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Thursday, May 26, 2005

Venture Capital : Its Not Your Father's World Anymore!!

(Via Bill Burnham)"Deal flow" has been long regarded as the lifeblood of venture capital and the primary point of competitive differentiation between venture firms. Changes in the venture industry are making deal flow far less important and rapidly making deal flow-centric business models unsustainable for all but a few venture firms. The approach is premised on a passive plane to venture investing that essentially subscribes to a "build it and they will come" theory of venture investing. To grossly, but not inaccurately, simplify this view: all it takes to have a successful venture firm is to open an office on Sand Hill Road, stock the office with well known/connected former operators/financiers, wait for the entrepreneurs to come flocking to your door and then simply invest in the best teams with the best ideas. In this model VCs are seen as capable of doing a communications equipment deal one day and an alternative energy deal the next. They have no need to be experts in specific industries but instead pass judgment on the quality and pedigree of start-up teams with the belief that their connections and experience can help get any company off the ground.
This flow-centric business model made a tremendous amount of sense when the venture industry was relatively small and immature. Venture capital in 1980 was a true "buyer’s market" with more demand for capital than supply. The investable landscape for venture capital, particularly technology venture capital, was both "thin" ( as in few sectors) and “shallow”( each sector was small).In this context, a passive deal flow-oriented business model made a tremendous amount of sense.
The world has changed dramatically. There are now over 3,300 venture firms managing an average of $280M each with a total of $265BN in capital under management. The investable venture landscape is vastly larger and more intricate; it is now both wide and deep. For all but a few firms, the dramatic increase in the scope, complexity and competitive intensity of the venture business makes a deal flow-based business model, no matter how good one’s networks or connections, unsustainable as the risk of adverse selection has become so great and in those rare circumstances that a good deal actually makes it into the public domain, intense competition is likely to drive pricing up to a point where the good deal becomes bad because it's just too expensive. Net, net the cold reality is that the venture business is now clearly and permanently a seller’s market.

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