The Coming Brick Wall in Venture Capital & Why This is Good for US Innovation

Posted on Jun 30, 2011 | 39 comments


This is the final part of a 3-part series on the major changes in the structure of the software & the venture capital industries.

The series started here if you want to read from the start.

Or the Cliff Note’s version:

  • Open Source & Cloud Computing (led by Amazon) drove down tech startup costs by 90%
  • The result was a massive increase in startups & a whole group of new funding sources: both angels & “micro VCs”
  • With more competition in early-stage many VCs are investing smaller amounts at earlier stages. Some are going later stage to not miss out on hot deals. I call this “stage drift.”
  • The opportunities for tech startups today are more immense than they’ve ever been with billions of people now connected to the Internet nearly all the time.

But …

Downsizing Venture Capital
The venture capital business itself is going through an even more fundamental change than just the entry of a new category at the earliest stage. The industry is shrinking back to a mid-90′s level in terms of both dollars and numbers of firms.

The doubling of the industry size was caused by the euphoria of the dot-com bubble and since funds take 10 years or more to dissolve the bursting of the funding bubble has taken its time. We all know the result of the over-funding of the asset class – poor returns in aggregate for the industry. The best firms have still delivered results, though.

So what’s happening now is the elimination of funds that probably should never existed as well as the questioned relevance of some older firms that failed to find good succession strategies or remain relevant.

That’s certainly good for our industry in terms of future returns for investors but I would argue also for entrepreneurs. In the last 90′s it was impossible to charge fair prices for products & services in a market where you had 5 competitors giving away free products to acquire “eyeballs” and fueled by an excess of venture capital.

A normalization of the venture capital market will bring more rational valuations over time but should produce more stable companies and better returns for VCs and LPs. It doesn’t feel like that now because we’ve entered a mini bubble in pre IPO valuations for a segment of the tech market but this, too, shall pass.

The Coming Brick Wall
What I’ve started to observe is that we’re certainly headed for a bit of a brick wall for early-stage companies. The explosion in number of startups coupled with the decrease in numbers & dollars of VCs portends this.

As an industry this is probably OK. Creative destruction is what drives capitalism and innovation. Some startups won’t make the cut but those founders will have developed invaluable skills and will join the ranks of the survivors. I’m proud to see this creative destruction happening more prevalently in the US right now because it gives me comfort that we haven’t lost our footing in terms of global innovation.

I would argue that the explosion in startups and the coming brick wall will continue to create compelling opportunities for venture capitalists. As an industry we have more startups feeding into the top end of our funnels from which to evaluate and choose the most prudent investments. The coming brick wall will ensure that valuations reach their natural limitations and return to normalcy. The coming brick wall will produce more second-time entrepreneurs whom we can fund that will bring real experience to the table in their next businesses.

I know that a brick wall is a rather nasty metaphor, but it’s not all bad. Like any market that overheats we will have the negative collateral damage but also the blossoming of the next wave of innovation and returns.

Borders, Normalization & The Continued Relevance of Venture Capital
My prediction for what comes beyond the brick wall?

  • Continued high pace of startup innovation. The lower costs & lower barriers to entry support this. Also break-out companies like Rovio and NewToy that grew big without much capital will continue to encourage young entrepreneurs to try
  • Increased reluctance of angel investors to fund any new hot team based solely on the “social proof” of who else invested. Brick wall = lost money for early-stage capital primarily concentrated on angels. I’ve been on-record here for a while.
  • Return to focused strategy for investors where Micro VCs have a more established position in their market and traditional early-stage VCs become more comfortable waiting for products to be completed as FOMO (fear of missing out) subsides
  • Hedge funds and growth equity firms returning to their traditional segments of the market

Basically, I believe that each market participant brings strengths relevant to their stage and I don’t believe in huge stage drift. The software industry is changed for good and the next decade will truly be dominated by the open cloud and open platform companies that embrace this. And the IT segment of the Venture Capital industry will continue to evolve to meet the market needs, not vice-versa.

Brick image courtesy of Fotolia.

  • http://usemighty.com Aaron Crayford

    Suster for putting “The Cliff Notes” I swear i’m gonna man hug you next time I see you :-)

  • http://usemighty.com Aaron Crayford

    Suster do you have any data points on firms AND dollars raised is decreasing? My finger in the wind says although number of firms are in fact decreasing the dollars raised per firm has increased drastically.

  • http://www.ryanborn.net ryanborn

    What a wonderful series and thanks for having the cajones to go on the record here with all the great info and analyses.  It’s still all soaking in and as much a I dislike the “great post” pat on the back comments I’m giving you one anyway!  Good night.

