VC Markets: No Easy Answers

Venture capital is in dire need of a fix, and the drumbeat is growing for the creation of a secondary market

By Sarah Lacy

The venture capital industry has been a slow-moving train wreck for much of the past decade. And one of the more radical steps aimed at avoiding disaster may only hasten it.

To recap, there's more money going in every year than can be invested properly, especially with Sarbanes-Oxley regulations discouraging smaller companies from going public. There are few areas of true high growth in the U.S., now that industries like chips and enterprise software have matured. And the recent Web 2.0 and clean tech darlings are not much help, either. Many Web companies don't need enough capital for VCs to take meaningful stakes, while the more ambitious clean tech gambits arguably need more capital than VCs can dole out.

I've long argued that a shakeout is inevitable. While some people claimed I was being hyperbolic, the disastrous returns of the past few quarters (following lackluster returns over the past nine years) validate my concerns.

Four-Point Plan Proposed

The realization is spreading that VC is in dire need of a fix. The National Venture Capital Assn. has proposed a four-point plan. VC Fred Wilson is saying venture math is irreparably broken. Super-angel investor and entrepreneur Reid Hoffman has even proposed that government money prop up worried VCs and encourage them to start investing again.

Amid the handwringing, the drumbeat is growing louder for a new solution, the creation of a secondary market. This would let anyone holding a private stock to sell it for a fair market rate, without having to wait for an acquisition or an initial share sale. A secondary market essentially makes an illiquid stock liquid. Proponents say it would ease the venture-returns gridlock and get innovation flowing again. But it would also change the venture capital economy in some radical—and in my view, undesirable—ways.

To be clear, some of the changes would be good. I've long been in favor of so-called "partial liquidations" that allow founders to cash out part of their stakes. In August, Facebook started letting employees sell up to 20% of their stakes at a $4 billion valuation. Entrepreneurs working day and night to build their dreams should be allowed to cash out a tiny percentage of ownership.

Good Times Will Come Back

But a full-fledged secondary market is a totally different matter. The lack of returns is a symptom of a larger disease that needs to be cured, not sidestepped. Put bluntly, VCs need to do better deals if they want better returns. The limited partners that park their funds in VC need to do the responsible thing and invest less in the asset class if they want the math to work again. Then good returns will come back.

Good idea or no, secondary markets will soon be put to the test, thanks to a new company appropriately called SecondaryMarket, as well as a handful of other players.

This may come as good news for VCs and entrepreneurs in the short term, I also see two big unintended consequences that aren't work the risk.

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