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Spending some more time on Ed Sim’s blog (hmm - I’m reading a lot of VC blogs lately - I’m in that kind of mood :-), I came across a most insightful, must-read post . Ed describes changes in the Internet Venture Capital business that need to happen, since the “VC model is broken”. So what is wrong and what needs to be fixed?

Market-side:
The Googles and Yahoos (and increasingly the Microsofts) of the technology industry are making faster, quicker acquistions. This is no market consolidation - the industry’s growing differently from the bubble-days. This time round, there are larger, established players in this fast-growing market who’re competing aggressively against each other to expand into newer areas, with newer business models targetting a different niche of users.

I mentioned that the market is growing very fast - that means that valuations of startups are changing just as quickly. That’s another reason why an acquirer will want to swoop in faster than it would have in more stable circumstances. There is less risk involved in such fast aquistions since the market has matured (in comparison to the pre-bubble days), the user base is there, the business models are there, the technology infrastructure (storage, connectivity and bandwidth) is in place, so software as a service is a tried-and-trusted model in many ways.

What does this mean for the VC?
It means that the 10x and above returns that he/she was used to, are drying up. To be able to bootstrap itself and generate a cashflow that will see it through break-even, the amount of capital that a startup needs today is far lower than the bubble days. We’re talking of in the $10-15 million range as opposed to $50 million. At the same time, as I pointed out in the preceeding paragraph, the acquisition-based exits have valuations which are smaller (since the acquisitions themselves happen faster).

VCs want larger exit-time valuations (for their traditionally very high returns). Now these are increasingly getting squeezed by the GYM variety of companies (Google, Yahoo, MS). In fact, we’re reaching a stage where the public listing-style exit route is almost exctinct.

So both input and exit figures have botten smaller, and to be able to get 10x returns and maintain volumes, VCs will need to get more deals done. That calls for multiple small funds , each tightly focussed on a technology area. For instance, one for VoIP solutions. This will call for VCs to get smarter, identify ideas and firms quicker and smarter than before. Technical insight is more valuable than ever before .

As an aside, Ed points out the difference in the acquisition strategies of Google and Yahoo:

Google’s expertise seems to be buying engineers, many times before a product is even launched.  Yahoo, on the other hand, prefers to buy companies that have some nice user base, maybe no revenue model yet, but also before a VC round.