  • http://www.ryanborn.net ryanborn

    What a wonderful series and thanks for having the cajones to go on the record here with all the great info and analyses.  It’s still all soaking in and as much a I dislike the “great post” pat on the back comments I’m giving you one anyway!  Good night.

  • http://www.ryanborn.net ryanborn

    What a wonderful series and thanks for having the cajones to go on the record here with all the great info and analyses.  It’s still all soaking in and as much a I dislike the “great post” pat on the back comments I’m giving you one anyway!  Good night.

  • Anonymous

    Seems like a bottom to me in the active VC’s chart. Very similar to the COMPX interesting how it follows it.

    The drop in the chart is 2.5% at its latest point which is the smallest movement so far. So the decrease is obviously getting smaller.

    You could look at that data and say a top tends to occur when the number of VC’s increased by 40-50% yoy. Which in a shallow way supports the bottom theory.

    I guess I feel that brick wall will be much higher from here, since the trend is strong and every Starbucks has turned into a startup’s conference room.

    I think the dumb money is going to be bringing up the rear once again ala 1999, but that is a ways out.

    I’m calling it now, Brick Wall 2015.

  • Anonymous

    Seems like a bottom to me in the active VC’s chart. Very similar to the COMPX interesting how it follows it.

    The drop in the chart is 2.5% at its latest point which is the smallest movement so far. So the decrease is obviously getting smaller.

    You could look at that data and say a top tends to occur when the number of VC’s increased by 40-50% yoy. Which in a shallow way supports the bottom theory.

    I guess I feel that brick wall will be much higher from here, since the trend is strong and every Starbucks has turned into a startup’s conference room.

    I think the dumb money is going to be bringing up the rear once again ala 1999, but that is a ways out.

    I’m calling it now, Brick Wall 2015.

  • http://paramountessays.com/essay pay for essay

    Thanks for
    the article. Very interesting. Especially liked this part “The Coming Brick Wall”

  • http://twitter.com/rekatz reuben e katz

    Hi Mark, do you see the international strength of other global powers making up for any of the decrease? Also, “The coming brick wall will produce more second-time entrepreneurs whom we can fund…” do you believe that it will be a hard stop or are we trickling into that phase already?

  • http://twitter.com/rekatz reuben e katz

    I’d had a similar question and wondered what the graph would look like with the amount under management overlaid. 

  • Mat Tyndall

    As a young entrepreneur looking into raising a seed round, it’s reassuring to know that funding trends are in my favor.

    Then again, it’s possible I might not need to raise much money till I reach the “get fat” stage since I recently figured out a way to get client funding (nothing definitive yet, but people seem interested). Coincidentally, it fits in with the whole Amazon theme of this series since I’m offering a missing piece of the open cloud, something you’ve explicitly asked for in fact. Don’t worry, I’ll definitely be keeping you in the loop since you’re a potential investor/customer/user hat trick, this is just a heads up.

    Anyways, I found this series to be very enlightening and informative about the evolving dynamics between the fundees and funders. It will be interesting to see how well your predictions hold up to the next tech disruption.

    -Mat

  • Smaxwell

    Mark, As an expansion stage investor, we have been waiting patiently for the super-angel/micro-VC baby boom to come of age.  It feels to me like we are starting to see more and more interesting companies from the super-angels/micro-VC  seeds…I hope that we continue to see more!

    I suspect it will be more an “invisible hand” than a “brick wall.”

    Scott Maxwell
    OpenView Venture Partners

  • Dave W Baldwin

    Great 3 part series. 
      
    @iCalled_it:disqus The brick wall will be before 2015 because too many are doing investing/building on short term products not thinking of the market/delivery capabilities of 2013-15.  Add to that the pressure of NMO enabling Devs to suck more fund than needed will bring confusion.

    Keep up the good work Mark and everyone needs to communicate to the Angel community the need of Due Diligence looking at the parameters moving forward.  Mark is right about the need to do something 10x better.

  • http://twitter.com/FSGriffiths Steve Griffiths

    The NVCA publishes quarterly data on number of new funds raised and total dollars. You can find it here: http://bit.ly/mqA924.  The recent trend is fewer, smaller funds.  In my opinion that should favor firms with a strong track record or a strategic advantage.    Which brings me to my question for Mark — how do you see strategic/corporate VCs impacting the VC industry in the future?  Great series, thanks for sharing.

  • http://twitter.com/drrichjlaw Richard J Law

    Is this “brick wall” going to be more pronounced in different sectors? i.e. Life sciences may be hit harder due to the need for larger tranches and longer timelines?

