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What Will the Crisis Mean for Venture Capital?

The financial crisis is sure to hit Silicon Valley startups hard, but even the VCs that funded them may find themselves on shaky ground

In the lingo familiar to the kids toiling away at Web startups, the U.S. financial system is on the verge of an epic fail. The same may soon be said of many of the firms whose investments are the lifeblood of those Silicon Valley entrepreneurs.

There's been plenty of discussion about the impact of Wall Street's woes on emerging tech businesses. Web entrepreneur Jason Calacanis wrote late last month that as many as 80% would go under in 18 months. Early-stage investor Ron Conway advised entrepreneurs not to quit their day jobs unless they could get a year's worth of funding in advance. According to Om Malik, Sequoia Capital recently told its portfolio companies to hunker down for a long economic downturn. At a recent dinner party, an entrepreneur told me that his startup had about six months to pull a business model out of thin, recessionary air or it was toast.

Startups get funded in bunches, and in a downturn, the strong survive and the weak get sold for cheap or shuttered. We get it.

But what's in store for the venture capitalists who pump billions into these fledgling companies? My growing concern is that the financial crisis gripping the globe might cause some firms to close their doors and leave many VCs looking for a new line of work. Returns for plenty of firms are tapering off, particularly in recent years. And before long, even looking back a decade will indicate that venture capital didn't yield much more than the stock market and other less risky places to park cash. Think that won't be lost on the institutional investors, university endowments, and other limited partners that look to Sand Hill Road for returns? Think again.

Venture Capital's Lasting Power

To understand why, take a look back almost a decade ago. Even after the air came hissing out of the tech bubble, venture capital kept attracting investment (, 10/3/07). Sure, a few firms retrenched, and a handful of reckless partners lost their jobs. But even more money poured into the asset class. That's because the last few decades have created such a surge of wealth in pension funds and endowments, and they all have to invest in what are commonly referred to as "alternative assets"—a category that includes VC funds. Even with a huge crash, venture capital was still a better long-term investment than the broader markets.

Limited partners look at industry returns in three-year, five-year, and 10-year increments. And in the early part of this decade, by those measures, VC returns could still be plotted upward and to the right. VC firms had little trouble raising new funds.

In fact, many took in more than they knew what to do with. Only two of the last eight years—from the end of 2005 through the end of 2007—have had any decent market for initial public offerings and acquisitions. Even during this window, the companies that went public or got acquired went for smaller amounts of money, and took longer than ever to get there.

No matter. On a 10-year time horizon that includes 1999, VCs returned 32.83%, according to Cambridge Associates, compared with a meager 3.5% for the Standard & Poor's 500-stock index. On that basis, who wouldn't look past the risk associated with shaky startups?

Regulation Fallout Ahead

But check your calendar. We're closing in on 2009. And even if the financial system on which VCs depend for returns averts collapse, it's still in for a few years of serious wound-licking and stepped-up government regulation. Ask anyone in Silicon Valley whether Sarbanes-Oxley had a chill on IPOs.

This realization hit me like a ton of bricks during a recent trip to Boston, coincidentally the same day Lehman Brothers (LEHMQ) filed for Chapter 11. I was sitting down with Tom Crotty, of the venerable Battery Ventures, which had a unique approach to the tech meltdown. Battery, full as it is with more financial gurus than Valley-style engineers, responded by diversifying from traditional startup investments into so-called Private Investments in Public Stocks (PIPEs). Battery also capitalized on the consolidation of cash-rich but fragmented industries.

Crotty hopes the atypical investment approach will insulate Battery, but he nonetheless sees a reckoning coming—specifically toward the end of 2010. He points to 2000 as the "last really good year" for venture capital. Looking back, "the one-year, three-year, and five-year indexes are all going to be terrible," Crotty says. "And once 1999 and 2000 fall off, the 10-year will be, too. It's going to be painful."

More Realistic Numbers

Data from Cambridge show why. Aggregate VC returns for the 12-month period before the crash of the Nasdaq stock market were greater than 300%—far better than any period since. Once that period is no longer captured by historical data, 10-year returns for many firms—even ones that had great years in the interim—won't look nearly as good. The fear is numbers will show that many won't have returned much more than the S&P even with a decent 2010.

If the 10-year investment period hits at or below the S&P 500, portfolio managers are going to wonder why they're investing in such a risky asset class. Crotty estimates that 20% to 30% of the money going into venture will go elsewhere, and that is going to be bad. A lot of firms will go under.

You know what else? That won't be such a bad thing. After a painful period of forced reckoning with bad past decisions, VC will emerge stronger. Entrepreneurs and the larger U.S. economy will still need venture capital. Some venture capitalists will engineer a new way to make venture-style returns, like Battery Ventures did eight years ago. Many will turn to emerging markets such as India and China. There will be even fewer Google-like (GOOG) home runs. Then again, a leaner, smarter industry may not need as many.

I predict a wave of superstar partners just quitting and becoming angels, the way Vinod Khosla did in the wake of the last downturn, bringing the industry back to its roots.

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