Is There Too Much Venture Capital?

There has been quite a bit of talk in the VC industry lately about whether there is too much venture capital chasing too few quality deals.  Much of the discussion has centered on observations about aggregate growth and total capital under management. For example, in the last 20 years total venture capital under management has grown a whopping 1400% from just under $18BN at the end of 1985 to around $265BN today.  Fundraising, which peaked at $106BN in 2000, was down to $17BN in 2004, but that was still almost 335% higher than 1985’s $4BN.  With growth numbers like these it’s not hard to see why many people feel that there is way too much capital chasing too few quality deals.

Table 1:  US Venture Capital Vs. NASDAQ Market Cap

            New VC   Total VC   Vintage   NASDAQ       VC/
YEAR    Commit   $s Mgmt    Return        Cap      NASDAQ
1985      3,983      17,759       12.9%          287          6.2%
1986      3,896      21,382       14.6%          341          6.3%
1987      4,435      24,694       18.3%          326          7.6%
1988      4,894      26,241       22.0%          339          7.7%
1989      5,599      29,597       19.3%          386          7.7%
1990      3,531      30,536       33.1%          311          9.8%
1991      2,059      29,022       33.7%          508          5.7%
1992      5,385      29,362       34.1%          615          4.8%
1993      3,903      30,636       50.3%          791          3.9%
1994      7,827      35,298       54.4%          787          4.5%
1995      9,973      40,400       88.3%       1,160          3.5%
1996    12,160      48,160       96.6%       1,517          3.2%
1997    19,043      63,154       83.7%       1,935          3.3%
1998    29,676      91,825         8.0%       2,589          3.5%
1999    62,767    148,904      -12.9%       5,205          2.9%
2000  105,801    228,236      -11.7%       3,597          6.3%
2001    37,937    256,890      -11.1%       2,900          8.9%
2002      3,821    258,479        -8.0%       1,998        12.9%
2003    10,613    257,529      -12.7%       2,988          8.6%
2004    17,325    265,000                        3,700          7.2%
CAGR                    14.5%                       13.6%

Notes: 2004 VC capital under management is my estimate.  All #s in Millions, except for %s and NASDAQ #s.
Sources:  NVCA, NASDAQ

It’s All Relative
However, as the table above shows, simply using aggregate statistics about the growth of capital under management is somewhat misleading.   First off, the 1400% growth in capital under management over the last 20 years actually pencils out to a cumulative annual growth rate of 14.5% which is very strong, but not exactly torrid.

Second, and more importantly, you have to put venture capital’s growth into a broader context to really draw any conclusions.  One way to create such a context is to compare venture capital to the public markets on the assumption that venture capital is closely tied to the public markets because public markets are the primary source of VC liquidity.

When you pencil out such numbers you make some interesting discoveries.  Over the past 20 years, the venture capital under management has averaged about 6.2% of the NASDAQ’s total market capitalization.  (Using the NASDAQ as a comparison point makes sense because it is the primary venue for venture backed technology and healthcare companies.)    In 2004 specifically, the estimated $265BN in venture capital under management represented about 7.2% of the NASDAQ’s $3.7 trillion market capitalization compared with 6.2% in 1985.  This means that on a relative basis, there is only about 20% more venture capital in the market today than there was 20 years ago.  Admittedly, there was over 100% more just two years ago, but a combination of greatly decreased fundraising and a somewhat recovered public market have quickly offset that imbalance.

In the grand scheme of things 20% more does not seem like that big an increase in venture capital especially given the relative immaturity of the venture market 20 years ago and the supply-side effects it has undoubtedly created since then.   Given this, at a macro level there does not appear to be a huge over supply of venture capital.

Something Doesn’t Add Up
At a micro-level though, anecdotal evidence often suggests that there is an over supply of Venture Capital.   The social networking space (which I have chronicled before) presents one such example in which not only a large number of deals were funded very quickly but in which many of the deals went off at high valuations even when blue-chip investors, which traditionally have a lot of valuation leverage, were doing the investing.  It’s hard to look at a space like that or anti-spam or storage software and not think to yourself “there is way too much money here”.

Ultimately, I believe both conclusions are right.  At an aggregate level, there is clearly a slight over-supply of venture capital relative to historical levels; however that oversupply should rapidly burn off as the 1999/2000 vintage matures.   In fact, I suspect that in the later half of this decade VC as a percent of NASDAQ market cap will probably be below average, similar to what it was in the mid to late 1990’s which would suggest a clear under-supply of capital at an aggregate level. 

That said, even though venture capital may not be wildly over-funded at an aggregate level, anyone on the ground will tell you that there are clearly localized pockets that are highly over-funded.  I believe that this localized over funding is primarily a consequence of the fact that most VC firms are pursuing what are essentially outdated “flow oriented” business models, an issue which I’ll address in my next post.