Thoughts on US Venture Capital Fundraising

The contraction of the number of US venture funds continued in 2010, despite the fact that M&A activity in the tech and life science sectors has picked up considerably from the market bottom a few years ago.

In 2010, U.S. Venture Capital fund-raising fell to a seven-year low as firms raised $11.6 billion across 119 funds, a 14% drop from the $13.5 billion collected by 133 funds in 2009, according to figures from Dow Jones LP Source. In the fourth quarter, 15 funds raised $2.4 billion, a 48% drop from the same period last year. 

The second graph depicts the number of new funds versus the number of follow-on funds.  It is clear that follow-on funding is way down, forcing many shops to significantly cut their fund size and staff. 

The consolidation of the VC industry is both a blessing and a curse for Osage.  While we are fortunate to have dry powder and are actively looking for investment opportunities, the number of firms to syndicate with – which is essential to support investments in capital intensive tech and life science companies – has decreased dramatically.  Lately, the lack of syndication partners has done some odd things to venture. 

First, there is a dearth in the number of firms that are capable of leading and pricing rounds.  Larger VC funds are being very careful with their money - choosing to hold back capital to support existing investments and only look for new investments that are attractively priced with significant downside protection.

Second, insiders are opting to close inside-led rounds instead of receiving a down-round term sheet from a new outside lead.  This results in insiders supporting companies longer than they would like, thus artificially maintaining company valuations.  Because so many rounds have been insider led, VC as a whole looks rather healthy when viewed through the macro lens of round pricing.  Companies that should be re-priced are holding firm on their valuation because they believe they are priced to “market”.  Many VCs are simply sitting on their hands until prices come down.

Lastly, as VCs have held onto companies much longer than anticipated due to lack of liquidity events, the amount of capital – and therefore pre-money value on future financing round – being put into companies has gotten quite large.  As the amount of capital creeps up, it becomes harder and harder for new investors to make a “venture return” on their capital.

Many people argue that a “right-sizing” of the industry is essential to work out the problems that I listed.  I do not think that is the issue at all, if anything the US needs more venture capital.  The US needs more ideas and to do that we need a university system that rewards innovation, and not incremental improvements.  But, the blame should not be on the universities or the government.  Instead, it should rest with venture capitalists. 

As an industry we need to do a better job of meeting with university thought leaders to articulate the things we look for in an investment opportunity.  By articulating to academics what deliverables we would want to see in a technology for it to become “investable”, we will help researchers become more entrepreneurial. 

By leveraging an already strong US university system, venture capitalists could improve the quality of their deal flow and in turn improve fund returns and the overall health of the US venture industry.