Last month we looked at the external factors partly responsible for the consolidation of the venture industry.  What also bears consideration is the internal economics of the industry itself.  As the industry grew and both the number of funds and fund sizes increased, the returns that venture funds promised their limited partners extended into the stratosphere.  The simple math behind most venture funds ended up encouraging investments with enormous risk profiles, while companies with a lower risk/reward profile had a harder time attracting capital.

You can either look at this problem from an industry perspective  (via Fred Wilson), or from the view of a single fund (via Josh Kopelman).  To quote from the latter:

Take a $400M venture fund.  In order to get a 20% return in 6 years, they need to triple the fund — or return $1.2B.  Add in fees/carry and you now have to return $1.5B.  Assuming that the fund owns 20% of their portfolio companies on exit, they need to create $7.5B of market value.  So assume that one VC invested in Skype, MySpace and Youtube in the same fund – they would be just halfway to their goal. 

Both posts are good reading, and they underscore a fundamental mismatch: with new technologies and processes, many entrepreneurial companies are increasingly capital efficient — requiring less investment, but particularly with the limited IPO market, also with lower exit value.  At the exact same time, the appetite for longshots increased at most VC firms, with an emphasis on the exit and placing more capital; thus spurning a basic imbalance between supply and demand.

For most executives, Josh drives home a critical point: “A company’s outcome should drive VC returns.  When VC’s required returns drive company’s outcomes, it’s a recipe for trouble.”  As you consider capital sources, make sure the their return expectations are aligned with your reality.