Big changes needed in the venture capital market
With the market for initial public offerings in a deep freeze and a dwindling number of potential buyers, start-ups have fewer opportunities to exit and retire to Costa Rica.
This is worrisome to entrepreneurs, but if anything, it should be of even greater concern to the venture capitalists that fund them, a point made by TechFlash's John Cook. Venture capital firms simply aren't structured to invest efficiently in this market.
VCs raised billions of dollars during technology's boom, and it's unclear where they can now profitably invest those dollars. IBM, Oracle, Cisco Systems, and Microsoft can buy only so many companies. The industry consolidation that paid big returns to VCs earlier this decade has left far fewer potential buyers, with an anemic IPO market to provide an alternative outlet.
The situation has the potential to get worse. As IBM's Savio Rodrigues writes, Oracle has been hit hard in its middleware business as enterprise IT seeks to minimize the damage from Oracle and SAP price hikes in applications. This could make it harder for the company to afford acquisitions down the road.
In venture investing, small is the new big. Smaller, strategic funds like O'Reilly Alpha Tech Ventures can score big on a "base hit" $20 million exit, given its seed-stage investments of $500,000 to $1 million. Meanwhile, a large firm such as Kleiner Perkins Caufield & Byers will struggle to break even on such an exit, given that its investments need to be much bigger because its funds are so much bigger.
Venture firms have compensated by throwing money at weaker companies that arguably shouldn't get funded. This isn't sustainable. If exit options are dwindling for good companies, they're nonexistent for bad ones.
Compounding the problem for VCs, not only are exits likely to shrink in the new technology economy, but start-ups need less cash to thrive due to low-cost open-source and cloud infrastructure. This is true for most start-ups, but particularly so for companies that sell open-source software.
VCs potentially need to trim their existing funds, and almost certainly should be raising smaller funds.
For those that want to put existing capital to work, it might make sense to swing for the fences with consolidation around portfolio companies. I've described one winning open-source combination (Acquia, Magento, and OpenX), but there are plenty more. The upside to this strategy is that it fattens up a potential acquisition. The downside is that equity positions get heavily diluted in the process, and there are few potential buyers.
It's hard to make early-stage investments in a climate when entrepreneurs need less money, and when the exits promise to return far less. But that is precisely the environment in which VCs find themselves. It may be time to trade in that Porsche for a Honda.
Matt Asay brings a decade of in-the-trenches open-source business and legal experience to The Open Road, with an emphasis on emerging open-source business strategies and opportunities. Matt is vice president of business development at Alfresco, a company that develops open-source software for content management. He is a member of the CNET Blog Network and is not an employee of CNET. Disclosure. You can follow Matt on Twitter @mjasay. 
There are two issues that should be address to get venture capital flowing again:
1) We need to change our national taxation system to -encourage- more personal savings and capital investment staying in the USA. Right now, our income tax laws are driving Americans to either participate in the cash-only "underground economy" to the tune of US$2 trillion or use every possible tax loophole to "offshore" American-owned liquid assets to "offshore financial centers" located around the world, with the amount "offshored" estimated at a frightening amount somewhere between US$12 and US$17 TRILLION! And American companies are moving corporate headquarter and manufacturing operations out of the country also for the income tax reduction reasons. This is economic stupidity, in my opinion; changing our tax laws to effectively end all taxes on -earning- money would provide a gigantic boost to the economy as millions of jobs come back to the USA under better tax circumstances and we can repatriate most of that US$14 to US$19 TRILLION originally taken out for tax reduction reasons.
2) The Sarbanes-Oxley Act needs to be repealed or heavily revised to better balance the need for initial public offerings and account reporting requirements. Have you noticed that ever since Sarbanes-Oxley passed, the number of new IPO's have just about dropped to nothing in even major US stock exchange?