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Big changes needed in the venture capital market

Venture capital firms are struggling as exits for start-ups dwindle, which suggests a need for VCs to change.

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.