For many struggling entrepreneurs, the venture funding environment of the past few years has felt like a long walk through the Sahara Desert. Getting their companies through it without dying of thirst has been painful at best, and fatal for some.
Now here’s an irony. While entrepreneurs scramble for every dollar they can get, VCs have been burdened with the opposite problem: too much cash. Instead of grasping for dollars, they are trying not to drown in the sea of funding raised from their own investors, known as limited partners (LPs). An estimated $86 billion lies dormant in venture capital funds waiting to be invested, according to management consulting firm McKinsey.
This amount of uninvested cash, often called the venture capital overhang, inspires dread in many industry veterans. With so much money lying around, VCs often develop a herd mentality, and make copycat investments. That is why scores of wi-fi and social networking companies seemed to pop out of the woodwork almost immediately after the first company in those sectors received funding.
“Me-too” investments have always been a part of the VC scene. Goes one old joke: “What do you get when you cross a sheep and a lemming? A venture capitalist.” But now the mounds of cash mean bad habits have more destabilizing consequences. Too many overfunded players chasing too few customers are creating intense competition. Customers play companies off each other. Price wars ensue as startups undercut each other – and even top companies find it difficult to keep profit margins intact. Imagine being a salesperson in the waiting room of a big customer and noticing dozens of people peddling the same wares as yours.
Why does the overhang exist?
The venture capital industry raised more than $200 billion between 1999 and 2001, according to research firm Venture Economics – more money than it had seen in all the years of its history, combined. VC firms were able to build this unparalleled pile of capital because of the enthusiasm surrounding the technology sector.
When the tech bubble burst, the value of young companies plunged. A VC could then buy the same percentage of a startup for a much smaller investment, leading to smaller chunks of capital being doled out. VCs also became more selective in funding business models. Capital-intensive approaches like Webvan, Kozmo, and the numerous competitive local exchange carriers (CLECs) fell out of favor, further reducing the amount of money that VCs required.
Only a handful of VC firms admitted that the environment had changed and reduced the size of their funds, forfeiting capital their limited partners had pledged. (VC funds generally have a life span of 10 or 12 years, and LPs are committed for the entirety of this period.) VC firms also charge a management fee, usually around 2 percent of the value of their funds annually, providing a strong incentive not to “give back.”
For entrepreneurs, venture overhang means too many competing companies springing up too fast. No doubt, the entrepreneurial world has always been especially cutthroat. But the dynamic is different when VCs are funding four, as opposed to 20, competing firms in a particular sector. There is also intense competition between VCs, angling for an edge in what they are betting is the winning place.
Jon Flynt, a managing director of Polaris Ventures, which manages total assets of $2 billion, says his firm had to pass up two deals in two weeks because they were too expensive. He wanted to give the companies a shot, but other investors became too eager, and Mr. Flynt bowed out.
The result is that the valuations of portfolio companies get bid up. If valuations get bid up too high, the return that multiple investors receive after a successful exit shrinks. This is likely to drive down the returns from investments in venture capital funds.
Avoiding the next hot thing, smart VCs will attempt to loop around the venture overhang and try to find better returns in sleepier sectors. Ultimately, these unexpected and marginal ideas may not be subject to groupthink pursuit, and may turn out to be a better bet than the big show.
For more, read Red Herring’s series on the VC overhang: