The Breakdown

Explaining Southern California's economy

How big should venture capital be? Try less than $25 billion

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32566 full

Earlier this week, the National Venture Capital Association and Thompson Reuters assessed the current state of the VC fundraising landscape. The verdict is that VC has "settled in a 'new normal,'" with the total number of funds decreasing while the total amount of money raised went up in 2012.

That performance lived up to expectations from earlier this year.

The total raised was $20.6 billion, which the NVCA suggests is the "Goldilocks" number: Not too big, not too small — but just right. There's a sense in the VC world that it's critical to keep the total amount of money raised under $25 billion.

That much money flowing into VC on an annual basis means that entrepreneurship and innovation can be funded in an optimal manner, without too many bad companies and bad ideas getting money, just because VCs need to put their funds to work.

However, there is a slightly alarming trend. The "new normal" has a barbell shape: early stage startups can get funded, as can companies that are fairly mature or have blowout prospects that would garner big funding rounds. If you're in the middle, trying to get a follow-on round, you could have a problem.

Additionally, the biggest VC funds continue to suck up a majority of that $20.6 billion. In 2012, 55 percent of it went to the five biggest funds, the NVCA reports.

This "rightsizing" and "barbellization" of the VC business is happening at the same time that a major funding source — big pension funds — are beginning to question the returns they've been getting on this risky, rapid-growth oriented investment class. CalPERS, the huge California public employees pension fund (it's the largest in the world), announced in August that it's reviewing the VC portion of its alternative investment portfolio.

It isn't hard to see the dynamic that's taking over. Brand new companies that have unexplored prospects are getting funded, as are companies that have an excellent chance of providing investors with a good return. The pipeline needs stuff at the entrance and stuff — big stuff — at the exit. 

But if you aren't clearly headed toward an exit, the money could dry up. This means that VC-funded companies need to be viable sooner. A bunch of pivots in the business model of product development, with VCs standing by to bankroll the experimentation, isn't going to cut it.

All the big funds are in California, so in terms of VC in the Golden State, this all just means Silicon Valley is going to consolidate its reputation as the place to go if you need funding. But it may not be the place to stay if your startup doesn't start to pay off — and pay off quickly — on the "new normal" VC timeline.

Follow Matthew DeBord and the DeBord Report on Twitter. And ask Matt questions at Quora.

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