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VCs Shuck Their Shellshock

In 2002, Mayfield Fund Managing Director Yogen Dalal found himself in a venture-capital industry licking its wounds. VCs were trudging through portfolios, polishing up their best companies, and junking ones they couldn't salvage.

Unlike many other venture firms, Dalal and his partners decided to get aggressive. They created a new rule: All Mayfield investors would spend 50% of their time looking for new opportunities -- no exceptions. "We were dealing with the aftermath of the bubble, and firms were spending more than 100% of their time dealing with existing issues," he says. "We needed to get our heads turned around."

Three years later, it looks like the rest of the VC community finally has the gumption to follow Mayfield's lead. For better or worse, venture investment typically follows a 10-year pattern, and 2005 could be the start of the next cycle. With new funds raised last year, many investors find themselves with a clean slate and a decade to produce returns. It's time, many believe, to take some risks and delve into some tough, company-building deals.

HOMEGROWN STARTUPS. This trend has been a long time coming. The VC community has been in a mild recovery for more than a year.Dollars invested have stabilized at about $20 billion a year, initial public offerings have picked up, and VCs themselves have raised billions in new funds in the last year.

But they've steered clear of risky, early-stage investments, which historically account for about half of the deals done every year in the U.S. But when the tech bust hit, that dropped between 20% and 30%.

The blame can't be placed entirely on VCs. When Mayfield started looking for new deals in 2002, it could barely find any interesting companies in which to invest. "Entrepreneurs were shellshocked," Dalal says. "We had to create our own" startups. To do that, the firm lured entrepreneurs to hang out at Mayfield while they worked on new business ideas. Mayfield has funded 10 of those internally incubated startups over the last two years.

"THE BIGGEST BANG." Toward the end of last year, the rest of the venture community started taking chances. Makes sense. They can get a bigger share of the companies they're investing in now than they could a few years ago. It's as though VCs remembered a simple equation: The bigger the risk, the bigger the reward. "Early-stage is where you can get the biggest bang for your buck," says Steve Baloff, general partner at Advanced Technology Ventures.

A rebound in early-stage deals won't just mean bigger returns for venture capitalists -- those grubstakes are vital to the entire tech industry. Bold venture capital is the lifeblood of Silicon Valley and how companies like Cisco Systems (CSCO), Intel (INTC), and Genentech (DNA) got off the ground.

The big unknown is what exactly these new companies will do. Startups of the past few years were filling gaps in technology -- not creating new categories. Baloff and others say many companies they're now looking at are better, faster, cheaper versions of current businesses. But there's nothing wrong with that. Google (GOOG) didn't invent search engines, but it sure made the most of them.

CLOSE TO THE VEST. Others say revolutionary deals can be had in areas like the digital home, nanotechnology, and alternative energy. But those kinds of companies require many VCs to leave their comfort zones, such as designing software for big businesses, where very little revolutionary is happening now.

Of course, don't expect a VC to show all his cards. The last thing he wants to do is announce where he's putting his money before the time is right, says Mark Heesen, president of the National Venture Capital Assn. Heesen doesn't expect VCs to disclose early-stage deals at all -- particularly to research groups like VentureOne and Venture Economics, which track venture investments.

Outsiders to the Silicon Valley investment elite will have to wait to see what's next. But if the industry's past is any indication, expect a new generation of groundbreaking tech companies with roots in 2005. By Sarah Lacy in San Mateo, Calif.

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