How to catch a VC fish

For those of us who track these trends, it seems like any bad financial news that hits the newspaper front pages these days can be attributed to the tightening of venture wallets.

This level of analysis on venture capital spending gives VCs way too much credit. It is the height of charity to say that the venture capital industry has the foresight to align investment activities to macroeconomic trends. Put another way, venture capitalists have more pedestrian concerns when deciding how much (or how little) cash to dole out.

Today more than ever, VCs are spending a lot of time talking to customers to gauge if a start-up's product can garner even a piece of a corporate information-technology manager's spending budget in today's tight-fisted environment. Questions such as, "Who's going to spend money on your product?" and "Are there enough interested companies to make a large market?" are really what it's all about when it comes to VC funding. The results of this kind of customer due diligence say enough to form some opinions on the direction of IT spending--hence this look at what's going on in the VC trenches.

"Customer due diligence" is really just a fancy term for "the unglamorous work of calling customers and grinding them for information on spending." In such an uncertain spending environment, I've been on the phone a lot. I've been spending a lot of time talking to anyone who has a budget, trying to find out what kind of technologies are getting dollars at large corporations.

The following are a few details from discussions with technology decision-makers, as well as the conclusions drawn as to target investment areas. This info is by no means exhaustive or complete--but it's very real.

• Budgets are super tight, with power shifting from the chief information officer to the chief financial officer. This I already knew: IT budgets are frozen at best, and in many cases, cut to the bone. Many IT professionals say they are now much more accountable to their CFO. One person said that they had recently "thrown away their budget" and were now "going to the CFO project by project" for approval. Obviously this is not a long-term solution, but it highlights the intense scrutiny that IT projects are under.

• Broad new initiatives are a tough sell. These days, you will be very hard pressed to find a corporate IT professional that will admit to starting up any sweeping new IT initiatives. During the Internet boom, you'd hear about many companies that would initiate wide-scale CRM or e-business initiatives for a host of reasons (most often competitive). One IT manager said that the "big bucks were spent in the last few years" and now it's time to build off "what they have." Small and tactical seems to be the rule of the day.

• The incredible shrinking ROI. While corporations have always used "return on investment" as a factor in making technology purchase decisions, the time in which this return has to be shown has shrunk considerably. Historically, it's not unusual for customers to want to see a return on a technology investment in 18 to 24 months for large projects, and 12 months for smaller projects.

But now those numbers are being reduced substantially, and it's not unusual to have potential customers want to see a three to six month ROI (either through tangible cost savings or increased revenue). As a result, VCs are now looking for companies that, while still having a compelling long-term vision, can show how they can get purchased and installed quickly, and show value almost immediately.

• Some markets are just not start-up markets. In the late 90s, many customers looked to emerging companies for innovative technologies. In the process, many of them got burned by start-up vaporware, or were left holding the bag when start-ups went out of business. As a result, customers are now very wary of vendor stability.

I spoke to the chief technology officer of a large computer manufacturer, who said the No. 1 concern of his customers was "complexity of their IT infrastructure." This is a big problem, one that many start-ups have identified and are trying to fix. But is a Fortune 500 company going to turn to a start-up for such a solution? Hardly. One CIO of a major financial institution said he has sworn off start-ups altogether. The result: Start-ups' tactics have changed from revolutionizing a business to a Trojan-horse model that sells bottom-up and shows value.

• Fix my IT indigestion. The good news is that the technology industry was very good in the late 1990s at plying its wares on corporate America. The bad news is that enterprise customers are now grappling with a whole host of new IT problems as a result. One IT professional at a multinational corporation told me that her biggest problem was a glut of disparate applications spread across the enterprise, creating "a million islands of data." Her challenge was getting them all to talk to each other. Now, many VCs are seeing these "tech glut" problems as fertile ground for new investments. It may also be why "application integration" has lately been one of the top five priorities in Morgan Stanley's widely read CIO survey.

As we all know, business units are enormous influencers of new technology projects. And yes, IT spending is not always the best indicator of strategic or future spending. That said, one thing is clear--from this data we can see a dramatic shift in the mood and tactics of corporate IT professionals from just a few years ago. And that can't help but influence the technology buying patterns coming from executive offices.

The directive for VCs and the start-up community is simple: focus. It's somewhat encouraging that we've landed in a period where fundamentals like stable vendors and ROI count. It also gives VCs something they haven't had in many years: guidelines with which to evaluate start-ups.

From this, many VCs are seeing security, application integration, storage, backup, infrastructure and network monitoring/maintenance as fertile investment areas. But since this business is a moving target, the best one can do is keep making the calls, talking to customers, and learning.