The venture capital industry is finally shrinking down to a workable size.

When a capitalist says that he is pleased to see profits increase as his competitors disappear and those that remain hold the line on price, is that a cartel? How is it different from the CEO of, say, Honda, gloating about the failure of other auto companies and then asking the remaining companies not to change car prices?

All these questions came to mind when I saw some upbeat views – more profits for us! – coming from a few U.S. VCs about their shrinking industry. The latest PWC Moneytree data shows continued shrinkage in 2009 to the point that information technology lagged behind health care investing for the first time ever. The annualized run-rate of venture investing has fallen from more than $40-billion to $17-billion, the lowest it has been since before the dot-com bubble.

It sounds bad for entrepreneurs, if good for profits, so is this a cartel in action? No. Instead, the U.S. venture industry is finally shrinking its way back to health.

We have an industry that hasn't delivered a multiple above 1.0 on invested capital since 1997. We have an industry that, as of end of year 2009, sunk to a negative ten-year internal rate of return. This is a sick business, and that is understandably leading to fewer investors wanting a part of it, which means outlays are shrinking. Eventually, the industry will shrink to a point where it delivers competitive returns – it may even be there now given the declines of last year.

Now, three points: First, some may say that the industry can fix performance by making better investments. In other words, U.S. venture capital doesn't need to shrink – we have can have our capital and our startups too. Fine, but history doesn't bear this out. The modern venture industry has never delivered competitive returns with this much money under management. Further, you can't point to deals that, had they been invested in, would have jacked returns sufficiently to compensate for all that money. Yes, absence of evidence isn't evidence of absence, but the heavy lifting must be done by those who would argue that the venture biz can deliver compelling returns to investors at historically high levels of capital outlay.

Second, others may argue that we are over-fixated on short-run returns. I have heard a version of this argument in Canada. To this way of thinking, venture capital provides a valuable societal function – job creation, innovation, economic growth, etc. – and we can't hold venture back when we need all three of those so badly. I understand the inclination, but a venture capital industry no longer trying solely to deliver competitive returns to its investors becomes a quasi-governmental entity – an expanded regional economic development agency, albeit one with your pension money at risk.

Finally, is it possible that venture is just so badly broken that we have no idea what the right amount of capital is? It is possible that we could see 10x as many startups and find that venture capital investment returns is a distribution with many local maxima, some of which are much more attractive than the current level of investing. To be honest, I would love it if that were true, because it would be wonderful for the economy. This assuredly isn't physics – annual outlays is not fixed like Avogadro's constant. Good luck making that case, however, to burned limited partners who have just watched an expanded venture industry deliver the worst returns in its history.

What does this mean for Canada? Given that this country is in a venture investing funk, it means Canada has an opportunity to reboot venture, drop the government dependency, and get things right. We can start by looking at what the post-shrinkage U.S. venture industry will look like. It will be dominated by smaller, fast-moving firms running less than $150-million (scale that lower for Canada's smaller population) and emerging angel and super-angel groups like Ron Conway, True Ventures, and Softtech VC.

Canada shouldn't aspire to the pre-diet U.S. venture industry. Aim for where it's going – which is going to look a lot like venture circa 1995 – and get there first with less baggage.