Whole lotta shakin’ goin’ on

Shake it to the left. Shake it to the right.

Shakeout in the industry. Who is right?

We recently had a run-in with Mark Heesen, NVCA President, over how to determine the scale of the shakeout going on in the venture capital industry.

Now, it is never a good idea to get into a data dust up with Mark. He has more facts about our business at his fingertips than just about any other human. Still, we enjoyed the banter, not because he was wrong, but because we think we were both right.

In the 2007 NVCA Yearbook (perhaps the best product this side of Lunesta to ensure nocturnal tranquility), it was revealed that the number of U.S. venture capital firms rose from 395 in 1990, peaked at 946 in 2001, and has now declined to 798 as of 2006. So, the long-awaited shakeout in the venture industry is occurring. Correct?

We agree, but we think those numbers dramatically understate the reality. That drop of about 15% of the firms in existence in 2001 misses what we see as a much more profound number. That is the number of active venture capital firms. Given the nature of partnerships, one may hang on in this business for a long time, doing follow-on rounds, while not really being in the game.

So, we focus on a different metric. We look at the number of firms that have made a new investment in the last 12 months. If you have not found at least one new deal in that time, there is a high probability you have indeed been “shaken out” and are simply playing out the cards in your hand.

In 2000, there were 1,156 different venture firms that made at least one new deal, but by 2006 there were only 597, according to the MoneyTree Survey by PricewaterhouseCoopers. This is more like a 50% drop, not just 15%! We think that is the big unwritten, story. The U.S. venture industry has been cut in half. That certainly qualifies as a major shakeout.

There is one more piece of data we found interesting, and here we and the NVCA are completely in sync. The average size of the most recent fund raised by the venture funds in 2006 was exactly double that of 2000. The 2000 funds came in about $100 million, while the 2006 funds were at $200 million.

So, how does this square with the well-reported shrinking of venture funds from the bubble vintage? The story is: Those mega funds were the exception, even though they were very noticeable. There were a gaggle of new funds of the bubble era under $100 million. Most of them have died (see shakeout), with a few succeeding and increasing their scale. Since 2000, and particularly recently, there has been a flight to quality.

So, the second unwritten story of the bubble was not so much the billion-dollar funds that cut themselves back, but the hordes of small funds that cluttered up the market with many “me-too” competitors in a given space, failed to deliver good returns and are now gone.

So, the shake-out is already behind us.

The result is the venture capital industry is healthier today than many people realize. We see solid returns returning. The latest NVCA data shows the following trailing IRRs for the industry:

• 5 Years: 2.7%

In 2000, there were 1,156 different venture firms that made at least one new deal, but by 2006 there were only 597. The U.S. venture industry has been cut in half.

Gerry Langeler, Managing Director, OVP Venture Partners

• 3 Years: 9.6%

• 1 Year: 18.1%

That dramatic upswing, now approaching pre-bubble historical return rates, is clear evidence that our industry is back on track.

So, let’s stop all the hand wringing about how the “model is broken.”

The historically successful venture model is:

• A reasonable number of firms

• Managing a reasonable supply of cash

• Investing at sensible prices, into companies with modest capital requirements

• Investing with a clear focus by space, by place or by stage (or a combination)

• Finding liquidity when those portfolio firms have proven their businesses with real revenue traction, and perhaps even profitability

Against this framework, today we have a venture model that is not only not broken, but is very much alive and well. We just lost sight of it for a while.

Venture partnerships that have survived the shakeout, and returned to the values that made this a great industry, stand to reap great rewards.

The shakeout is over. It’s time to move forward.

Gerry Langeler is a Managing Director in the Portland, Ore., office of OVP Venture Partners. He may be reached at langeler@ovp.com.