(Xaume Olleros/Bloomberg)

Venture capital and innovation… who is following whom?

Here’s the myth: venture capital is the driver of innovation in the United States and is the financial engine disrupting industries and starting new ones. After years in the venture industry, I completely understand why the venture industry loves this myth. It’s good for business. However, the reality has become very different.

(Photo courtesy of Jonathan Aberman) (Photo courtesy of Jonathan Aberman)

Venture capital is now a momentum-based investment business, one that is predicated on finding a deal with an upward trajectory and riding it to a higher valuation. On paper, the venture industry is outperforming broader market indexes for the first time in many years. These returns have caused a growing number of people to ask if this current venture market is a new bubble, giving lift to ever higher market valuations that must eventually be reflected in the public market. Ironically, a mythical animal – the unicorn – is now used to describe a privately valued start-up with a paper value of more than $1 billion. A term used more often with each passing month.

It’s not a coincidence: Venture capital tends to aggregate in places where momentum is obvious or achievable, promising quick returns. This momentum is not about innovation or solving social, economic or demographic challenges — it’s about making money. Which is what a venture fund manager should be doing for his or her investor clients. However, this focus on short-term return means that investors cannot take the time, or make the investments necessary, to start new industries. They must seek incremental innovations with ready markets.

Accordingly, today’s venture capital market is pooling a large amount of risk capital in a small number of industries — particularly in Internet and mobile software. If you are in these sectors, and well-located (for example, in Silicon Valley or New York City) venture money seems much easier to find. If not, getting venture capital funding can be very, very hard.

For instance, there was roughly $18 billion in capital invested in venture fund-backed companies in the second quarter of this year. A few years ago that amount invested over an entire year would have been considered a healthy level of investment activity. Out of this large number, cyber security, a seemingly essential area for investment if current news articles are to be believed, received around 1 percent of venture capital invested during that quarter. Conversely, investments in Airbnb, an innovative way to rent out your second bedroom, and Snapchat, a wonderful way for teenagers to send instant pictures to one another, together received more than 10 per cent of all venture capital invested during that period. You tell me which is more important to our long-term national interest – disruption of the hotel industry and sending candids or preventing cyber-theft or damage?

Our national security agencies are growing ever more interested in finding new sources of innovation and technology. Meanwhile, technology entrepreneurs look to grow the businesses that will generate future growth and opportunities. In both cases, they look to the venture capital industry as a source of capital, a source of new technologies — or both. It will likely be a fruitless search, because they are looking in the wrong place.

These days, venture capital will follow, not lead, the creation of the new technologies and start-ups that form new industries and solve tomorrow’s problems. Combining the technology requirements of our agencies with the entrepreneurial talent of our nation requires creative actions to bridge the gaps between the two. Successfully bringing the two together will create momentum and opportunity. And, the venture capital will follow.

Jonathan Aberman is a 25-year veteran of the venture capital industry and currently the Chairman of TandemNSI, a public/private partnership connecting innovators with national security agencies.