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The View From The Dark Side: #1, Why VCs Are Greedy

[This is the first of a series of posts that attempt to explain how the venture capital business looks from the VC side.]

VCs are often characterized as greedy, eg:  “vulture capitalists” or (the more contemporary phrase) “not founder friendly”.  Like any broad characterization, there is truth and untruth here, and good and bad reasons for what you see.

Bad Reasons

1. Some VCs really are in it largely to make a lot of money, and they engage in sharp tactics in pursuit of the quick buck.  This group is probably moving on, however, given how tough the market has been of late.
2. Some VCs bring a primarily financial perspective to the business, although they are perfectly good folks.  This can come across as excessive greed.  I like to say that you should not become a minister, a pshrink, or a VC until you are 40, because until then you lack sufficient life experience.  But, the institutionalization of VC in the last 10-15 years has brought in a group of career investors whose perspective is more financial.

Good Reasons

1. Many (most?) VCs have pretty big egos and alpha personalities.  It’s almost a natural job requirement:  the business is characterized by murky bets with big stakes and very long time horizons.  It takes some ego to believe you can succeed.  And those who have been successful believe they’ve earned a lot.  This can read as selfishness or greed.  But it’s better understood as entrepreneurial drive.
2. VCs need to make more money, not for themselves but for their Limited Partners (the “LPs”) who are the source of most of the money.  The LPs have done poorly with their venture capital investment for a long time now; they are losing interest; and the money is drying up.  VCs need to deliver better returns to their investors to bring the money back.  Most of us are generally aware of this, however, when you look at the numbers, the magnitude of the problem is a bit of a shock.  Here are a few cuts at the data.

In each year since 1997, LPs have put more money into venture capital than they have received back.  In 2008 the input/output ratio was over 3x.

LP Cash-Out / Cash-In From U.S. VC Funds, Source: NVCA

Meanwhile, the LPs have cash flow problems:  their liquid asset portfolios have shrunk in the last two years, and the distributions they receive from private equity investments have dried up.  This has driven major changes in LP asset allocations; many have decided to stop making commitments to venture capital funds, and others have cut back the size of their commitments.  As a result, VC fund-raising is off about 50% versus recent years, and no one expects a fast recovery.

Commitments to U.S. Venture Capital Funds, Source: NVCA

It’s no surprise that the VC industry is going through a severe shake-out:  the number of U.S. venture firms has declined 22% from 2006 to 2009, and that understates the reality, as many of the remaining firms are out of money.  Recently, a number of well known VC fund managers have failed to achieve target fund sizes.

So, VCs need to make more money to maintain access to LP money and continue funding entrepreneurs.  This is not a reason for the VCs to turn against the entrepreneurs, however.  It’s a reason to work together to make the numbers improve, recognizing what each party needs to survive and prosper.

How do we do this?  The whole answer is not obvious.  But, smaller venture funds and focus on more capital-efficient business models, which can achieve good ROIs based on realistic exit values, are a very good start.