    Having said that – biotech investment in 2010 was actually higher than in the VC/dot-com bubble of 2000: http://www.signalsmag.com/signalsmag.nsf/0/C706DECAFD78AF6E8825781C006F4BE1

  • Paul Hazel

    In any other predator/prey relationship, an increase in the number of prey species allows an increase in the number of predators as the system moves to a new equilibrium. There may well be a brick floor that the investment community rebounds from, and it might seem to be a brick wall to entrepreneurs caught in the bounce, but won’t the growth in startup opportunities drive  growth in the investment community – in particular foreign funds looking to poach?

  • Anonymous

    In my opinion, the decrease in LP dollars going in and the decrease in the number of firms will reverse within a couple years. The recent and imminent IPOs will result in some pretty strong returns for some firms, and LPs will start to see what they missed out on by backing away from venture. They will pile back in and the whole cycle will repeat itself.

  • http://www.justanentrrepreneur.com Philip Sugar

    It will be interesting to see.  Right it feels like there is euphoria over valuations.  “I put in $100k at $1.5M pre and the company just raised at a $12M pre, my investment must be worth $1M!!!”

    Honey, its like keeping all your chips on the craps table.  It doesn’t mean squat until you get to take them off the table or you crap out.

  • http://angel.co/energie-praemisse james ferguson

    Hi Mark   (s indeed – for the insights) 

    Paraphrasing Karl Marx  - “Ramen Noodles are the Opiate of the Entrepreneur.”

    I’d like to share my experience of an “internal inflection point” – One that may or may not occur if you become Ramen profitable.  So my story…We built a small but well thought of consultancy which reached hand-to-mouth tick over TOO early – It is still trading (ten years later in the UK), but after five years I literally moved out of the country (to Switzerland) essentially to throw out the Noodles – to make space to automate and scale the business.I believe Ramen profitability seduced – I felt “At last” and took a breath, and safe (“If it ain’t broke – don’t fix it” ), and I felt content  (a transient thing – that wealth cant buy).In my view taking a breath is OK, and spiritual ease a life goal – but the middle one will dull you.”Don’t fix what ain’t broke” = stagnate. Decisions break stagnation – they change things.  So Ramen profitability brings on indecision and stasis - VC’s just love that –  right !Like your own Kool-Aid (thanks again Mark)  it only  tastes good at first. To decide is to cut from the past (from what IS)  - hungry entrepreneurs need sharp incisors for clean decisions – and they need Molars to grind down resilient barriers – like those walls of which Mark speaks. So how do you not stagnate – Instead of stepping back you step up – and set a higher bar.  You ask what could be better, more efficient, more sought after, more easily but not always simpler  (if it gets the same work done its called efficient) .  You also can do this by looking up!  It’s why I – just getting Ramen profitable for the second time – but now scalable take time on a Friday afternoon to write this and consider my next steps.  The answer – Another step, and another, and so on.  We’re looking for product/market fit and have some traction – and I know where thats going.  This time I won’t stop to eat noodles though – catch me at http://angel.co/energie-praemisseBTW – I do think VCs should let Founders take a little money from the table at round A – why because fear is what makes Ramen profitability seductive. Founders conquered their fears once – so now we are better off with a safety net in place – because with that we will try anything !Long post – sorry – always way to passionate about an insight !

  • http://www.misterluna.me Kenneth Luna

    Thanks for the post. 

    I like your analogy of the ‘brick wall’.  I definitely agree that this normalization will be healthy for this asset class.  Money rushing in to be part of the next ‘big thing’ is definitely a destructive process – akin to the laws of diminishing returns.  We’ve seen this happen with all asset classes, tech, real estate, and commodities.  

    Excited to see what the near future will look like once the dust settles.  

  • http://blog.patternbuilders.com Terence Craig

    Mark – I am long time
    lurker and as a serial entrepreneur love the way you share your
    experience with brutal honesty – I would have made a lot more money if this
    blog had existed when I founded my first company.  

    I think your post is dead on. The brick wall will be beneficial to
    startups as well as investors.  As you said, it will reduce the
    overcrowding that exists in almost every software niche. This overcrowding is a
    huge problem that has driven the price of services and solutions and their
    associated margins down to levels that often make it impossible to build a
    business for anything other than exit by acquisition.     Just as
    important IMO is that it will help alleviate two other
    problems: 

    1. People who join startups for “easy” money – More targeted
    financing will reduce the number of people who join startups with the hope of a
    quick flip.  Those folks cause a huge amount of dysfunctional behavior in
    the current crop of early stage companies because they have no interest in
    building a business for the long term.  They are one of the primary causes
    of number two.

