Finding the money

Will the venture capital industry survive? This is the question being asked both in the US and Australia after very poor returns cause investors to shun the asset class. In the US, as the exit market remains shut, one researcher Paul Kedrosky has argued in a report published by the Ewing Marion Kauffman Foundation (where he is a senior fellow studying entrepreneurship) that the industry needs to shrink by half its size because at present it has too much capital that causes higher valuations and lower exit multiples.

The investor and author of the blog Infectious Greed argues that the sector must sink its way back to health as poor returns make the asset class uncompetitive and at risk of very large declines in capital commitments as investors flee this underperforming asset.

The dot-com bubble “led to a collapse in performance from which the sector has never recovered,” Kedrosky says. Since then, it has been slow to shrink, as the life of a venture fund is typically a decade and investments are generally illiquid during that time. Plus venture capitalists are paid more to run bigger funds.

Kedrosky also attacks the widespread and incorrect belief that venture capital is a necessary and sufficient condition in driving growth entrepreneurship. “In fact, only about 0.2% of the estimated 600,000 new businesses created in the United States each year are financed by venture capital and about 16% of the fastest-growing companies are,” he found.

And in bad news for young companies he warns that venture capitalists will never again back the money losing companies they did in the late 1990s but only focus on companies with large revenue and profits.

Another problem he cited was that information technology has matured to the point that new innovations will not be hugely profitable and it costs a fraction of what it once did to start an IT company.

The venture capital industry in Australia while facing many of these problems, is different to a degree. It has mostly been supported by government and many have been criticised for investing in safer, more mature businesses and avoiding the types of start-ups that were popular in the dot com boom.

However Australia does tend to follow US trends and entrepreneurs should understand that they are far more likely to get funds for growth from private equity – not VCs.

And the good news is there is money looking for a home from private investors. I recently caught up with Reuben Buchanan, who started Wealth Creator and now runs Wholesale Investor, and he was telling me of a survey of 2000 of his readers (60 responded).

He says that 96% of investors are positive about investing now because of the low values of public and private assets. “Investors have waited years for an environment like this so they are now very keen to invest their money at prices/values that are not likely to be repeated ever,” he says. And 71% prefer to invest in private companies because they are perceived as more stable and tend to carry less debt.

So entrepreneurs should not waste their time looking at the VC industry but seek cashed-up private investors who know that even if the entrepreneurs are talking last year’s prices, they can be beaten down quickly to get the cash in the door.