class and they are simply investing less because they have fewer funds available.

But I'm not so sure that is the case.  According to TechCrunch, the amount of capital that VC and private equity firms have raised over the past few quarters exceeds that invested.

I plotted the two sets of data which are basically the amount of money that goes *in* and comes *out* of VC.  The green bar is the quarterly net of the two, i.e. it shows whether money is accumulating in funds or not and the purple line is the cumulative net flow.

What you see is that aside from Q4 of last year, money has been accumulating in venture funds for the past 2 years; to the tune of about $6 billion dollars.  If these data are correct, then it would mean that the problem is not having enough capital to invest, but rather not having enough companies to invest in.

So what would cause this kind of imbalance, i.e. an excess of capital relative to companies to invest in?  The first thing to check is are there fewer companies.  I couldn't get great data, but at the macro level the answer is no (the US Census Bureau shows 370,000 more companies in 2006 than in 2000).  My hypothesis is that, while there are more companies seeking funding, their are actually fewer companies in total that meet the VC's investment criteria, specifically the companies need less money than the VCs want/need to invest.  What is driving this is three things:
  1. Open source.
  2. Cloud computing. 
  3. Virtual office infrastructure. 
These three forces have dramatically cut costs over the past few years and in turn hugely improved capital efficiency.  No longer do companies have to hire armies of programmers and buy buildings full of hardware to launch a business.  And the virtual office powered by Skype, Basecamp, Gmail, WebEx, et al is at least as efficient in terms of productivity as a traditional office but at a fraction of the cost.  The bottom line is that companies no longer need millions of dollars for real estate, hardware and employees which they would have needed even just a few years ago and this in turn takes them out of the VC's consideration set.

How ironic is that the one thing (capital efficiency) that VCs promote above all else is the thing that threatens their business model?

So this could explain why VCs have been accumulating capital over the past couple of years.  They basically have fewer companies that meet their investment criteria (which, by the way, means there is a huge, growing class of companies that need an alternate form of funding).  Now, I know someone is going to post a comment saying that the VC funding numbers are over estimates because they do not factor in failures to meet capital calls.  That could be true.  I've heard the anecdotes too, although it's a recent phenomenon which wouldn't explain the net funding imbalance 2 years ago.  And until I see the numbers I'm not sure how to plot a story on the chart above…