Contrary to popular belief, the venture capital industry is not a necessary condition in driving high-growth entrepreneurship, according to Right-Sizing the U.S. Venture Capital Industry, a new study by the Ewing Marion Kauffman Foundation. While venture capital will continue to be crucial to some forms of high-growth companies, the report concludes that the sector’s size must be reduced to be viable. The venture industry has seen stagnating and declining returns coupled with rapid expansion in venture capital assets under management in recent years.
"The venture industry needs to shrink its way to becoming an economic force once again," said Robert E. Litan, vice president of Research and Policy at the Kauffman Foundation. “To provide competitive returns, we expect venture investing will be cut in half in coming years. At the same time, lowering valuations and improving overall exit multiples should help resuscitate the industry.”
While the venture industry is known for backing icons such as Google, Genentech, Home Depot, Microsoft and Starbucks, less than one-in-five of the fastest-growing and most successful companies in the United States had venture investors, according to the study. The report evaluated venture financing among companies on the Inc. 500 list of the fastest-growing private companies. Only approximately 16 percent of the roughly 900 unique companies on the list from 1997-2007 had venture capital backing. The report also noted that only a tiny percentage (less than 1 percent) of the estimated 600,000 new employer businesses created in the United States every year obtain venture capital financing.
"Professionals in the venture industry have gotten comfortable with the way their industry is set up in terms of size, structure and compensation," said Paul Kedrosky, senior fellow at the Kauffman Foundation and author of the study. "It has been a profitable business for many. However, our study indicates venture participants now need to overcome their resistance to change, so they can most effectively fund entrepreneurs and offer investors competitive returns."
The study states that the venture industry’s current returns are unsatisfactory, both in a relative and absolute sense, when compared to various public market indices. For example, the venture industry lags the small-cap Russell 2000 Index by 10 percent on a 10-year timeframe, despite the fact that those 10 years include the dot-com period, which materially inflates venture industry performance.
While the economy clearly impacts industry results, the study cited other performance factors that predate the current downturn. The industry itself might be structurally flawed: The core markets that made it successful—information technology and telecommunications—are now mature and less capital intensive. In addition, exit markets are unwilling to take on young and unprofitable companies. Given that, the study says, the real question for venture is one of capital and size. As opportunities shrink, the venture business should shrink too, possibly by as much as 50 percent.