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Back in Black

The VC industry is fattening up again--but what does this mean for your business?

Wondering what happened to that looming shakeout in the VC industry you were hearing about a few years ago? The VC industry has weathered the storm and is now entering a new funding cycle with increasing momentum.

There are currently two prevailing schools of thought on the phantom shakeout. The first and more optimistic view holds that fears were greatly exaggerated and the state of the VC industry was never as bad as was rumored. "I never believed the doomsday scenarios for the VC industry," says Mark Heesen, president of the National Venture Capital Association. "We heard the number of firms was going to be cut in half. Where we have seen a decline is in the number of VC professionals. Because the fund sizes are smaller today, VC firms don't need as many partners. As a result, many partners have gone out and started smaller, regional firms, so the number of firms has remained relatively constant."

The second point of view holds that the bad investments from the 1999-2002 period have yet to work their way through the pipeline. These supposed realists suggest that in another few years, when VC funds that were started in 1999 or 2000 go out looking for new funds from their limited partners, they won't find many takers because their returns were so low. "When this happens, it's going to squeeze firms out of the industry," contends Rick Frisbie, founder of Wellesley, Massachusetts-based VC firm Battery Ventures. "Today there is too much money relative to the number of good investment opportunities for VCs."

As with most debates, the truth lies somewhere in the middle. What is clear is that the amount of capital in the VC industry is down significantly from the bubble era. According to Thomson Venture Economics and the NVCA, in 2000, the industry raised $106 billion. In 2001, that number dropped to $38 billion, and in 2002, it plunged to $3.7 billion. But in 2003, the industry rebounded, raising $10.5 billion. And in 2004, the industry continued its resurgence, raising $17.6 billion.

These wide swings have forced some fundamental changes in the way VC firms are structured and run. Venture capital has evolved into a more mature industry with more procedures to follow. "If you're going to scale the venture capital firm, inevitably you have to have process," says Stewart Alsop, venture partner with New Enterprise Associates, a Menlo Park, California, VC firm. "It's not a bad thing because you have to keep track of what you're doing. Venture capital investing can't just be pure intuition. Process can get in the way of actually making returns, but it doesn't have to." So today, for better or for worse, many VC firms are becoming more bureaucratic.

So what does all this mean for the entrepreneur? Since there's a favorable climate right now for fund raising from limited partners, the supply of VC capital available to entrepreneurs will also increase. Says Heesen, "Over the past six months, we have seen a marked change in attitude from VCs. A lot of that is due to the fact that we have seen and will likely continue to see good exits through the acquisitions market or the IPO process. That, of course, is the end of the line for VCs." So in the short run, it means a period of rising expectations, and that's good news for anybody looking to raise capital. (For a list of the top VCs for entrepreneurs, check out our 5th Annual VC 100 in the upcoming July issue of Entrepreneur.)

But in the longer term, it may cause problems for the industry if VCs take in more money than is prudent. "We should have learned the lesson of 2000, which was, If there is too much money in the industry, a lot of it will end up invested in 'me too' companies instead of important new technologies," says Heesen. "If we, as an industry, don't stay disciplined, we could find ourselves in a situation where once again there is too much capital."

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This article was originally published in the May 2005 print edition of Entrepreneur with the headline: Back in Black.

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