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Venture Capital: After "the Perfect Storm"

Like most of the financial world, venture capitalists have taken it on the chin of late. One-year fund returns, at a negative 27%, are at record lows, according to researcher Venture Economics. The pace of investments is off sharply, too. The $3.9 billion invested in the third quarter puts the industry on a pace not seen since 1996. Compounding the problems are few liquidity opportunities and begrudging spending by Corporate America.

So what does this mean for the venture-capital business, the technology industry, and innovation? BusinessWeek Senior Correspondent Linda Himelstein asked four industry veterans how they're coping with the extraordinary challenges they're now facing. Sam Colella is co-founder of Versant Ventures, which focuses on health-care and biotech investing. Irwin Federman, a partner at US Venture Partners, has been involved in technology, from both the operating and investment sides, for 25 years. In his 30 years of tech investing, C. Richard Kramlich, a co-founder of New Enterprise Associates, has backed such companies as Juniper Networks (JNPR), Healtheon (now WebMD, HLTH), and Silicon Graphics (SGI). And Howard Cox, who has been with Greylock since 1971, is chairman of the National Venture Capital Assn. Edited excerpts of the conversation follow:

Q: Venture capital is a cyclical business with plenty of ups and downs. How does this downturn compare to previous ones you have experienced?

Kramlich: Each downturn, at the time we went through it, was always the worst. The difference was that, in the '70s, it was death by a thousand cuts -- it wasn't dramatic. This time, it was dramatic because we really have gone through the perfect storm. We had a combination of the Internet explosion coupled with Y2K overspending, an overload of venture funds, and an overload of people. So the rate of drop is greater than it has ever been since the Depression.

Federman: The issue is that there are no safe harbors. In previous downturns, semiconductors were down but telecom was up. There was a little balancing of things. Now, there is no balance. Everything is flat.

Q: Have we reached the bottom?

Kramlich: I think we are kind of nearing the end, and we anticipate moderate gains. It may not be next quarter. But there are going to be some events that come along in the very near future that could signal better news late next year.

Colella: I tell my partners we are going back to the mid- or late-1980s. You saw good deal flow. You had time to really perform due diligence on deals. You saw entrepreneurs that were practiced in the art of starting companies. You saw syndication among venture capitalists. Salaries were at reasonable levels, and the cost of starting companies seemed to be reasonable. I feel like that is where we are.

Q: There's some thought that the technology economy has matured, and it Just isn't possible to have the kind of growth it had in the past. Is it a slow-growth sector? And if so, how does that affect the opportunities you'll have with startups?

Federman: The electronics industry is the largest in the world. The largest industry cannot grow at the same rate as the smallest. However, a small increment is trillions of dollars in a very large company. So perhaps I would ask, "Does the electronics industry have to grow at historical rates to create the same level of opportunity?"

I would say no. Large, diverse companies create opportunities for niches, and those niches can be extremely large. The consequence is the formation of highly focused, excellent companies. Ultimately, those companies expand too far and create mediocrity, which creates a niche for the next guy. Technology is a Pac-Man business that eats itself up.

Colella: One of the things VCs do is to expand market opportunities. Who would have thought that venture capitalists would invest in health-care services? And we are. That's why venture capital can still get bigger. Health-care service is a whole new segment. The whole pharmaceutical industry, which is consolidating, is going to outsource from startups.

And so you create little companies that can be specialists. What we do with innovation and entrepreneurs is create more segments, and that is an expansion of the technology economy.

Q: A recent study showed global entrepreneurial activity down by 25% last year. Are you still seeing good opportunities? If so, what kind of innovation is going on, and what do you see as the next big thing?

Cox: When venture capital is hard to find and when the route to a public offering is longer, the people who decide to do startups are the most dedicated, the most talented, and are believers that they have something that is really going to make a difference. When thinking about major breakthroughs in terms of innovation, life sciences is the area. I have a company that's working in the area of growing bone. There are so many chips on the table now that there are going to be major breakthroughs.

Colella: The health-care segment is in the early stages of a revolution. Everyone wants to focus on genomics, which has great promise. But it isn't just genomics that's going to change the way medicine is practiced. I'm very excited about the whole world of individualized medicine, which is reading genetic profiles of individuals to figure out how to apply proper procedures rather than do the shotgun approach. I also think the whole theme of noninvasive surgery and noninvasive medicine is growing.

Kramlich: Innovation doesn't have an on/off switch. How do you measure innovation? A good way is by patent applications. Right now, we're running at 120,000 patent applications annually, and grants are running at about 70,000. If you look at that relative to historical norms starting in 1900, these are peak levels of applications and grants.

Federman: We are an evolutionary business. Revolutions rarely happen. And when they do happen, you see them retrospectively. The track record of people calling the situation in real time is dismal. The business of innovation has been evolutionary from the start, and it is evolutionary now.

Q: Investors in venture capital are obviously disappointed with current performances and have raised questions about how venture firms are managed, including the size of funds and management fees. Also, there's a movement to get public institutions invested in venture funds to disclose the performance of individual firms. Do you think returns for venture funds should be made public?

Federman: It's not a question of being open or closed. We have disclosed fully and completely for all interested parties, including public investment entities. And the nature of our business is long-term. It's very difficult to judge the returns of private companies.

Q: Do you have any objection to disclosing your information to the California teachers, for example, if you have their money?

Colella: Everybody doesn't have a right to everything when you have a private relationship. Investors knew when they came into these investments that they are confidential. I don't have a problem with the State of Texas saying, "We are going to share your return data with the whole world. That's our policy." But then I, as a VC, have to decide if I want them as a limited partner or not.

There are some who want to have portfolio information. That could be damaging to the companies and to innovation and to the economy. The trouble is we're changing the rules in the middle of the game, and I don't think that's fair.

Q: So will you stop taking money from public institutions that seek to disclose your returns publicly?

Kramlich: We'll have to rethink that.

Q: Lastly, Silicon Valley has been hit hardest by the tech downturn. Do you think the Valley will lead or lag the tech recovery?

Cox: I would say that Silicon Valley is still preeminent, and Boston is No. 2. The downturn in some respects has made Silicon Valley more attractive. I had a company that, three years ago, had a large facility in San Jose, and the guys came to the board and said they had to move out of town. They couldn't afford to renew their lease at $75 a square foot. We just rented it at $25 a square foot. So all of a sudden, Silicon Valley is more attractive again.

Federman: Silicon Valley has taken a good hard knock on the noggin. I wouldn't prefer to be in any other place, however. The people are all in place. The ethnic diversity is here. The networks are in place. It's a Garden of Eden for technology.

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