VCs prepping for a souring economy

In a contracting U.S. economy, venture capitalists are in the somewhat awkward position of sitting on billions of investment dollars with fewer opportunities to strike it rich. The question is whether VCs will hold tighter to their purse strings.

In the next two weeks, researchers will issue numbers on how much VCs invested in the first quarter of 2008, which ended March 31. Early projections of financing deals suggest that venture activity isn't waning--at least in the first quarter.

"I don't think VCs have changed their strategy--they seem to be taking a longer-term view and continue to deploy capital at a healthy rate," said Tracy Lefteroff, global managing partner of the venture capital practice at PriceWaterhouseCoopers.

Emily Mendell, vice president of strategic affairs at the National Venture Capital Association, said she expects first-quarter investments to be worth a total of about $7 billion, nearly equal to the fourth quarter of 2007. But NVCA and others are still tallying figures from the quarter, which ended this week.

Inside technology circles, however, executives say some venture capitalists are becoming much more discerning about deals. While they're still sitting on a war chest of money, VCs are examining business models more closely and taking longer to finalize rounds of funding, Silicon Valley tech executives say. Another ramification of a flagging economy is that the valuations of private companies are coming down to Earth along with those of companies like Google, whose share price has dropped from a high of $747.24 in November to $465.70 at the end of trading Wednesday.

"There's a lot of money out there. But the requirements to raise money have become more strict," said Dave McMurtry, CEO of Web 2.0 company Loomia, which announced this week that it had raised $5 million. "I don't envy the VCs--they're under pressure to invest in quality companies that have a clear business model."

To be sure, information technology investments are still flowing, even though there are fewer deals compared with life sciences and clean tech, analysts say. Two reports out this week showed that VCs are getting squeezed on the exit side of the equation. Venture capital-backed mergers and IPOs are on the downslide, resembling the years following the dot-com bust. It will be a stretch to make up for early declines over the rest of the year, analysts say.

In the first quarter of 2008, there were 56 venture-backed deals total, down from 87 mergers and acquisitions in the comparable period a year ago, according to Thomson Financial and the National Venture Capital Association. Similarly, the organizations reported only five VC-backed IPOs in the quarter. For a healthy year overall, there should be in the range of 100 public offerings, Mendell said.

In the first quarter of 2008, the median time for a VC to take a company public jumped to 8.26 years, up from 6.11 years in the same period a year ago.

"Today's economy doesn't impact their investment choices in the sense that they're still going to be funding companies," Mendell said. "What might happen if the exit market remains closed over time (is) VCs will have to fund added rounds while they wait for the exit market to open.

"So money that would perhaps be normally earmarked for new start-ups like two guys in a garage may have to be directed to maintaining older companies, but the dollar amounts we expect to remain stable," she said.

One Silicon Valley technology executive who recently raised funds said he expected a downturn this year. That's why he sought to raise money at least one quarter early (in the fourth quarter last year to close in January) to get ahead of the curve to improve the valuation of his company. When times are good, he said, a promising start-up might raise $10 million from a VC for a 33 percent stake in its company, for a valuation of $30 million. But now, that same $10 million might give the company a valuation of only $25 million.

"We didn't want to experience any pressure on the financing. There's still tons of liquidity, but we're seeing pressure on valuation. If the whole industry goes down 20 percent, VCs aren't insensitive to that," said the executive, who asked not to be named.

It's also now more of a buyers' market for venture capitalists, who can afford to take a wait-and-see attitude. Some VCs may actually ink fewer deals not because they don't have the money, but because there are only going to be certain number of companies that are successful in a down period.

Impact of a Microsoft-Yahoo deal
"We're seeing early-stage companies raise money sooner than expected in anticipation of a harder financing environment later in the year," said Brent Tworetzky, a venture capitalist with Shasta Ventures. "Another complicating factor is the Microsoft-Yahoo deal," he said, referring to the potential for one less company that buys up smaller start-ups if and when that merger closes.

VCs are also likely rethinking investments in new companies that rely solely on online advertising. Gina Chan, research manager at Dow Jones VentureSource, said she's seeing trends of VCs investing more in medical devices and clean technology, as well as emerging markets in China and India.

"For the past few quarters, venture has been heavily concentrated on Web 2.0 and Internet investments, but going forward, investors will be looking at those other areas more."

Despite that, venture capitalists have a war chest of money to invest. Last year alone, they raised $35 billion from the private equity market, according to data from the National Venture Capital Association. What all this means is that VCs will turn a more critical eye to their next investments. And they will likely need to resupply companies with funds to help them through an economic downturn.

"I think investors are going to continue to support the companies that they invested in with time and effort," Chan said.

Still a further note of caution: if the economy retracts further like some economists predict and for a protracted period of time, venture capital could grow scarce, Lefteroff said.

"In the long run, if VCs don't see the kind of returns they traditionally get, there's a solid possibility they may not be able to raise added capital," he said. "But that's a much more long-range phenomenon."