Venture Capitalists Said To Be Taking Larger Stakes In Early And Mid Stage Companies

When long time observers of the venture capital industry start talking about innovation deficits and capital scarcity, I find it worth paying attention.

This week, I had a chance to speak with David Millard, a partner in the Indianapolis office of the law firm Barnes & Thornburg, who, like many is carefully watching the return of the IPO market.

It is a defining year for venture, he says, with sagging fund returns in the position to benefit from a return to liquidity.

But until then, industry crosscurrents are anything but calm. Fundraising is well below investment outflow, an unsustainable situation over the long term, and non-performing funds could be shuttered.

More immediately, entrepreneurs find capital more difficult to get. The result is that GPs have an upper hand in negotiations and can take greater ownership stakes in portfolio companies.

The typical Series B deal will now give a venture investor 25% of a company, says Millard (pictured). Four to five years ago, 15% was more typical. “You don’t have two or three competing term sheets anymore” to bargain with, he says.

Along with greater ownership stakes have come lower valuations, which in early and expansion stage startups have fallen 10% from 2006 and 2007 levels, he says.

“There isn’t the supply of capital to go around,” says Millard. “I think this dynamic is unhealthy for companies.”

The result is that early stage entrepreneurs need to rely more closely on angels. But angel cash isn’t plentiful enough to fill the gap created by a shrinking in the VC industry. This is particularly true in later rounds, when venture firms are no longer confident they can find other firms to lead follow-on rounds.

Many companies make a go of it without venture capital. Instead of the traditional Series A round, they raise $10 million or $15 million over time from angels.

“We’re in a negative innovation environment because of the restraints on capital,” says Millard. It could take as much as two years for a pendulum to swing back to a better balance.

Of course, all this leads back to the IPO market and whether a steady, sustained welcome for public offerings may put more money in the pockets of VCs and more confidence in the hearts of LPs. Until then, you may hear terms such as innovation deficit and capital scarcity with increasing frequency.