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Venture Capital Industry Sees Glimmers of Hope, Still in a Deep Slump

The Founders Fund is one of the top VCs in the Bay Area.

For two shining moments last week, Benchmark Capital reminded Silicon Valley of the win-win way venture capital is supposed to work.

First came news that Facebook, the social networking giant, was buying startup FriendFeed for $50 million. Then VMware, the computer “virtualization” pioneer, snapped up SpringSource for $420 million. Kudos were lavished on Peter Fenton, the Benchmark partner involved in funding both FriendFeed and SpringSource, for deals that produced timely, lucrative returns for Benchmark and its investors, as well as for the startups’ founders and stock-owning employees.

“Venture capital is a home-run business,” said Astrid Noltemy, managing director of the financial research firm Cambridge Associates.

But most VCs are swinging and missing these days, suffering a profound slump that dates to early 2008. Splashy Wall Street initial public offerings of stock, as well as merger and acquisition deals, have been few and far between since late 2007.

Glimmers of hope are found in a mild rebound of IPO registrations with the Securities and Exchange Commission, which dropped to zero in the first quarter of 2009. Fortinet, a Sunnyvale computer security firm, recently joined a flurry of registrations. But many companies that signal intentions by registering for an IPO haven’t follow through with the Wall Street debut.

“We are seeing more positive signs than at the beginning of the year,” said Mark Heesen, president and

CEO of the National Venture Capital Association. The group has tried to rally its membership around a series of private-sector and public policy initiatives that it says will revive the IPO market.

But more than a year after the NVCA first warned of a “crisis in capital markets,” Silicon Valley’s startup economy seems to be crawling through a financial desert. VCs are having a much harder time raising money, and scrimp as they make investments. Entrepreneurs may be feeling dizzy with the topsy-turvy economy in which so-called “down rounds” of venture funding are up and “up rounds” are down (as will be explained later.)

“I think its going to roughly stay the way it is now until we see the IPOs and M&A exits reopening, because that drives the VC business,” said attorney Michael Patrick, a partner at Fenwick & West and co-author of recent survey of startup funding. A recovery, some observers say, may not occur until well into 2010 or later.

“Because of the shortage of exit opportunities, venture fund managers will need either to own companies longer or potentially sell at reduced values,” Cambridge’s Noltemy explained. “Either will hurt future returns.”

How tough is the current venture market? Draper Fisher Jurvetson, one of the valley’s prominent firms, has reportedly lowered its fundraising target for its tenth fund to $400 million from $600 million. Co-founder Tim Draper, known for his bullish posture and outspoken opinions, declined to discuss the fundraising environment. But in previous interviews, Draper has blamed post-Enron financial regulations for creating “constipation” for portfolio companies that would otherwise be poised to go public.

Many venture capital firms have chosen to postpone fundraising efforts, Noltemy said, while others try to put a positive “spin” on their inability to meet targets by saying they’ve concluded that smaller funds are more “appropriate” in the current economy.

Venture capital is a small niche within the massive financial industry, but a vital force in Silicon Valley’s economy, helping to grow such startups as Intel, Genentech, Apple, Cisco Systems, Sun Microsystems, Yahoo, eBay and Google into multi-billion corporations. Each year hundreds of valley companies rely on venture funding.

The industry seemed in ruddy health as recently as late 2007. But as Wall Street started to stumble, the venture industry’s own economics turned sour.

When the second quarter of 2008 passed without a single venture-back IPO for the first time in 30 years, the NVCA warned of a “crisis.” Industry leaders later acknowledged they had no idea how bad it would get. The later collapse of Lehman Brothers, the ensuing global financial crisis and the deep recession served to compound the venture industry’s troubles, intensifying a long-anticipated shakeout.

Today, venture capitalists are feeling pressure on all sides. Limited partner investors such as pension funds and foundation endowments are curtailing venture allotments. Cambridge, an adviser to many such institutions, is encouraging its clients to negotiate with venture firms for lower fees and greater transparency.

Meanwhile, many entrepreneurs are pushing back against what they feel are unfair power plays by VCs. And anxiety is growing that Washington will increase the tax burden on the venture industry as the Obama Administration and Congress try to pay for the financial bailout.

An array of recent data gives a profile of an industry in turmoil:

– VC ranks are thinning. Hard data is hard to come by, but the VC-review and discussion site TheFunded.com keeps a “Transitional Zone” list that names roughly 200 venture capitalists who “have left one firm and are currently not listed as being part of another firm.” Many venture funds created during the dot-com bubble are now considered “zombies” that are managing lackluster portfolios, not making new investments and not trying to raise new funds.

– The latest snapshot of venture investment returns, for the first quarter of 2009, showed continuing disappointment. Cambridge’s U.S. Venture Capital Index showed three consecutive quarters of decline. “Deterioration was also evident in the 1, 3, 5 and 10 year time horizons for the period,” but still outperformed such indices as Nasdaq, Dow Jones and S&P 500.

– Startup founders feel the squeeze on their equity, according to an arcane industry barometer that compares so-called “down rounds” in venture financing to “up rounds.” In a healthy economy, startups typically enjoy “up rounds” in which the price per share increases from the previous funding round. But the new Fenwick & West survey found that in the second quarter of 2009, down rounds exceeded up rounds 46 percent to 32 percent, with the remainder flat. The first two quarters of 2009 were the first since late 2003 that down rounds exceeded up rounds, the survey found.

These reports come on the heels of news that, nationwide, fundraising by VCs plummeted in the second quarter of 2009 to $1.7 billion from $4.6 billion in the previous quarter. The number of funds created shrank to 25 – the smallest number in 13 years.

But while the data and the averages offer a broad-brush portrait of gloom, several top-tier valley venture funds figure to weather the turmoil that could help the rich get richer.

Benchmark’s latest deals followed seven other “exits” this year, including Cisco System’s $590 million acquisition of Flip camera maker Pure Digital and the IPO of OpenTable, an online restaurant reservation service.

Earlier this year, Accel Partners succeeded in raising two funds totalling $1 billion – one rooted in Silicon Valley, the other in Europe. Last year, Kleiner Perkins Caufield & Byers closed two funds totalling $1.2 billion, including a $500-million fund devoted to the growing clean-tech industry.

And the new, well-connected firm launched by Netscape founder Marc Andreessen, called Andreessen Horowitz, recently raised $300 million amid expectations that it could quickly achieve top-tier status.

Contact Scott Duke Harris at sdharris@mercurynews.com or 408-920-2704.

© 2009, YellowBrix, Inc._