Venture Capital and the Decline of the Startup Middle Class

Venture capital investing rebounded after a grim 2009 with venture capitalists investing $21.8 billion in 3,277 deals in 2010, which was up 19 percent from the dollars invested the previous year and reflected a 12 percent increase in deals according to the MoneyTree Report by PricewaterhouseCoopers LLP and the National Venture Capital Association (NVCA). However, the big story arising from the full year and fourth quarter MoneyTree results was that the superstars in the startup world appeared to be reaping the rewards of big valuations while the others are pretty much left to suffer.

The business world has always idolized and venerated a few top companies, but as the web focuses on consumers and rewards scale there seems to be less room for a Number 2 player in a portfolio and in the market. I think of it as the decline of the middle class of startups, but perhaps it’s also a reflection of the media frenzy around the biggest names and the focus on consumer-focused startups that need scale to make it big. Seth Levine of Foundry Group put it best on the conference calling the crop of super startups such as Facebook, Zynga and Groupon that have grown really rapidly to huge scale, “the new normal,” and saying that venture firms are now seeking out and rewarding companies that can rise quickly to the top with huge valuations and financings.

Unfortunately the venture capital data offered up on Thursday doesn’t detail valuation, but it does offer some positive insights. Early stage and first time financings are continuing to happen (although the dollars are shrinking while the number of deals are rising in seed stage deals). This could reflect this decline of the middle class in part because venture firms are happy to invest a small amount and then pull out if the startup doesn’t gain users rapidly. Although is also likely because startups today are far more efficient. In addition, the number of later stage deals is finally decreasing from record highs in the 2006-2008 time frame.

Later stage financings hit that high as it became more difficult for companies to file for initial public offerings, which meant that VCs who had invested in a company hoping for an exit during that time frame often had to keep it on the books, much like a parent may have to do with an adult child who doesn’t leave the nest. However, a combination of startups closing, acquisitions and a few initial public offerings have helped clear the decks for VCs and freed up capital for the early stage and expansion capital deals. Ironically, the crop of super startups that are defining the upper class are not as interested in going public, which could create some interesting effects in the venture industry later on, and can even be seen today in the wider popularity of the secondary markets.

Overall the venture industry has become smaller than it was during the 2006-2008 time frame. While it still hasn’t shrunk to the point that some experts had called for, it’s getting closer to a new normal baseline according to John Taylor, VP of research at the NVCA. However, without a credible IPO market and the rise of a few superstar companies raising several hundred million dollars instead of going public, I think we’ll see a disruption to that baseline amount invested soon enough. Either that or a change in the way venture firms disperse their cash.