It's the winter of due diligence for VCs: venture fundings are dawn and IPOs are dead in the water, but venture capitalists remain upbeat - Business of Technology - Industry Overview

Computer Technology Review, July, 2002 by Mark Jensen

Like down cycles of the past, the current slump in the capital markets is widely viewed as a great 'buying opportunity for the patient and prepared.

Entrepreneurs have less to cheer about, since VCs, like other potential backers, can be much choosier--and can get far better prices--than during the boom of 1999 and 2000. Venture-backed firms in later funding stages have the least to cheer about, since most have no hope of an IPO. anytime soon and may have to keep relying on VCs simply to stay in business. Standards for funding are also stricter than they were, a year or two ago. But promising firms in certain industries, such as life 'sciences and nanotechnology, are still getting attention and money.

Many venture capitalists seem to be making deals again. What's gone, though, is the mad rush to throw money at half-baked business models. As Menlo Ventures general partner Sonja Hoel noted, "We have more time to do due diligence. It's less competitive to be a venture capitalist."

Hoel says her firm's deal-making has slowed only slightly. As of December 2001, Menlo Ventures had invested in 11 new companies during the year, compared to 16 in all of 2000. "We weren't crazy in the high times, and we're being quite steady at times like these."

The Waiting Game Is Back

Hoel and other VCs have also said goodbye to the remarkably short turnaround times of the recent past, when firms went from start up to P0 with lightning speed. Historically, VCs have waited four to seven years from the first funding round to the final cash-out, typically through an acquisition or an IPO. That time frame got a lot shorter during the IPO boom. According to Hoel, one deal for her firm had a six-week turnaround. Now, with M&A activity well off its highs and the IPO market virtually shut down, VCs are re-learning their old waiting game.

Peter Wendell, a general partner at Sierra Ventures, said the market for liquidating venture-backed investments is only slowly returning to normal. The VC community is hopeful, though it doesn't foresee prices hitting quite the levels seen at the height of the technology stock bubble. "There are few among us who don't think the capital markets won't be back four years from now, albeit at more traditional multiples," Wendell said. Jensen agreed. 'To some extent there's blind faith here, but we all know the [IPO] market will come back; it always has."

In the meantime, the VC firms with established track records and ample fundraising power should find themselves in a sweet spot. Not only can they afford to shop around for the most promising start-up firms, but their financial resources and staying power also make them attractive to entrepreneurs. As long as the M&A market is sluggish and the IPO window is closed, venture-funded companies will rely on their VCs for capital. That means the edge goes to the VCs who have the financial resources for the long haul.

"They have to stay with a deal longer and invest in more rounds before they get out," said Graham Watson, partner-in-charge of corporate finance of Deloitte & Touche's technology, media, and telecommunications group in Northern California. "Today, a VC-backed firm should, be prepared to stay with a private company for four 'or five years, through three or four funding rounds. You don't want to be a partner with a 'venture capitalist who isn't going to be around," he said.

This environment is not favorable for young, unproven funds. Nor, as Wendell and others point out, is it good for startups that seem likely to consume lots of capital without charting a clear path to profit in the foreseeable future. "Those pie-in-the-sky, very-high-burn-rate deals were very attractive when money flowed freely but are less attractive now, for obvious reasons," Wendell said.

In short, the contraction in both venture funding and liquidation markets has led to more choosiness on both sides. With the risk that a VC might not have the staying power for future funding rounds, startups have reason to be more selective in picking their backers. But the VCs, given the commitments they are about to make, also will be picky.

VCs have other reasons to be cautious inapproaching new deals. The lack of a liquid IPO market makes it difficult to gauge the future stock market value of today's startups, and VCs must be able to offer their investors the reasonable chance of high returns (as a rule of thumb, Wendell said venture investors look for returns of about 5-8% above what they would expect in the stock market).

VCs also have to devote money and time to their portfolio of companies. Even though the VC may have assumed that a company wouldn't require funding after a certain point, given today's market, these companies may remain in the fold for quite some time.

What does it take for a new company to make the cut and get VC backing? Being in certain industries seems to help, but, whatever the business line, the company has to be a lot more than just a concept. For instance, VCs like businesses that are continuously adding customers because it's a sign that 'their product or service is making a good first impression on the market. They also look for growth in revenue and a break-even point that's visible in the near future. Experts say that it also helps to have a management team that has been through the startup process before and has successfully taken a company public.