Too Much Ventured Nothing Gained VCs are a hurting bunch. New companies feel their pain.
By Russ Mitchell

(FORTUNE Magazine) – The venture capital business has a size problem. A monstrous, staggering, stupefying one. Brobdingnagian even.

In three years, from 1999 to 2001, venture capitalists raised $204 billion to back young companies in what are now known as Bubble Funds. That's a lot of money, but to appreciate the magnitude, match it against the past: Between 1970 and 1998, VCs attracted a total of $132 billion to finance startups. In other words they raised more money in three manic years than they had during the nearly three decades that preceded them. If you include money from previously raised funds, VCs have $252 billion in capital under management today.

Now consider the pickle in which the industry finds itself. Venture funds run ten years. To earn 18% annual returns for their investors--the low end of historical venture capital returns--the funds would have to create $1.3 trillion in market value by selling or taking public their portfolio companies over the remainder of the decade.

Think about it this way. eBay is one of the few successes to emerge from the dot-com boom. At its peak, eBay had a $16 billion market value, and its venture backer, Benchmark Capital, made more than $4 billion on its investment. So how many eBays would have to be taken public by the end of a decade for venture investors to achieve 18% returns? More than 325. That's roughly one eBay every 10 days between now and 2010.

Obviously that's not going to happen. Venture capitalists are stuck with their Bubble Funds and have no clear idea how, when, or whether they'll be able to cash out their assets. Bon French, head of Adams Street Partners in Chicago, a venture capital investor, says the funds raised in 1999 alone are so sick that three-quarters will return zero or less. That's bad news for the pension funds, foundations, endowments, and rich individuals that invest in venture portfolios. They're all locked into ten-year commitments.

The biggest losers could be the entrepreneurs who depend on venture capital to fund their startups. If new, innovative companies have a tough time raising funds, economic growth will be hard to come by. "Long term, we could lose our edge in a lot of the technology we pioneered,'' says economist Jesse Reyes of Venture Economics.

However the Bubble Funds work themselves out, it's clear the venture industry is in a world of pain. Some funds have already gone out of business. Many more will follow. The smallest fry are most likely to die. The top firms won't go bust, but even they are vulnerable. If key partners quit to start new funds or just retire to enjoy their wealth, the firms' reputations would suffer.

The headquarters of Kleiner Perkins Caufield & Byers on Sand Hill Road in Menlo Park, Calif., looks like a modern ski lodge, a lofty A-frame of blond wooden beams and plenty of glass. Outside, parked under the trees, are the Jaguars and Porsches, the Z3s and the TTs, with a few secretaries' Civics tucked in between. Standup desks are popular at Kleiner Perkins. On the way to Vinod Khosla's office, several administrative assistants are erect at their workstations, each rolling a plastic ball with one foot to keep their posture fluid. Parked in the corner are two Segways, those goofy scooters that look a little like push mowers. Kleiner is an investor in Segway.

Khosla is not as well known as the other big wheel at Kleiner, John Doerr. But these days he's more accessible. Doerr, who famously overhyped the Internet in the bubble years by insisting that it was being underhyped, is laying low. It used to be you couldn't read an article about the new economy without seeing a quote from Doerr. Now he can't be found. Maybe it's because one of Kleiner's biggest investment projects, the merger of Excite and @Home, was such a bust. More likely it's his recent troubles with Martha Stewart stock. Doerr and Kleiner both are being sued for allegedly misleading investors before dumping shares in Martha Stewart Living Omnimedia, another Kleiner investment.

The Kleiner firm might as well be called Doerr & Khosla--or perhaps Khosla & Doerr. Kleiner, Perkins, and Caufield are all retired, and Byers gets closer to partner emeritus status every day.

Khosla is intense. He's considered brilliant but cold and tough. Thin, fit, wiry, he dresses impeccably, even when he's wearing sports clothes. His only bow to whimsy is his shoes, fine brown Italian-looking loafers with leather flaps like those on golf shoes covering the front.

As far as Khosla's concerned, venture capital has two basic components: fear and greed. There was too much greed during the bubble, and there's too much fear now, he acknowledges. "But fear and greed, that's the American capital-allocation system,'' he says. "It's not a great system, but it's the best there is. It's most efficient in the long run despite the short-term inefficiencies. But we're driven by greed and fear, so we never get the right level of venture capital."

Doing its part to nudge the balance back toward equilibrium, Kleiner earlier this year in effect handed unspent money back to limited partners, reducing the size of its latest fund by $160 million, to $470 million. Other big-name firms followed suit, some voluntarily, some under pressure from investors. Overall, $4 billion in capital commitments have been returned to limited partners.

Of the $252 billion in venture capital under management, $90 billion sits unspent. When the 1999 funds were raised, venture managers invested the money fast; by the time the 2000 funds were raised they had already turned skittish. Most of the money has not yet been put to work. One of the supreme ironies of the Bubble Funds is that so much capital is waiting to be invested, but so few funds are willing to do the deed. The reasons are many, but they boil down to one stark fear: A strong IPO market is years away, and any money invested now might drag the performance of the funds down further.

