As VC Industry Shrinks, First-Time Investments Plummet

It’s been suggested that the venture capital industry needs to shrink to as little as half its former size, and new data from the National Venture Capital Association shows that it’s almost there — with some evidence suggesting that further contraction is in order. According to its latest report, produced in conjunction with PricewaterhouseCoopers, VCs invested a total of $17.7 billion in U.S. startups during 2009, off 37 percent compared to the $28 billion invested in 2008 and down 42 percent from a recent peak of $30.5 billion in 2007.

After more than a year of few exits and generally unsatisfying returns, the slowing pace of investment parallels the decline in venture fundraising, which fell 47 percent in 2009. Still, the second half of the year generated more robust dealflow, with more than $10.1 billion invested after July 1.

For the NVCA, that’s cause for optimism, as is the relative enthusiasm for seed and early-stage companies, in which 8.6 percent less money was invested in 2009 than in 2008, compared to 46 percent fewer dollars going into expansion and late-stage rounds. In sharp contrast, however, was another stat: 2009 was the worst year the survey has ever recorded for startups attempting to raise money for the first time, with first-time investments accounting for a smaller portion of overall dealflow than ever before. (See the two slides below.)

One would think that the two would go hand in hand, so why the disconnect? Most likely, this means that more early-stage companies –- which the NVCA says are mostly pre-revenue -– are collecting more follow-on money, as VCs are continuing to fund startups in their portfolios that are adjusting their strategies now that the good times of 2007 and early 2008 are long gone, while taking fewer gambles on new ideas. Indeed, only 35 percent of the money going into seed and early-stage companies was in a first investment round; historically, that figure has hovered between 50 and 70 percent, and has dropped abruptly since 2005.

I asked John Taylor, the VP of research for the NVCA, about this, and he noted that since time to exits has lengthened over the years, venture investors now tend to reserve four to five times their initial investment for follow-on rounds, rather than three times as they did in the past.

Venture firms that fold tend to do so slowly, gradually bleeding people and ceasing to make new investments while retaining a few partners to shepherd portfolio companies toward an exit. With first-time investments in such sharp decline and startups needing more capital to reach their first revenues, the writing’s on the wall for an industry in contraction.