Venture capital (VC) is what used to drive the U.S. into the lead in the global economy. That ended around 2000 and it's been downhill ever since. Why? First, the dot-com boom let too many fake companies go public among the many real ones. Second, we had a lost decade when it comes to business-focused technological innovation. Now many question whether VC has a future. That's really the wrong question though -- they should be seeking the source of the next wave of business-transforming-technology.
Before exploring just how much woe faces VCs -- and by extension America's place in the global economy -- let's take a look at how VC became so important. It really got started back in 1957 with American Research and Development (ARD), which invested $70,000 in exchange for 70 percent of the now-defunct, Digital Equipment Corp. (DEC). Founded by MIT grad, Ken Olson, DEC took the lead in minicomputers and was a dominant IT company through much of the 1970s and early 1980s. In 1972 ARD sold its stake for a 70,000 percent return.
Business technologists and venture capitalists have been working hand-in-hand since the 1970s. In the 1960s, thanks to International Business Machines (IBM) and others, the mainframe computer found its way into large organizations. Such mainframes were tightly controlled by a centralized data processing department and there was limited opportunity for VCs because IBM completely controlled all doorways to its mainframes.
In the 1970s, DEC introduced the mini-computer which made it possible for companies to create many computer systems across different departments. The 1980s saw the rise of the Personal Computer (PC), which blew DEC out of the water as it distributed computing power to the individual worker, and VCs who put money into PC companies did quite well.
The latter half of the 1990s introduced the Internet to business. This created huge opportunities for VCs that invested in software, eCommerce, routers, consulting and a whole range of other companies that made it possible for business to profit from this new technology. Thanks to the vibrant IPO market, which woke up following the enormous success of Netscape's 1995 offering, The 1990s were a peak period for the VC industry.
But as I wrote in 2005, the business-focused technology innovation stopped about 10 years ago. That -- and the related dearth of VC-backed IPOs -- is why VCs have taken a huge blow in this decade. How bad is it? A third to a half of the 882 active VC firms could disappear, if only because poor returns -- 5-year VC returns through 2008 were 6 percent compared to 48 percent in 2000 -- will force under-performing firms to shut down.
Meanwhile, investment in VC funds shrank 39 percent to $4.3 billion in the first quarter, from $7.1 billion in the same quarter a year ago. This decline is due in part to the fact that endowments have been big investors in VC funds and they are hurting. For example, Harvard's endowment fell 30 percent in value in the last year and such collapses are making it hard for VCs to raise new money.
But the simple fact remains that unless engineers can come up with new technologies that will spur a new wave of business reinvention, there will be little of real value in which VCs can invest their dwindling capital resources. The few IPOs of VC-backed companies in this decade have been related to consumer technologies that only support one or two companies, rather than an entire business ecosystem.
Without such a wave of new companies, it will be difficult to support the kind of IPO boom that makes VC pay off for its investors. And without an IPO market, at $11.4 trillion in national debt, the U.S. is just the world's biggest debtor -- and that's not a prescription for economic growth.
Peter Cohan is president of Peter S. Cohan & Associates. He also teaches management at Babson College. His eighth book is You Can't Order Change: Lessons from Jim McNerney's Turnaround at Boeing. He has no financial interest in the securities mentioned.