    2.  Distrust of startups by enterprise customers – By
    removing fly-by-night and badly conceived companies, a funding crunch
    will let us began to rebuild the faith that has been lost by enterprise
    customers in early stage companies.  The damage caused by early stage enterprise
    focused startups selling software that didn’t work or who abandoned their
    customers due to a pivot, bankruptcy, or acquisition is incalculable.
     Most of these companies should have never been funded and their abuse of
    their customers has made selling to the enterprise a frustrating process for those
    of us who have real products and are committed to long term successful relationships.  The level of mistrust these “fern bar”
    startups  have engendered in the Fortune
    1000 needs fixing for innovation in the enterprise space to really flourish –
    cutting off bad companies access to capital is one way to start that process.
     
    Please keep writing you are providing a valuable service.

  • Elliott Dahan

    Mark – we met a long time ago – we had breakfast in Palo Alto. The early stage is the beginning of the Liquidity Food Chain. the early stage is a global community, not a linear transaction. All members of the early stage are active and constant buyers and sellers. Lots more to talk with you about. visit the static demo at – http://www.earlystagemarketplace.com. Contact me at elliott(at)thegrowthgroup(dot)com. We should definitely talk.

  • Anonymous

    Great series – I just wonder how the devaluing US dollar will change the VC firm. That’s a trend that I’ve been concerned about lately, and I think it could have a massive impact on the startup industry as a whole. With rapid inflation, money invested becomes worth less as time goes on (even if it’s returned 5 years later at a 10x multiple), thus less money in the system, etc. 

    Maybe I’m a bit crazy, but it’s a macroeconomic trend that really concerns me and I don’t see many people talking about it in relation to startups.

  • http://www.justanentrrepreneur.com Philip Sugar

    What a great comment.

    I written extensively about your point number 2.  I cannot express how spot on you are on that one.  I have said I love startups getting financed but when you fail or pivot and you sell to the enterprise people lose their jobs, so you better take it very seriously.

    The reason its hard to sell to enterprises is that decision makers realize that if they make an out of the box decision and have a huge win they get a 5% raise, if it doesn’t work out they get fired.

  • Dave W Baldwin

    You and @philsugar:disqus are both dead on.

  • http://katelynfredson.com Katelyn Friedson

    wow, great post.

  • Otso Fristrom

    Mark,
    Thanks for yet another great post. I think you are right on the changing landscape, but instead of lack of capital creating the wall, I think it’s more about the lack of access to capital (hence the changing industry and new micro-VCs). Thanks to ever-growing funds, later focus, and slower start-up scene, the capital overhang that the VC industry has built up over the last decade created a wall of tens of billions of uncalled dollars. Unfortunately for the start-ups, that money will be chasing deals that I find difficult calling “ventures” anymore. Having said that, I do believe that the change will happen, but when the LPs will recognize it and want to (or be able to) really invest into start-ups remains a mystery (I am working to solve).

  • http://twitter.com/V_xklsv Vineeth Kariappa

    Don’t you think decreasing number of VCs, imply that the companies that ‘shut down’ were run by bad money managers? So, shouldn’t that be better for the remaining VCs (as more money being managed by lesser VC’s) ? Isn’t lesser VC’s that have more money, better for everyone?

  • http://www.taxlawpro.org Property Tax Law

    One of the oldest forms of taxation in the US is that of buildings and land, commonly known as property tax. As a matter of fact, property tax law was introduced first, even before the introduction of sales and income tax.

  • http://solutionzmedia.blogspot.com chickefitz

    In my book Bootstrap Business, I pose the question “Are entrepreneurial ventures high risk because they are generally not well funded, or do you believe they are not well funded because they are such high risk?  

    I would love to hear you address this Mark.  Six years ago I raised $7m, mostly in angel funding, built out a game changing technology and launched on a top online player in the travel space.  We ran out of runway before we could raise additional funds to expand our client base and then the crash came.  

    Not to be deterred, I’m at it again, this time gaining corporate support from some big guns in the mapping, navigation, media and travel industries.  Trying to decide whether or not to involve the VC community this time, but need to be able to address the risk issue

  • http://www.braxton-group.com Braxton Group

    Well, you say very clear which is your ideas about the future of the VC industry. The only point we have here is that almost everything looks very “Silicon Valley”. In Europe (not UK or Scandinavian countries), funding from VCs were always difficult.

  • http://www.media-marketing-online.com Media Marketing Online

    I agree with all the peole who comment to your post that the series of articles about the VC industry were really good. I did not agree exactly with your article in http://www.alwayson-network.com/AOStory/Changes-Software-and-Venture-Capital-Part-2 that investments of 500.000 wer not enough to form a big company. Offline business showed the contrary.

