Paul Ferri, one of the legends in the venture business, is quoted in the most recent issue of Private Equity Analyst (not available online) as saying that the venture business is headed for some really tough times. He is recommending that his investors (called LPs in the industry vernacular) stop putting money into the business right now. That's a tough call but Paul has got the credibility to back it up.
His reasoning is two fold. First, he thinks there are too many inexperienced VCs in the business doing silly things with the LPs money. I think he's right about that, but I also think that's slowly changing as the business shakes out and the less experienced managers leave the business or get the required experience to become better investors.
His second reason is something I call venture fratricide. This is when a entrepreneur with good idea is funded by a small group of VCs and the idea is then "knocked off" by a bunch of other entrepreneurs backed by a bunch of other VCs. It's happened so many times in the venture business that it would be too hard to name them all. But everyone's heard of the 50 disk drive companies funded in the mid 80s, the 20 gigabit router companies funded in the late 90s, the 10 social networking companies that have been funded in the past three months, and the list goes on and on.
I've been on the recieving end of venture fratricide a number of times. It "sucks balls" as Jerry's son says. The first company often spends a lot of time, money, and energy developing and evangelizing an idea and the "fast followers" often benefit from "drafting" on them and then passing them at the first opportunity.
I don't think there is any way to truly end venture fratricide other than a major shakeout in the venture business. And it would have to be a very large shakeout, much larger than the one we just went through. I honestly don't think that's in the cards right now.
I think there are some things that can be done though. The first thing is that LPs (who write the checks to fund the VCs) should look hard at the portfolios and figure out which VCs are the ones who tend to fund the first and second companies in an emerging market and which ones are the ones who fund the fifth through tenth companies. They shouldn't give money to the VCs who are funding the fratricide. That takes a lot of work, but the best LPs are smart enough to do it and they should.
Second, VCs should recognize that too much "me too" investing is harmful to the business and stop doing it. VCs can self police the business to some extent by "blackballing" VC firms that do too much "me too" investing. There are a number of ways VCs can put the "me too" firms in the penalty box and I think its going to start happening.
But until all of this policing of the venture business happens, if it ever does, i think the only thing a VC firm can do to protect itself from venture fratricide is stay small, avoid overly competitive markets, build your best companies quietly, and avoid "me too" investing at all costs. This may mean passing on some deals you'd really like to do, but that's an important part of the venture discipline.
So that's a long way of saying that I agree with Paul's analysis of what's wrong with the venture business. But its not complete. In fact, I believe the VC's tendency to overfund companies is a much larger issue than inexperienced VCs and venture fratricide.
I also don't agree with Paul's conclusion that these problems will make it impossible for VCs to deliver good returns to investors. We've been dealing with these issues in the venture business for a long time now and they haven't ruined the business yet. I think innovation and entrepreneurship are the best things about our capitalist system and the venture business is the engine that monetizes them. That's a recipe for solid returns for a long time to come.