Peter Rip, the managing director of Leapfrog Ventures, has posted a very thoughtful piece in his EarlyStageVC blog on the ROI dilemma facing traditional VCs. It is titled Traditional Venture Capital Sure Seems Broken – It’s About Time.

Fewer VC dollars are going into early technology startups, and then at higher valuations and with larger amounts invested.  Meanwhile, technology has become democratized with faster times to market and with narrower innovation edges. This poses dilemmas both to VCs and to company founders, as Peter accurately notes:

The traditional venture capital model formula in technology was … a form of arbitrage based on two scarcities — risk capital and understanding of technology. Starting in 1995 the scarcity of both these drivers began to disappear….

The traditional venture capital model has been “fund twenty, pray for two.” Since you could only lose 1X your money, you could make it up with a couple of big hits. But big hits are fewer and much farther between than ever before. To make a modest venture return on a $500M fund, you need to generate $1B. Assuming you own an average of 20% of companies at the exit, you need to create $5B of shareholder value. If the average IPO valuation is $216M (per VentureOne, according to a WSJ article last week), that means you need 23 IPOs in a portfolio of 30 companies. The math worked when venture funds were $200M and exits were $500M. It doesn’t work when the numbers are reversed.

Venture capital is a three parameter problem. Buy Low, Sell High, Sell at the Right Time. Most people seem to have ignored the third parameter. Time-to-exit used to be 4-6 years. Then it collapsed to 2 years in the Bubble. Now it seems pretty much infinite. Divide by Zero and get infinite IRR. Divide by infinity and get -100% IRR. The proof is left to the Investor.

I can only see two venture capital strategies that make sense in this environment. One is to be small, focused, and totally aligned with market realities and founder incentives. … There is no magic to this strategy. It just takes discipline….

You would think that cheap, abundant capital was a great boon for entrepreneurs. It isn’t….Lots of cheap capital, available at high valuations seems great, until you do the exit math. Raise $8M at $12M pre-money and your post-money valuation is $20M. Your investors want to sell for $200M. Raise $2M at $4M pre- and your investors get the same rate of return at $60M. But a $60M exit is 10X more likely than $200M. [But] few VCs will write the $2M check these days, precisely because a $20M return doesn’t move the needle in a $500M fund. That’s why valuations are moving up . . . the need to invest more money  . . . not the intrinsic value of startups….

The other strategy is to be treat venture capital as one of many capital markets to search for inefficiencies across the private-public spectrum.

Smaller funding rounds align financing more closely to actual development needs and increase cash management discipline. The likelihoods of meaningful ROIs also go up for both entrepreneurs and VCs. Yet one dilemma is that smaller funding still imposes the same overhead costs to management and financiers in deal packaging and due diligence. As Peter notes, this can be an unacceptable cost to larger fund VCs. And, for entrepreneurs, this can also lead to the need for multiple rounds, dilution by a thousand cuts, and overhead burdens that detract from the real business of building a business.

I think Peter’s insights are very appropriate from the VC perspective.

But, as an entrepreneur, I look at this issue from the different end of the telescope. Yes, smaller (and therefore more) funds make sense, with smaller funding rounds to help capital discipline. But more patience and nurturing of the venture, especially with respect to business models, is even more critical. So long as the success rates for VC-backed ventures remains so abysmally low, the mentality of venture development will remain too much a Vegas “crap shoot” or rely on false “safe bets” on “proven management.”

Entrepreneurs are well advised to forget the question of initial valuations — which will prove meaningless very quickly — and focus on success rates by the VCs. That is the best indicator that critical expertise and insight will be brought forward — likely with some patience and staying power — in addition to the lubricant of capital.