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Published: August 28, 2012
 / Autumn 2012 / Issue 68

 
 

Venture Capital Firms Trim Their Wings

In cutting down on risky investments, the VC industry is both curbing its upside potential and shortchanging startups.

Title: Investment Risk Allocation and the Venture Capital Exit Market
Authors: Susan Chaplinsky (University of Virginia) and Swasti Gupta-Mukherjee (Loyola University Chicago)
Publisher: Social Science Research Network Working Paper Series
Date Published: March 2012

Observers were transfixed recently by the mountains of money generated by Facebook’s initial public offering (IPO), flawed as it was. But such a rich outcome belies the tougher odds that startups now face. Since 2001, venture capital (VC) firms in the United States have been less willing to invest in the earliest stages of the startup process, this paper finds. The shift has reduced VCs’ risk, but also their upside potential. Additionally, it means that there’s less capital flowing to startups when they need it most. Indeed, the decrease in early investment may be slowing the pace of innovation.

The researchers analyzed all U.S. companies with VC investments that resulted in IPOs; mergers, acquisitions, or buyouts (so-called M&A exits); or failures and write-offs, combining several databases. They computed the returns from 1,436 IPOs; 1,222 M&A deals; and 3,518 failures from 1986 through 2008, measuring VC firms’ risk allocation by the proportion of funding provided to early-stage and first-round investments.

The proportion of IPOs fell sharply, from almost 75 percent of the total outcomes between 1986 and 1997 to 37 percent after the dot-com bubble burst, from 2001 to 2008. Meanwhile, M&A exits soared to 63 percent, from 25 percent, during the same periods.

That shift is important because IPOs had substantially better returns on investment than M&A deals did. The VCs doubled their money with IPOs, which produced an average return of 211.7 percent; with M&A deals, they barely broke even (the average return was 99.5 percent).

“IPOs more frequently generate the extremely high returns that help lift overall VC performance and cover losses from failures,” the authors write. In contrast, the rise of M&A exits “forces increased consideration of downside risk in VCs’ evaluation of investments.”

M&A deals could be increasing because companies have been more reluctant to go public since the passage of the Sarbanes-Oxley Act in 2002. Some analysts also argue that many of the industries that were nascent in the mid-1990s have matured, offering less growth potential.

The venture capitalists themselves became more conservative after 2001, likely because of the more uncertain exit market and their own increased difficulties in securing capital. In cutting back early-stage investments, the authors say, the VCs “appear to have moved away from ‘swinging for the fences’ and...toward ‘batting for average.’”

Bottom Line: Over the past decade, venture capitalists have cut down on riskier investments, significantly lowering their potential returns and diminishing their role in early-stage innovation. 

 
 
 
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