Fresh Seed In The Valley

After a long drought, small VC firms are popping up to fund startups

When John Jaeger set out to raise $3 million for his year-old tech start-up in January, he skipped right past Silicon Valley's top-tier venture-capital firms. "It might be difficult for somebody who has an $800 million or $900 million fund to take an active role" in such a small investment, Jaeger says. His company, telecommunications gear maker OnSite Systems, got the money from the $330 million Woodside Fund, which specializes in nurturing embryonic companies.

After a long drought in early-stage finance, VC firms are seeing opportunity in the industry's neglected first rung. At least 15 new firms have started raising funds in the past two years. They're joining longtime specialists such as Woodside and Labrador Ventures, which have recently raised new funds.

The rise in seed-stage VCs should soon translate into more deals as investors gain confidence that more startups can be nurtured all the way to an initial public offering. Such investments have shriveled over the past four years, falling from $3 billion in 2000 to just $378 million last year, according to a survey by Pricewaterhouse-Coopers, Thomson Venture Economics, and the National Venture Capital Assn.

These days, small VC players have an extra edge because newly minted companies are now worth much less than they were in the late '90s. So early-stage investments are smaller, taking many of the bigger VCs out of the game. "The math doesn't work," says Eric Janszen, managing director at Osborn Capital LLC. Indeed, a firm that must put $500 million to work in five years can't do too many $2 million deals without running its partners ragged chasing new companies and keeping tabs on all the investments.

So most of the big venture-capital firms will use smaller ones as pipelines to deliver them promising new companies to invest in. For example, IP3 Networks Inc. couldn't raise a dime from the Valley's top VCs. Founded in 2001, it was still too immature. Finally, in December, Garage Technology Ventures, a seed-stage VC, agreed to lead IP3's $500,000 first round of financing. The startup reached profitability in six months. Impressed, Sequoia Capital -- the legendary backer of Cisco Systems and Google -- led a subsequent $5 million round of financing in June.

That's how the system should work. So, as the industry recovers, expect those small VCs to get quite busy.

By Justin Hibbard in New York

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