Venture capital: size and focus

I first started writing and thinking about venture capital back in 1984 when I was an editor at San Jose Mercury News in the heart of Silicon Valley. To understand the shape of the industry then and now, consider two figures. The first of the National Venture Capital Association’s 2010 Yearbook shows the total assets under management of the venture capital industry.

If you look at the short bars of the 1980s and squint a little, you can see that at that time the growth rate in the industry looked very high. The tiny bar for 1986, for example, is a multiple of the even tinier bar for 1982. But there used to be rather restrictive rules about whether large asset pools, such as pension funds, were allowed to invest in venture capital. These rules were relaxed, and the dot-com boom began in the 1990s, bringing much more money into venture capital.

Here is a chart from Latest NVCA Yearbook 2022, showing the total assets under management of venture firms. From a total range of around $220 billion 15 years ago, the total has more than quintupled to reach nearly $1 trillion in 2021. values) is likely to fall this year. But the general trend of the time I wrote about an industry with, say, $20 billion in assets in the early 1980s is quite remarkable.

Another way to look at the venture capital industry is in terms of new investments made in a given year, rather than in terms of accumulated assets. The 2022 Yearbook reports: “Any concerns about a slowdown in U.S. venture capital investment due to the pandemic were allayed in 2021. 14,411 venture capital firms received $332 billion in funding, an annual record.” Perhaps in that statement, “any fears … have been allayed,” but VC deal activity could pick up a notch or two in 2022 and still be well above the level it was just a few years ago.

I was a supporter of the venture capital industry and the role it plays in American innovation and start-ups in 1984, and I still support it today. But this is a real industry. You just don’t manage a fast-growing $1 trillion industry the way you managed a $20 billion industry four years ago. Thus, it is useful to think about what the venture capital industry does well and what does not. As a starting point, here is a figure from the 2022 Yearbook:

Note that from the point of view of the venture capital industry itself, the industry is not associated with the very early stages of firm development or early product development. Instead, early-stage venture investing occurs when cash flow is no longer as negative as it used to be, and it’s time to introduce the product itself. As the new firm moves into growth and expansion, it is time for late-stage venture capitalists to consider an exit strategy, such as selling a small firm to a larger firm or doing an initial public offering.

A few years ago, Josh Lerner and Ramana Nanda discussed their concerns in “The Role of Venture Capital in Funding Innovation: What We Know and What We Still Have to Learn”. (Journal of Economic Perspectives, Summer 2020, pp. 237-61). They argued that while the venture capital industry has made great strides in the past, “venture capital funding also has real limitations in its ability to drive substantial technological change.” In particular, they wrote:

We are particularly concerned about three issues: 1) a very narrow range of technological innovations that meet the requirements of institutional venture investors; 2) a relatively small number of venture capital investors who own and direct a large share of the capital used to finance radical technological change; and 3) the weakening in recent years of intense attention to the corporate governance of venture capital firms. We believe that these phenomena are not short-term anomalies associated with the boom in the stock market about a decade before the start of 2020, but may have a lasting and detrimental effect on the speed and direction of innovation in the economy as a whole.

In my own words, the venture capital industry has taken a liking to web-based firms, especially those that could use network effects to drive their small sector of the market. Such firms can often have relatively low start-up costs—no factories! There is a significant amount of spray-and-pray venture capital investment where firms put money into a group of these web companies and then monitor the firms to see what happens.

Again, you can’t manage $1 trillion in assets the way you could manage $20 billion in assets 40 years ago. Previously, venture capital firms supported companies from a much broader range of industries and played a more active role in offering recommendations and business connections to the managers who started these firms. So while I do think that the large and growing venture capital industry as a whole is a force for good in the dynamism of the US economy, I also think that the current version of the industry works best at a certain stage of business development in the US. rather narrow industry range. In terms of the dynamism of the US economy as a whole, the venture capital industry is a special piece of the pie.

Readers interested in the current state of the venture capital industry may want to check out a recent article in June 30 issue Economist, “Venture capital payback: why the dot-com crash won’t happen again”.