Where would they put the money anyway? It's unclear what corporations will want once they start buying infotech again. And the payoff for biotech and nanotech investments seems a long way off. "The future of where the next emerging markets are is as cloudy as I've ever seen it," says Geoff Yang at Redpoint Ventures.

Limited partners have grown impatient. If the money is going to just lie there, they'd rather have some of it back. They have no illusions that there are better places to put that capital to work; keeping the money in cash beats a bum investment by a long shot. The problem is the management fees that venture funds charge limited partners on their capital commitments--between 2% and 3% a year at most funds. That's bearable if you think you'll make several times your money back. But today a venture investor with $10 million in an inactive fund pays $250,000 a year for the privilege of keeping cash under a mattress. The longer the economy stays bad, the more money limited partners will want back. The venture funds are torn. Most know they have too much money to manage effectively. But those fees are sure sweet.

Khosla and many others in his business prefer not to discuss such matters. They'd rather talk about the help and experience they provide to young companies trying to make their way in the cold, cruel world. "I never say I'm in the venture capital business," says Khosla. "I say I'm in the venture assistance business." People with entrepreneurial aspirations "don't need investors," he adds. "They need coaches."

Congenital optimists, venture capitalists believe their own funds will thrive, even as the industry suffers in aggregate. "You can't judge a venture fund until five years into a fund," says Khosla. By that time initial investments should start paying off, as startups are taken public or sold, and stock or cash is distributed to the limited partners. The venture industry may need to create 325 eBays, but an individual venture fund needs to create just one or two to earn a respectable return. Not that it's easy. But Kleiner's 1999 fund does include the still private Google, which dominates the Internet search business. "We're on a roller-coaster ride," says Khosla. "When you go high fast, you come down fast. You can either believe in it or not believe in it."

In his blue blazer, blooming with a pocket handkerchief formed into a golden poof, 67-year-old Dick Kramlich will never be mistaken for an Internet punk. Yet his venture firm, New Enterprise Associates, got caught up in the bubble like everybody else. "My wife calls me a wildcatter," he says. He certainly drilled some major pipe during the new-economy boom. NEA's most recent fund, raised in 2000 when the Nasdaq had reached its zenith, totals $2.3 billion.

One of the venture industry's patriarchs, Kramlich is a believer. Still, he says, the coming years will sorely test the industry. "It hasn't been this bad since 1968," he says. The venture capital drought that followed lasted nearly a decade, exacerbated by the collapse of the Nifty Fifty growth stocks.

Kramlich is confident NEA will emerge a winner. Of course. "We're focused on best of breed," he says. "We're just getting to the payoff on this stuff. I mean, broadband to the home is just getting started. Our business is not a short-term business." Still, NEA funds look nothing like they did in the early days, and it's not just a matter of size. Like some other large venture firms, NEA is moving into areas not traditionally considered to be venture capital. It recently closed deals on ten biotech companies for a total investment of $250 million, but most aren't startups. Several were carved out of big pharmaceutical firms. Historically, venture capital has brought higher returns than other forms of private equity. If bigger VC firms continue to search for safer investments, long-term returns could suffer.

Whether the definition of venture capital gets stretched or not, Kramlich sees a nasty shakeout that's only now getting started. During the bubble the number of professionals in the venture industry grew to nearly 9,000. Kramlich predicts that by mid-decade, at least a third of them will be gone.

Another industry veteran, Phil Young, 62, says that can't happen soon enough. Young helped take FedEx public, and Sun Microsystems too. His firm, U.S. Venture Partners, has been around forever but doesn't get much attention. Though its investment record is strong, the firm lacks flash. Other venture firms have built more elegant digs. USVP's offices, down the street from Kramlich's and Kleiner's, could pass for the headquarters of a small Midwestern insurance firm, with plain white walls and cherry-colored cabinetry in the style of those TV-stereo consoles that dominated living rooms in the '50s and '60s. When a colleague, USVP general partner Magdalena Yesil, calls Young a "Renaissance man," his face flushes bright red.

But Young isn't shy about pointing fingers. The bubble created a "warped view" of venture investing, he says. "It lured a lot of transaction-oriented people, people not accustomed to thinking long term. They were fundamentally oriented toward investment banking. It's unhealthy, and over the long term it's not what venture capital is all about."

Young and Yesil believe USVP is in better shape than most firms to weather the downturn. Of course. Twenty-six firms raised funds of $1 billion or more in 1999 and 2000. USVP was one of them. But it plans to give no money back to investors; Yesil says no investors have asked. The firm is confident it can squeeze decent returns out of its $1 billion fund. While many firms are cutting back on partners, USVP in recent months added three. Young says people have questioned whether fund sizes have grown too big since the '70s, when he worked on one that invested $52 million. At the very least he believes that for many years to come, the limit has been reached. Since the creation of USVP's billion-dollar fund, the Monday morning meetings of its partners have gone from half a day to all day long. Anything bigger, and the meetings would stretch into Tuesday.

