Once again the year end numbers are out and the ritual wringing of hands has started. As is often the case, Fred Wilson has a clear point in his post The Venture Diet is Working. His basic point, which many others have also made, is that there is too much money floating around the venture industry and that this excessive amount of money drives down industry returns. If there is less money invested in any given period, presumably it will go to the better deals (generally speaking) and will ultimately provide better returns. You can’t argue with that proposition. It is economics 101.

However, Fred is looking at the supply side of the equation (i.e. the supply of money). I am not an economist (in fact I am an attorney with a graduate degree in English literature), but if you look at the demand side of the equation (entrepreneurs seeking money) you might conclude that underlying Fred’s and others’ analysis is an assumption that the rate of change along the demand curve is more or less constant. For every dollar that you take out of the venture market a somewhat consistent corresponding amount of demand increases (or to put it another way – the value of the investment dollar gets bid up in a somewhat consistent way).

I keep saying "somewhat" because I think the demand curve may be more (and sometimes less) steep at various points along the supply curve. Here is the part that I cannot "prove" or demonstrate, but I believe that the ecosystem needs a certain amount of investment activity to remain viable. In order to motivate people to pursue their entrepreneurial dreams, they have to have some hope of getting funded and, ultimately, of a cool exit. If the investment supply becomes too small, that hope may disappear and the ecosystem may not support entrepreneurial life at all. If you take enough oxygen out of the pond, the fish will die.

So, the system needs to be smaller to permit good returns to investors (or they will go away), and the system needs to be large enough to provide incentive (hope of funding), even to those who might fail. Those two points define the space of viability for the venture capital/tech entrepreneur ecosystem. The question that needs to be answered is whether that space exists at all. A second question is, if it does exist, where is it?

To me this issue also raises larger questions about the so-called venture model. From my vantage point, I see VCs investing in well conceived tight investment thesis tech companies with the plan of an M&A exit (mostly). One way to think of this (and not a particularly original way) is to observe that the buyers (Microsoft, Google, et al) are outsourcing new product development risk. That is why VC investments seem to be focused on tight investment thesis companies with a seeming clear path to an acquisition. (I can just feel the VC community pounding me with the "we want to create great companies speech," but look at what they actually do not what they say they want to do.) In part this model is driven by the ten year fund cycle. Recently, I have run across VC investments (I have two in my client portfolio), that are not driving to an exit so much as towards developing larger sustainable businesses.

While it may be that the VC diet works, it also may be that it doesn’t and something new must emerge. Either way, it is a critical issue. We need tech entrepreneurs to grow wealth and we need a way to value them and provide a handsome return to people who invest in them. If we don’t we will end up having to compete with Brazil to make Nike sneakers.