The VC industry is broken. So now what?

By Stacey Higginbotham   This was originally posted here.

OMG!  These returns!

The investment team at the Kauffman Foundation believes the venture capital industry is broken and they — or rather investors in VC funds — are partially to blame. The report condemns venture firms for being too big, not delivering returns, and not adjusting to the times. But then it blames the situation on a misalignment of incentives: Namely, limited partners that invest in venture firms have done so in a way that encouraged VCs to raise huge funds at a time when huge funds weren’t really warranted. And now, for the Kauffman Foundation at least, the chickens have come home to roost. From the report:

The most significant misalignment occurs because LPs don’t pay VCs to do what they say they will — generate returns that exceed the public market. Instead, VCs typically are paid a 2 percent management fee on committed capital and a 20 percent profit-sharing structure (known as “2 and 20”). This pays VCs more for raising bigger funds, and in many cases allows them to lock in high levels of fee-based personal income even when the general partner fails to return investor capital.

A smaller VC industry is needed

The solutions to the problem — changing the compensation structure, investing in smaller funds where the partners have also committed at least 5 percent of their own capital, investing directly in startups or alongside funds at later stages, and taking more money out of the over-saturated VC market — are already happening. Look at the widespread trend of angels or smaller funds created by a few investors. Or look at the rise of hedge funds orDigital Sky Technologies’ investing directly in hot companies like Twitter or Facebook at crazy valuations.

It’s unclear if other LPs will take the advice issued in this report, but the trends around VC investment these days are fairly clear. There are plenty of firms willing to put small amounts in at an early stage, so they have the option to keep playing if the deal gets hot. And they are just as likely to drop firms quickly around the second (Series B) fundraiser if they aren’t shaping up into a Pinterest or a Spotify. This hit-driven style of investment is a symptom of too much money chasing a new type of startup, and it’s likely that venture investors will compete until much of the return is squeezed out of a hot deal. And that’s no good for limited partners either.

The Kauffman report lists the ways it has decided to solve the mismatch between LPs and venture firms, and it goes into a lot of depth on how to improve the industry overall. But if one agrees with the assessment and solutions offered in the report, it also will result in some serious questions about the startup economy. The venture industry invested $28.4 billion into 3,673 deals in 2011, according to the NVCA and the PWC MoneyTree report. About 50 percent of their total investments were in seed and early-stage companies.

Does less venture money mean fewer startups?

Following the Kauffman Foundation’s suggestions means the pool will shrink. In many waysthis is a good thing, as there will be less money chasing the few standout deals, but it also opens the door to thinking about building companies in a connected era. Angels are already picking up some of the VC slack and will likely continue to do so. Once Facebook goes public, I expect we will see a host of newly minted millionaires playing at being an angel or perhaps taking their riches and using it to build something new.

For those without soon-to-be-liquid options, Kickstarter and the gold rush promised by the JOBS Act are also likely to fill the gap. So it’s entirely possible the pool of venture capital will shrink while the pool of startups will remain about the same. In such a scenario, VCs, angels and then the rest of us play the role of investor. It’s a role millions already undertake, withKickstarter’s seeing $200 million pledged and 22,000 projects funded since its founding.

And the passage of the JOBS Act means startups can now beg for money among the ranks of friends and family who aren’t accredited investors. I for one am leery of this development, believing it ripe for scams. The law also has the side effect of cloaking information about companies until right before they hit the public markets, which I think is the exact opposite of what a bill that encourages consumer investment ought to do. But still, there will belegitimate companies that will be able to start businesses thanks to the bill.

And as lawyers and entrepreneurs get comfortable with the law, new funding platforms should arise. So perhaps the Kauffman Foundation will find itself on the cusp of a trend, from the old-school style of fundraising where an entrepreneur has few choices and has to play by the VC industry’s rules to a crowdsourced and connected era of raising capital that mimics how the Web is changing a variety of businesses. Maybe the VC industry is like Motown. And it’s going to have to adjust to the new reality.