Ashley Read plays in a different league. Her latest fund at Blueprint Ventures raised $53 million, almost exactly the size of Young's '70s fund. The firm has yet to invest that money: It can't afford to make mistakes. Nonetheless she's pumped, eagerly pointing out research that shows smaller firms on average offer the highest returns in the venture capital business.

Read, 31, is smart, fit, and ready to rumble. Besides managing venture capital, she's an adventure racer, competing in events like the Eco-Challenge, sort of a deep-in-the-woods 12-day triathlon. She and Blueprint partner Bart Schachter left Intel's venture unit to form Blueprint in 1999, along with industry old-timer Tom Unterberg. Big VC firms get all the attention, but most firms are small. Blueprint has two funds under management, with $138 billion in total capital.

Times are tough, Read acknowledges, but she believes Bluepoint will prevail. Of course. Unlike her huge competitors, she has no patience for bland niceties about the role of venture financing in the American capitalist system. She gets right to the point. "I don't believe these guys can effectively manage the dollars they have under their belt," she says of the biggest Bubble Funds. They have so much money, she says, that they can't invest several million bucks in a small startup anymore--they wouldn't be able to manage that many investments. So they're stuck investing larger sums in later-stage ventures or seeking other investment alternatives. At that point "it's no longer a venture capital firm," she says. "What is it? I don't know. An investment company? What it is is an accident waiting to happen."

Read has plenty of incentive to dump on the big boys. After all, the best deals tend to go their way first. The small guys are left with the scraps. But she's fun to listen to anyway. And she makes worthwhile observations: "You look at the personal net worth of some of these guys, and you have to ask yourself, Are they still hungry? When it's so tough today to make a dollar, for anyone with the means to retire or choose which of their planes they'll fly today, going to work to dig themselves out of a hole is not a very attractive proposition."

Small venture firms achieve high returns by getting in early, when a startup's valuation is low. Established firms say their own results are just as good, and their funds are safer. But it's hard to know. When it comes to returns on individual funds, venture capital is a very secretive business. So Read was overjoyed a couple of months ago when the University of Texas Investment Management Co. made the results of its venture investments public. She saw that the "clubby" established players like Austin Ventures and Morgenthaler Management Partners were performing as badly as anyone. "It gives me personal pleasure," she says. "It's nice to know they're in the same ballpark as everybody else."

Her joy is not widely shared on Sand Hill Road. The bigger VCs are incensed that the results were released, some of them even threatening to exclude other loose-lipped investors the next time new funds are raised. They claim that they're concerned not about secrecy, but that the results could be misinterpreted. In fact the way VCs report their results is complicated, perhaps intentionally so. Read says, so what? "They say this thing could be misinterpreted. I go...yeahhhhhh. So footnote the goddamn thing!"

If venture firms are getting squeezed, entrepreneurs are hurting worse. Through the bubble years, valuations placed on new companies seemed to go only up. At every stage of funding entrepreneurs got richer--on paper.

Now companies are encountering what's known in the venture world as "down rounds." Struggling companies need cash to survive. Instead of prepping their investments for IPOs, VCs are pumping in survival funds. Valuations go lower, founders' stakes are reduced, and some entrepreneurs get so "washed out" that they wonder whether it's worth their time anymore.

That happened earlier this year to Hau Lee, a business professor at Stanford University and one of several co-founders of a San Francisco startup called Nonstop Solutions, which makes supply-and-demand analysis software for retail chains. With corporate spending in a deep freeze, the company's main backer, Kleiner Perkins, restructured and squeezed the equity stakes of the founders so much that several left the company, according to Lee. The professor says "the new valuations hurt," but he's sticking around, accepting that the world has changed, happy that the company wasn't simply liquidated.

Some VCs wish more entrepreneurs saw things the way Lee does. "Now is the time to be squeezing money out of the turnip instead of petting the turnip," says Ann Winblad, co-founder of Hummer Winblad Venture Partners. Or as USVP's Yesil puts it, less colorfully, "Our attitude is, you can't protect the past. Investors lost money. I have lost my investments and my time. We're all starting again because we believe there is great opportunity."

What really worries Lee, however, is not washouts and wipeouts but the fact that a fresh, new generation of entrepreneurs is finding it nearly impossible to get venture backing. "The idea that this is hurting entrepreneurism is certainly true," he says. "I have a number of students with interesting ideas. In the past they wouldn't have hesitated [to start a new company] and try them out, but now they've opted to go work for a conventional company."

Venture capital is hardly the only way to finance a startup or bring an innovation to market. Some of Lee's students may well boost the economy by creating products and services at the corporations they work for. And bootstrapping has not disappeared--staking a startup with credit cards, money from family and friends, and, eventually, cash flow. In fact most companies start just that way. "Generally what that means is you don't grow as fast," says Jeffry Timmons, a business professor at Babson. "Multiply that by a few thousand companies. It will have a significant impact on the economy."

The way out of a down market, of course, is economic growth. The minicomputer industry, personal computer industry, networking industry, and the business end of the Internet were all seeded by venture capital. But with so little money going into new ventures today, says Marc Barach, co-founder of Insweb.com, "we're going to be sitting on an empty pipeline. We're eating our young here."