VC rebound hopes stagnate

Hopes of a major turnaround this year in the Bay Area’s once-thriving venture capital industry are not looking good.

A new report by Ernst & Young LLC’s venture capital advisory group shows last year both VC investments and valuations of startup companies fell to levels not seen since the mid-1990s.

But that doesn’t mean the VC industry is the same as it was back then.
Bill Reichert, president of Menlo Park-based Garage Technology Ventures disagrees with opinions that venture capital is at levels similar to 1995 or 1996.

“Both you and I know we’re not where we were in the mid-1990s. There is a huge difference between the absolute level of activity and the direction of activity. Clearly the fact [is that] the direction of VC investing is dramatically different and that means the whole environment is different,” Reichert says.

“Another big difference is that there were investment theses back then that people held on to fairly confidently and the problem is there is no investment theory that anybody is holding on to with any confidence whatsoever,” he says.

Ernst & Young says the VC industry will need an outside influence to act as jumper cables to get its engine running again — possibly the reemergence of the initial public offering market or a new emergence of a successful business model.

In the aftermath of the dot-com bubble, E&Y says the VC industry still hasn’t established a firm footing although there is an understanding with VCs that the industry needs to change.

Garage’s Reichert says some VC investors may sound confident about their industry, but that they are trained to do so, and it doesn’t reflect the real world.

“The reality is there is a huge lack of imagination, vision and confidence that there is any reasonable and solid investment thesis. Often you hear VCs are balancing their approach. That means instead of chasing after early stage deals, they’ve decided to go after deals that are generating revenues and are close to break-even,” Reichert says, explaining VCs increasingly will mix both kinds of investments.

He says investment strategy for many VCs has reversed their usual mode of operation as they no longer compete to be the first to invest in a startup.

“‘Last money in’ is the new investment thesis that you’re hearing a lot of,” Reichert says.

Some say early-stage investors have been burned too many times as they lose money when startup valuations at second- and third-round fundings fall.

“That’s been going on for a couple of years now. It’s not a new trend, but I don’t know how much longer you can have down rounds,” says Deepak Kamra, general partner at Canaan Partners in Menlo Park.

“Nobody invests in a first round thinking the company will be cheaper in the second round,” Kamra says.

“First rounds are dropping in both price and quality. Am I seeing a change in that? No,” he says.

Garage’s Reichert agrees.

“Very few [VCs] are willing to say they’ve abandoned early-stage companies. But practically speaking, there are a number who have.” he says.

There were 510 initial financings of startups in 2002, the lowest number in seven years, according to research by Ernst & Young and VentureOne. The silver lining is that 83 percent of that first-round money went to IT and bioscience startups, industries the Bay Area dominates.

The lower level of initial financings doesn’t concern one investment banker.

“You had more companies funded in the past than probably should have been,” says Rick Osgood, CEO of Pacific growth Equities Inc. of San Francisco.

He says the current crop of new startups will probably be more healthy than those funded during the boom years.

Garage’s Reichert says in the current market, huge VC fundings reliant upon billion-dollar IPOs will likely be replaced by a larger number of small deals, which still can provide reasonable returns on VC investment.

“Maybe that’s whistling past the graveyard, but that’s clearly what all of us are betting on,” he says.