  • Alex Mashinsky

    Agreed with most of the assumptions but there is an alternative to the VC brick wall, corporate buyers have higher earnings than ever and are desperate to show growth.  It’s the same cycle as 1999, they come late spend big dollars off their balance sheets to buy young promising ideas.  This will pro long the disconnect you are talking about not solve it.

  • http://www.linkedin.com/pub/samuel-shafner/0/555/696 Samuel Shafner

    Thanks for this series: very informative.  I do take issue with the idea that LP’s are feeling negative about VC as an asset class. I moderated a panel in Boston (at the Colonnade Hotel) a year or so ago, with Harbourvest, Knightsbridge, MA-PRIM and Harken Capital on it. They all felt that this coming decade was likely to be the best ever for venture capital as an asset class (lower valuations, full pipeline and amateur hour is finally over), although many existing funds would not be funded further and would close up.  I wrote up the results of this panel in a newsletter last year: http://www.burnslev.com/apps/uploads/publications/Fall2010_Focus.pdf.  This view has been confirmed by other LP’s since, although it is by no means unanimous, but what is? 

    Strategics have become much more active lately, and I have led several panels of them recently. Family offices are also a good source, although more in Europe than here. And then we have angels (and super-angels, if you believe in them), and a growing movement to link angel groups across national and even international borders.  It is an exciting time to be in the VC business.  

  • http://www.linkedin.com/pub/samuel-shafner/0/555/696 Samuel Shafner

    Thanks for this series: very informative.  I do take issue with the idea that LP’s are feeling negative about VC as an asset class. I moderated a panel in Boston (at the Colonnade Hotel) a year or so ago, with Harbourvest, Knightsbridge, MA-PRIM and Harken Capital on it. They all felt that this coming decade was likely to be the best ever for venture capital as an asset class (lower valuations, full pipeline and amateur hour is finally over), although many existing funds would not be funded further and would close up.  I wrote up the results of this panel in a newsletter last year: http://www.burnslev.com/apps/uploads/publications/Fall2010_Focus.pdf.  This view has been confirmed by other LP’s since, although it is by no means unanimous, but what is? 

    Strategics have become much more active lately, and I have led several panels of them recently. Family offices are also a good source, although more in Europe than here. And then we have angels (and super-angels, if you believe in them), and a growing movement to link angel groups across national and even international borders.  It is an exciting time to be in the VC business.  

  • http://www.linkedin.com/pub/samuel-shafner/0/555/696 Samuel Shafner

    Thanks for this series: very informative.  I do take issue with the idea that LP’s are feeling negative about VC as an asset class. I moderated a panel in Boston (at the Colonnade Hotel) a year or so ago, with Harbourvest, Knightsbridge, MA-PRIM and Harken Capital on it. They all felt that this coming decade was likely to be the best ever for venture capital as an asset class (lower valuations, full pipeline and amateur hour is finally over), although many existing funds would not be funded further and would close up.  I wrote up the results of this panel in a newsletter last year: http://www.burnslev.com/apps/uploads/publications/Fall2010_Focus.pdf.  This view has been confirmed by other LP’s since, although it is by no means unanimous, but what is? 

    Strategics have become much more active lately, and I have led several panels of them recently. Family offices are also a good source, although more in Europe than here. And then we have angels (and super-angels, if you believe in them), and a growing movement to link angel groups across national and even international borders.  It is an exciting time to be in the VC business.  

  • Anonymous

    Samuel – you write “and a growing movement to link angel groups across national and even international borders.”  What is needed is a true Early Stage Marketplace (“ESM”)

    ESM is a global community for early stage start-up
    partnering and investing. The early stage is a true community serving
    the self-interests of multiple members: the start-up company, validation
    partners (corporate development), investors (angels, VCs, etc.) and
    sponsoring organizations.

    ESM sits at the beginning of the Liquidity Food Chain. The ultimate goal
    of the Liquidity Food Chain is either IPO or M&A. Between ESM and
    Liquidity sit the stages of: Expansion (VC/Corp Dev); Growth
    (Alternative Trading such as Xpert Financial and Axial Market, Series
    B+++ VC, Corp M&A); and Pre-IPO (Alternative Trading such as
    Sharespost and SecondMarket).

    ESM’s static demo can be viewed at –

    http://www.earlystagemarketplace.com

    and it’s alpha can be viewed at – alpha.earlystagemarketplace.com (registration required).

    Thanks,

    Elliott Dahan
    elliott(at)thegrowthgroup(dot)com

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