Clouds are gathering over the venture capital industry

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The past couple of weeks brought another round of startup funding data that reinforced my belief that the venture capital industry is staring into the abyss.

The money coming in to VC firms, and the money going out, were both bleak. It’s the latest clue that a massive shakeout looms for a VC industry that remains bloated from the dot-com boom days.

I, and many others, have been predicting consolidation for some time. But the potential size of that reckoning really hit home to me recently after talking to the valley’s two newest venture capitalists: Marc Andreessen and Benjamin Horowitz. Earlier this month, the pair announced they had raised $300 million to launch the Andreessen Horowitz venture capital fund.

That’s an impressive sum in the best of times, and speaks to the high esteem investors have in this entrepreneurial twosome. Andreessen was a co-founder of Netscape, where Horowitz was hired. They later co-founded Opsware, which Hewlett-Packard bought for $1.6 billion.

At first, the launch of their VC startup brought to mind an old saying, “Planting a tree shows faith in the future.” But don’t mistake their decision to start a venture capital fund as a vote of confidence in the VC industry. They’re extremely pessimistic.

“Most VCs won’t give you a return that exceeds the S&P 500,” Andreessen said. “Those firms are broken.”

It might be easy to dismiss their views as just a couple of guys trying to hype their fund, and themselves in the process. But a couple of things struck me when talking to them. First, given their history in the valley, their analysis on startup funding is always worth hearing.

But second, rather than lowering the bar, or dampening expectations, their take on the way things will play out raises the bar for their own success.

Let’s look at their numbers. They figure that each year there are about 15 companies created that matter (most of them in Silicon Valley). That’s it. Just 15. Those are the companies that will have an impact, and deliver a product and business that will justify a strong exit, either through being acquired or an initial public offering.

That’s simply not enough to sustain an industry that includes the 460 venture firms that are members of the National Venture Capital Association.

In their view, more and more deals are going to go to fewer and fewer firms. To succeed, they figure their new firm needs to be one of the top 10 firms. Below that number, anyone is going to have a tough time of it.

Think about that: Just 10 firms raising and investing the bulk of VC dollars. It would represent a radical contraction of the industry.

Why are Andreessen and Horowitz so confident they can crack the top 10? They don’t have any dramatic new approaches to investing. Instead, they think that too many in the industry are professional VCs, rather than former entrepreneurs such as themselves. It’s a kind of “back-to-the-future” mindset, hearkening to the early days of the valley when most venture capital flowed from entrepreneurs. Basically, they think they’re smarter, and their years as entrepreneurs will help them see those winners more clearly.

The pair are also betting that their name recognition, and their recent successes as angel investors behind some of the most successful Web 2.0 companies such as Digg and Twitter, will help them capture a decent chunk of those 15 companies.

As gloomy as things are, this is all going to take a while to unfold. The shakeout will be more of a slow-motion train wreck rather than an outright collapse. A firm here, a firm there will close its doors. These funds measure their returns over five to 10 years, and many still have sizable sums committed from investors.

“I think that there is still a way to go, both in terms of number of funds and dollars,” Horowitz said in a follow-up e-mail exchange. “That is, a lot of funds will close and a lot of funds will raise smaller amounts. Very few (present party excluded) new funds will get started.”

The same applies to the Andreessen Horowitz fund, which will invest that money over 10 years. It will take us a decade, or more, to know for sure whether the pair’s confidence was warranted.

It’s hard to bet against them, given their track record as entrepreneurs and advisers. But if they escape and rise above the carnage they’re predicting, that just may rank as their most impressive feat yet.

(c) 2009, San Jose Mercury News (San Jose, Calif.). Source: McClatchy-Tribune Information Services.