In finance we look ahead as much as we look from a future point backward. Almost every financial principle is based on this symmetry of perspectives. An asset produces economic value that we try to forecast from time present, and from its future we discount back to present-time to determine its current worth. The two directions are sides of the same coin, inseparably linked: The more aggressive our forecast, the higher the discount rate coming back; the more certain our outlook, the more risk-less our discount mirror. The system applies to any economic asset, any financial asset-class. Calculators are designed around this rule, as are financial models of all sizes and shapes, the purpose of which is to compare amounts going in with those coming out. It’s common sense really… though sometimes I wonder. And when I do, I often wonder about venture capital.

There was a time, around the middle of the last decade and the one prior to it, when successful venture investing was predicated on the following principle: Of ten investments, one would return its investment fund, and the other nine would produce upside… somehow. All things considered, not a bad deal. The extent of upside would naturally depend on the quality of the nine positions, and in an environment that gave rise to (1) AOL, Netscape, Yahoo!, and Google… and years later (2) Facebook, LinkedIn, Twitter, and Zynga… it isn’t difficult to see how the prescribed formula could work rather well. There was plenty to go around, (pending exits among the second grouping), to produce sufficiently high terminal values that could be profitably discounted back (to the original investment), accounting for risk and time to realization.

Before proceeding with an eye-opening extract from recent M&A news about Google – related to and in support of this discussion – I would first draw attention to footnotes that should not be neglected. In grouping the two sets of venture success stories above – (1) and (2) – separated by a ruptured bubble in between, observe the general diminution in the order of magnitude between the first and second set. One could blame this on a financial bubble that, as indicated, burst about half-way between the two eras in question, but one ought to be fair and acknowledge that the sector itself had matured. One could not reasonably suppose that the upside trajectories at “time zero” and “time zero plus ten years” are going to be the same, as if no innovation and no market-coverage had occurred between the two times. Such consequences must be considered when we read the following news item about Google’s M&A effort, one of the more reliable exit alternatives for venture capital these days:

“The company says it spent $148 million in cash to purchase 11 companies during the quarter, up slightly from the $145 million in cash it spent to purchase 9 companies during the first quarter of the year.” This does not include three larger deals (one pending) that in the aggregate amount to about $1.5 billion… but regardless, such acquisition expenditures don’t seem particularly large from the perspective of a company with some $30 billion in cash on hand, and which boasted a market cap of $23 billion at the time of its own venture exit via IPO.

The point: Exit values as a whole are diminishing. Running this trend through a financial calculator one should expect venture rounds to diminish accordingly – that is, money out and money in should balance. But while it is true that much sector dialogue has recently revolved around the smaller amounts needed to launch a web business, it is also true that VCs insist on growth capital requirements being steadily the same as ever. It is as if, looking forward, we estimate our upside to be as exciting as it was back in 1996, without discounting a realistic terminal value back in the other direction. Taking this discussion around again to the subject of symmetry, of forecasting and discounting, of funding in and terminal out – in other words, the pendulum that does not only swing in one direction – it seems as though the analysis is half-way incomplete. This is unsatisfactory and must be addressed. I plan to in a subsequent post.