Feeling financial squeeze, VCs curtail investments

In what could be the start of a long, dry spell for entrepreneurs on college campuses and elsewhere across the country, venture capitalists are gradually closing their financial spigots as it becomes increasingly difficult to cash out of their previous investments.

Although a drought hasn’t set in yet, it’s looking inevitable as the ripple effects of a worldwide financial crisis rattle venture capitalists.

The trepidation was evident in the third quarter when the venture capital flowing to startups totaled $7.1 billion, a 9-percent decline from the same time last year, according to data released Oct. 18 by Thomson Reuters, PricewaterhouseCoopers, and the National Venture Capital Association.

It marked the first quarterly decline in year-over-year venture capital investments since the final three months of 2005. And it was the largest decrease since the spring of 2003, when the industry was still recovering from losses sustained in the dot-com bust.

Now, venture capitalists are girding for the most challenging period since an internet bubble that they helped create finally burst in 2001.

"We have been through this before and, hopefully, we have learned some lessons," said Mark Heeson, president of the National Venture Capital Association.

Two of Silicon Valley’s best-known venture capital firms, Sequoia Capital and Benchmark Capital, have already advised companies in their investment portfolios to redraw their business plans for next year and cut costs so they have a bigger cash cushion to weather what is expected to be the worst recession in a quarter century.

In a slide presentation this month, Sequoia Capital—whose past successes include investments in Google Inc. and Yahoo Inc.—advised startups to "get real or go home."

The comedown this time shouldn’t be quite as jarring in this cycle, mainly because venture capitalists haven’t been as loose with their money as they were during the dot-com boom. Venture capitalists invested $200 billion from 1999 through 2001. In the nearly seven years since then, venture capitalists have invested a total of $168 billion.

A purge already has started at some startups, and other cutbacks seem likely for any still-unprofitable company that isn’t meeting its budget projections, because raising more money will be difficult.

The drop-off in venture capital investments during the third quarter would have been much more dramatic if not for the rising interest in biotechnology and alternative energy—sectors that traditionally require a significant amount of cash before they become profitable.

Biotech startups raised $1.35 billion from venture capitalists, a 21-percent increase from last year, while alternative energy, or "clean tech," raised $1.04 billion, a 17-percent increase.

With few exceptions, venture capitalists are becoming particularly reluctant to invest in startups seeking their first round of financing, because the financiers can’t easily extract the money they have invested in other startups.

With the stock market in upheaval, investors haven’t been willing to roll the dice on the unproven, albeit promising, companies typically funded by venture capitalists. So far this year, just six companies backed by venture capitalists have completed initial public offerings of stock, the lowest volume in 31 years. Just one venture-backed company, Rackspace Hosting Inc., has gone public since March.

The downturn in the stock market also figures to make it tougher to sell startups to larger companies that are already public. The buyers in those deals typically finance those purchases with their own stock—a currency that’s worth dramatically less than just a few months ago.

There were 58 acquisitions of venture-backed companies in the third quarter, a 43-percent drop from the same time last year, according to Thomson Reuters.

The climate means venture capitalists are having to spend time and money on their existing investments rather than taking on new challenges. Companies soliciting their first round of financing raised $1.5 billion in the third quarter, down from $1.9 billion at the same time last year.

To make matters worse for entrepreneurs, the credit crunch and slumping real estate market are closing financing options outside the venture capital industry. When entrepreneurs are looking to raise their first $1 million, they often rely on credit cards and home equity loans, but beleaguered banks have been imposing more restrictions on those sources.

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