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— Venture Capital —
For most of the year, the native optimism that flows through Silicon Valley doused concerns that the fires sweeping Wall Street posed a serious threat. Financing technology is a straightforward enterprise, reasoned venture capitalists, miles from the brand of sorcery that torched century-old investment banks. Technology entrepreneurs -- even wizened veterans of the dot-com campaigns -- also were sanguine, eyes cast confidently toward the future. So it came as a collective shock when the flames reached the fortress. Venture capital investment in the third quarter fell to levels not seen since the aftermath of the Internet bust in 2000. Bellwethers of tech finance, from top venture capital firm Sequoia Capital to prominent angel investor Ron Conway, warned their portfolio companies to slash costs in preparation for a long economic drought. And already frothy corporate valuations, especially among consumer Internet companies such as Facebook Inc., deflated with a whoosh. Big tech companies and startups alike were singed, forcing layoffs amid a steep decline in corporate and consumer spending. In truth, the economic malaise triggered by the credit and subprime mortgage crises merely opened long-festering sores afflicting venture capitalists. But for VCs, the financial crisis metastasized into an existential one.
Along with the usual questions -- what is new, where is value hiding, how much capital is enough? -- VCs and entrepreneurs are now asking more fundamental ones: Does venture investment really work; do startups need outside funding; what is the evolving nature of risk; how long will the hard times last, and how do we survive them? As usual in times of flux, the answers are elusive. Clearer is the evidence that something is amiss. According to industry data, the money invested in venture funds now exceeds the total value of exits involving VC-backed companies. By that measure, venture firms are destroying, not creating, value. "We are at an intersection where parts of traditional venture capital are broken and we have a broad economic crisis," says Lewis Gersh, managing partner of Metamorphic Ventures LLC, a boutique VC firm in New York. "That intersection is like a railroad crossing with a Ford Pinto stuck on the tracks. One break point is that 'traditional venture capital' evolved faster than the technologies it was investing in." Indeed, the largest venture firms face a problem more commonly associated with hedge and private equity funds: excess capital. For years, big VC funds have been getting bigger, sopping up money from institutional investors on the perpetual hunt for the highest returns. As economic crises in recent decades underscore, whether stemming from savings and loans, dot-coms or mortgages, too much capital often leads to systemic "inefficiencies." Investment criteria erode, copy-cat deals abound, bubbles form, returns swoon. As their funds have grown, big VC firms also have edged away from investing in early-stage startups -- the historical preserve of VCs -- to focus on funding more mature companies, which can absorb larger doses of capital. Yet only so many of these tech players exist, and this has led to inflated valuations. Meanwhile, under pressure to deploy capital, large VC firms have repeated their past mistakes by crowding into promising but commercially unproven technologies. Most notably, investors have sunk big bucks into video, digital media and other "Web 2.0" companies, whose business models remain as uncertain as their exit prospects. "The field has already bifurcated, and that will continue," says David S. Rose, managing principal of early-stage investor Rose Tech Ventures LLC and chairman of New York Angels Inc. "The big funds will get bigger and move much closer to private equity funds. The small firms will go smaller and move much closer to tech incubators and accelerators." The torrent of capital pouring into leading VC funds also arguably distorts the financial incentives for venture investors. With typical VCs collecting a 2% fund management fee, investors are rewarded for courting deep-pocketed limited partners rather than for tracking down innovative startups. These symptoms remained dormant as long as companies kept striking billion-dollar deals and going public. But the exit side of the tech finance equation also has broken down. As the financial markets cratered, only six VC-funded companies went public in the first three quarters of 2008, compared with 86 for all of 2007. That total represents the lowest volume of offerings for the period since 1977, according to the National Venture Capital Association. Notably, many of the enterprises that postponed initial public offerings are financially sound, with significant profits and well-formulated business models. If the lid on new issues remains shut in 2009, this IPO backlog is likely to reduce venture funding for other young startups as investors focus on later-stage companies. M&A also withered. Venture-funded companies were involved in roughly 200 deals in 2008, down from 359 in 2007, according to the NVCA. The total disclosed value for VC deals to date this year is $11.2 billion, less than half the $28.4 billion in liquidity generated a year ago. Yahoo! Inc.'s swift decline punctuated the stasis in deal markets. The Sunnyvale, Calif., Internet company, which only in February had felt bullish enough to reject a $47.5 billion offer from Microsoft Corp., saw its stock price plunge 61% as shareholders hounded Yahoo! co-founder Jerry Yang into quitting as CEO. So are VCs facing a reckoning? Most venture pros, ever optimistic, think not. "I don't think we're going to see a significant washout of venture funds the way we're seeing a significant releveling in, say, the hedge fund market," says Drew Lipsher, a partner at New York venture firm Greycroft Partners LLC. "Venture funds have unique characteristics to their business. They don't have redemptions, the capital calls tend to be smaller, they're not public securities and the time horizon, both from the fund's perspective and the LP's expectation, is far longer." Some technology sectors, including clean energy, life sciences and mobile computing, also continue to see healthy amounts of funding as VCs reset their sights on growth areas. Despite such bright spots, 2009 is shaping up to be a year of retrenchment for VCs and austerity for entrepreneurs. Some predictions: Overall venture funding and deal volume will continue to slow, making it harder to raise new funds. Follow-on financing will dry up for all but the strongest startups. The weak public markets will depress valuations for fledgling tech firms seeking capital. Venture firms will increasingly prospect abroad -- particularly in China, India and Israel -- for promising deals. As a market, the venture business will continue to divide into megafunds and small early-stage firms. Exits will remain blocked, although the dearth of IPOs could spur a relative increase in trade sales. Yet VCs will continue to invest, if more cautiously. Another facet of the global explosion in capital is that money must find a home. Light the bonfires. |
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