Fred Wilson: what crowdfunding means for the VC business

For the past couple of decades, venture capitalists have had the upper hand. They’ve had the funding and, traditionally, they’ve held most of the power in the startup ecosystem. But, Fred Wilson, managing partner of Union Square Ventures (and beloved blogger), believes that balance of power is shifting (As noted in Stacey’s take on a similar notion advanced by the Kauffman Foundation earlier Tuesday.) And as it does, venture capitalists themselves must rethink their role.

Speaking to a crowd of entrepreneurs at the Grind work space in New York this morning, Wilson said that since the mid-1990s institutional investors have poured $30 billion into the venture capitalist business every year, but venture capitalists have only been able to figure out how to generate good returns on half of it. (Actually, venture capitalists haven’t seen that much money flowing in since 2007, according to the National Venture Capital Association, which notes the recession dramatically lowered investment.)

“There’s two times as much capital in the venture capital business today than we, the professional investors who make up the venture business, can actually put to work intelligently,” he said. As an asset class, venture capital has not beat the public markets on a consistent basis since the mid-1990s, he added.

Mo’ money, mo’ problems

That underperformance alone has given VCs reason to stop and think about their position, but he emphasized that the recent influx of new sources of capital has exacerbated the need for reflection. (The Kauffman Foundation report referenced in Stacey’s post on the “broken” VC industry outlines even more reasons why venture capitalists need to adapt to the times.)

In the past five years, the amount of angel investment has grown fivefold and more international funding is also entering the startup sector, particularly from Russia and the Middle East, Wilson said. The growth of crowdfunding (made possible by the recently-passed JOBS Act) will further flood the startup market with new capital. If every American family gave just one percent of their investable assets to crowdfunding, he said, $300 billion – or ten times the current amount invested in the sector – would come barreling into venture capital. (That seems to be a pretty big assumption but, regardless, the point is well taken: crowdfunding stands to dump a huge amount of new money into startups.)

“This is, I think bad news for the venture capital industry, but terrific news for the entrepreneurs,” Wilson said, adding that over the past two decades, “it’s been an inexorable march from an industry that was very much skewed towards institutional VCs to an industry very much in favor of the entrepreneurs and it’s just going to get more and more and more that way.”

So, what’s a professional venture capitalist to do?

The new venture capitalist.

Given all the new pools of funding, he said, it doesn’t make sense for VCs to continue aggregating capital. And considering the industry’s inability to generate returns on more than half of the current investment in venture capital, he added that the allocation aspect is another area ripe for rethinking.

Still, he continued, VCs, can keep on adding value as board members, advisors and resources on exits and governance.

Going forward, VCs have a few options on the table, including becoming more selective, shrinking, halting investment of instutional capital or taking more equity for the governance and advisor services they provide, Wilson said.

But one of the more compelling ideas he floated was building a business on top of crowdfunding.

“If these crowdfunding markets really do develop into these vibrant markets… maybe the answer is to leverage that capital and do something interesting there as opposed to going out and raising money from the institutions,” he said.

A possible model could be a scenario in which a VC spots an interesting deal in the crowfunding market and offers to sponsor the deal with one-tenth of a $1 million round, he said, potentially making it easier  for the startup to raise the remaining $900,000. The hypothetical VC could also join the board and get added equity for the expertise.

Of course, if nothing else, there’s always blogging – “a pretty good gig if you can get it,” he said.

And, as a last resort? Quipped Wilson, “We can just retire.”

Fred Willson will be interviewed by GigaOM’s Mathew Ingram at paidContent 2012, May 23 at the TimesCenter in New York. Register here.