Venture Firms Recoil from Crisis, But Not for Long

Venture capitalists will protect themselves first amid the crisis. But, better prepared this time, they'll seek opportunities before long

Venture firms are sounding the alarm over what this downturn might mean for their portfolio companies. While it's true that great companies are built during downturns, it's also true that plenty of entrepreneurs are going to be shut out of any sort of financing for the foreseeable future, as their personal wealth dwindles and banks decline to offer home equity loans or other lines of credit.

We've already reported on how the rest of this year is going to be a cautious time for venture and angel investors, but what does that mean for tech entrepreneurs? And how long, exactly, will VCs stay on the sidelines? As bad as things are forecast to be, my bet is they won't be there for long.

For venture firms, this economic crisis looks a lot different from the nuclear winter they went through after 2001. From a high of $105 billion invested in all of 2000, investments by venture firms hit a low of $19.76 billion in 2003. Since that time, the growth has been slow and steady, so there's not as far to fall—last year, the total came to $30.69 billion.

This time around, rather than putting tens of millions into startups whose basic business models would never enable them to reach profitability, venture firms have been, in most cases, investing in real businesses. Some, most likely the Web 2.0 businesses whose goal is to get eyeballs now and revenue later, will end up flopping, but even they haven't raised as much as the dot-coms did. Also, having learned from the bubble, most VCs have been putting money into reserves so that it can be used for follow-on investments. That means they can keep funding their portfolio companies a bit longer than originally planned.

That's the good news. But first venture firms have to tackle an exit environment that's going to force their hands. If the IPO market doesn't open up and interested buyers get worried enough to stop shopping, by the middle of 2009 VCs might have to turn to triage. So far this year there have only been six initial public offerings, and late-stage deals are piling up. In January I noted that the backlog of later-stage deals was getting higher, and indeed, a few months later, second-quarter data showed the greatest number of late-stage financing deals ever. We're even seeing more fourth- and fifth-round financing, such as that of telecommunications software maker Kineto Wireless, which just raised $15.5 million in its fourth round, or RFID company Alien Technology, which just raised $38 million on top of $258 million raised since 1994.

"Most VCs have adequate funds they have held back for their late-stage deals, for companies that can't go public or get acquired for two years," said Mark Heesen, president of the National Venture Capital Assn. When I pointed out that this backlog had been growing since late last year, Heesen admitted that if things don't improve, we could see fire sales and the shuttering of certain companies—starting in the second half of 2009.

"When one avenue is shut down and there are fewer buyers because of gyrations in the market, then the Ciscos (CSCO)and IBMs (IBM) of the world will still have to buy some companies, but it will become a question of those they have to buy vs. those they'd like to buy," Heesen said. "Those they would like to buy will be left on the table unless the [acquirer] can get them for a low price."

So those pitching early-stage rounds may want to keep their day jobs while venture firms focus on getting their later-stage companies out the door. As for those at the helm of later-stage firms, they should hunker down and give up those dreams of ringing the opening bell on the NYSE—at least for now.

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