Venture Capital Continues to be in Distress

May 28, 2009 at 3:44 pm

Earlier this year, I wrote about how I felt the current venture capital market is broken. There is now more evidence of this fact.

At the PricewaterhouseCoopers Shaking the Money Tree event for the first quarter of 2009, the standard answer to almost every question became 50%.

The amount of new VC money raised compared to a year ago, the number of deals done in the first quarter; the amount of money invested in the first quarter compared to a year ago. These are striking statistics. And while 2008 was actually the fifth best year for dollars invested and dollars raised since the statistics were first being recorded, 2009 looks to be – well 50%. That could make it the worst year in the venture industry since 1996. If we discount the 2009 dollars back to prior years, it might actually become one of the worst years in history.

The exit alternatives for VCs have also further deteriorated. In the first quarter of 2008, there were 5 VC backed IPO’s. In the following three quarters of 2008, only 1 VC backed IPO (3rd quarter). And none in the first quarter of 2009. The number of M&A transactions continued the same type of decline – remember the answer to all questions was 50%. And the average deal value for M&A fell to under $50M in the first quarter, compared to more than $115M in a comparable period last year. The average VC deal consumes approximately $15M to $20M over its life. If the total return is averaging less than $50M, and remember that most deals don’t even get to the M&A stage, it’s hard to imagine an attractive ROI for VCs based on these realities.

New Federal Tax Proposals Would Increase the Pain for VCs

Now, couple all of this with proposed tax laws from Washington that will tax VCs carried interest – their share of any potential gain on investments made by their funds – at ordinary income tax rates instead of capital gain rates, and we have to begin to wonder what will replace VCs, as their model continues to collapse.

Clearly there will always be a place for some type of venture capital investment. But I believe that an organized angel investor community will continue to grow and fill the gaps left by VCs. However, angels also need some sort of exit strategy. A return to a more normalized stock market is needed to make this happen, but angels are used to waiting a little longer than most VCs. In a more normalized stock market, there will more IPO’s, and there will be stronger currency for potential acquirers, as their own stock values increase. In either case, lower valuations mean better deals for the investors and lower terminal value requirements.

So, let’s all hope that someone invents the next “big thing” that everyone must have. Together with this, we should see our stock markets returning to “normal” in 2010 or 2011, and that we will see a new investing model that may combine aspects of the old venture model, the current organized angel model, with something new sprinkled in to make investment capital plentiful again.

Rich Brenner is Founder and CEO of The Brenner Group, one of Silicon Valley’s premier professional services firms. Rich is a veteran executive, entrepreneur, investor, board member, and philanthropist.

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