While there is no shortage of issues for venture capitalists to worry about in 2003, there is one concern that swamps all others-the substantial oversupply of committed dollars. Consider this: If you construct a line that approximates commitments to venture capital funds from 1970 through 1995 and then extend that line through 2003, you will find that during the bubble more than $150 billion of venture capital was raised in “excess” of the long-term trend line. This “excess” is greater than the aggregate amount of venture capital raised from 1970-1997. If this weren’t enough, the oversupply situation corresponds with a constricted global IT budget and stagnant IPO market.
Some readers may wonder why oversupply is such a major issue. At their core, average financial returns for any asset class are the simple result of supply and demand. If there is an undersupply of venture capital and a huge demand for innovative private companies (either in terms of demand for their product or interest in the public stock market), VC returns will rise. However, we find ourselves in the exact opposite situation. We have an ample supply of dollars and a reduced demand for startup wares and emerging company IPOs. Until this “imbalance” is corrected, it will be impossible for the industry as a whole to generate adequate risk-adjusted returns.
In the near term, there are two ways that oversupply rears its ugly head. The first and most obvious is with respect to valuations. With an oversupply of funds, one would expect unrealistically high valuations. While some sectors (like biotechnology) and individual companies continue to levitate, for the most part valuations have contracted substantially. This gives some investors comfort that the market is behaving rationally and, therefore, returns should improve. This ignores the second potential affect-an oversupply of companies with similar solutions for the same marketplace.
While everyone is aware that investments based on inaccurate predictions are likely to result in poor financial returns, very few people comprehend that accurate but consensus predictions are likely to encounter the same fate.
The “Accuracy” Problem
If too many companies enter the same market with similar products, market dynamics will ensure that returns are dismal. Pricing pressure will be high, customer power will be enormous and in many cases the entire market will implode. Consider what happened to the optical equipment market in the latter half of the 1990s. Some experts calculated that startups outnumbered customers by more than 5 to 1. Today you can see the same dynamic in the markets that appear “obvious.” The hottest sectors-such as 802.11 chipsets, security and Web services-are also the most over-invested.
Recognizing that “accurate” predictions can lead to poor returns is amazingly anti-intuitive. As we absorb the shock of the deflated bubble, most venture capitalists are executing a conservative and potentially erroneous game plan. Recognizing the sins of the 1990s, these investors are returning to core principles-the industries, technologies and business models that are “tried and true.” Ironically, with everyone running to the same lifeboat, the only “safe” place to invest is off the beaten path. The big winners over the next five years will come from inventors who were willing to take a chance on a crazy idea, an unproven business model or an emerging but unrecognized market. With everyone choking up on the bat, there could not be a better time to think outside the box.
William Gurley may be best known as the author of the “Above the Crowd” e-letter. A VC for five years, Gurley sits on the boards of Avamar Technologies, Epinions, FHP Wireless, OpenTable and Vcommerce. His exits include Crossgain (acquired by BEA Systems).