What Will the Crisis Mean for Venture Capital?

In the lingo familiar to the kids toiling away at Web startups, the U.S. financial system is on the verge of an epic fail. The same may soon be said of many of the firms whose investments are the lifeblood of those Silicon Valley entrepreneurs.

There's been plenty of discussion about the impact of Wall Street's woes on emerging tech businesses. Web entrepreneur Jason Calacanis wrote late last month that as many as 80% would go under in 18 months. Early-stage investor Ron Conway advised entrepreneurs not to quit their day jobs unless they could get a year's worth of funding in advance. According to Om Malik, Sequoia Capital recently told its portfolio companies to hunker down for a long economic downturn. At a recent dinner party, an entrepreneur told me that his startup had about six months to pull a business model out of thin, recessionary air or it was toast.

Startups get funded in bunches, and in a downturn, the strong survive and the weak get sold for cheap or shuttered. We get it.

But what's in store for the venture capitalists who pump billions into these fledgling companies? My growing concern is that the financial crisis gripping the globe might cause some firms to close their doors and leave many VCs looking for a new line of work. Returns for plenty of firms are tapering off, particularly in recent years. And before long, even looking back a decade will indicate that venture capital didn't yield much more than the stock market and other less risky places to park cash. Think that won't be lost on the institutional investors, university endowments, and other limited partners that look to Sand Hill Road for returns? Think again.

Venture Capital's Lasting Power

To understand why, take a look back almost a decade ago. Even after the air came hissing out of the tech bubble, venture capital kept attracting investment (BusinessWeek.com, 10/3/07). Sure, a few firms retrenched, and a handful of reckless partners lost their jobs. But even more money poured into the asset class. That's because the last few decades have created such a surge of wealth in pension funds and endowments, and they all have to invest in what are commonly referred to as "alternative assets"—a category that includes VC funds. Even with a huge crash, venture capital was still a better long-term investment than the broader markets.

Limited partners look at industry returns in three-year, five-year, and 10-year increments. And in the early part of this decade, by those measures, VC returns could still be plotted upward and to the right. VC firms had little trouble raising new funds.

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