Business Tech

With the market for initial public offerings in a deep freeze and a dwindling number of potential buyers, start-ups have fewer opportunities to exit and retire to Costa Rica.

This is worrisome to entrepreneurs, but if anything, it should be of even greater concern to the venture capitalists that fund them, a point made by TechFlash's John Cook. Venture capital firms simply aren't structured to invest efficiently in this market.

VCs raised billions of dollars during technology's boom, and it's unclear where they can now profitably invest those dollars. IBM, Oracle, Cisco Systems, and Microsoft can buy only so many companies. The industry consolidation that paid big returns to VCs earlier this decade has left far fewer potential buyers, with an anemic IPO market to provide an alternative outlet.

The situation has the potential to get worse. As IBM's Savio Rodrigues writes, Oracle has been hit hard in its middleware business as enterprise IT seeks to minimize the damage from Oracle and SAP price hikes in applications. This could make it harder for the company to afford acquisitions down the road.

In venture investing, small is the new big. Smaller, strategic funds like O'Reilly Alpha Tech Ventures can score big on a "base hit" $20 million exit, given its seed-stage investments of $500,000 to $1 million. Meanwhile, a large firm such as Kleiner Perkins Caufield & Byers will struggle to break even on such an exit, given that its investments need to be much bigger because its funds are so much bigger.

Venture firms have compensated by throwing money at weaker companies that arguably shouldn't get funded. This isn't sustainable. If exit options are dwindling for good companies, they're nonexistent for bad ones.

Compounding the problem for VCs, not only are exits likely to shrink in the new technology economy, but start-ups need less cash to thrive due to low-cost open-source and cloud infrastructure. This is true for most start-ups, but particularly so for companies that sell open-source software.

VCs potentially need to trim their existing funds, and almost certainly should be raising smaller funds.

For those that want to put existing capital to work, it might make sense to swing for the fences with consolidation around portfolio companies. I've described one winning open-source combination (Acquia, Magento, and OpenX), but there are plenty more. The upside to this strategy is that it fattens up a potential acquisition. The downside is that equity positions get heavily diluted in the process, and there are few potential buyers.

It's hard to make early-stage investments in a climate when entrepreneurs need less money, and when the exits promise to return far less. But that is precisely the environment in which VCs find themselves. It may be time to trade in that Porsche for a Honda.

As the CEO of Adobe Systems, Bruce Chizen was credited with turning that company into a software powerhouse. Now Chizen will bring his experience to a new role as a venture partner for Voyager Capital, a top venture capital firm.

Voyager Capital invests mostly in start-ups involved with early-stage digital media, software and servers, wireless, and Web infrastructure. Previously a member of Voyager's advisory board, Chizen will expand his role by working with budding technology entrepreneurs in the areas of digital media and software.

"Bruce possesses a rare combination of valuable market insight and senior business experience," said Bill McAleer, managing director at Voyager Capital. "His strong industry reputation, connections, and background in digital media and software will benefit our ventures."

Chizen made his mark in the industry as CEO of Adobe. After six years with the company, he took over the CEO reins from co-founder John Warnock in late 2000.

During his tenure, Chizen was the driving force behind Adobe's expansion into new markets. He oversaw the growth of the company's customer base beyond the graphic arts niche into the enterprise and general consumer arenas. He helped transform Adobe from a software vendor into a platform company, branching out onto the Web and open source, among other areas.

With Chizen at the helm, Adobe made some key deals, notably the acquisition of Macromedia in 2005.

After having tripled Adobe's revenues as CEO, Chizen exited the company in late 2007, placing it in the hands of then president and now CEO Shantanu Narayen. In an interview with CNET News, Chizen spoke about his decision to leave Adobe at the time.

Prior to his role at Adobe, Chizen served in several executive positions at Claris. He also worked in the merchandising group at Mattel Electronics and as a regional sales director at Microsoft.

Editors' note: This guest column was originally published on Bill Gurley's blog. See his bio below.

Many are speculating that the year 2009 represents a fundamental turning point for the venture capital industry. Some are arguing that the industry is in dire straits after years of poor performance. Others have argued that the math simply does not work for the industry's current size.

Another theory suggests that permanent challenges with the market for initial public offerings call into question the fundamental economics of the VC industry. Lastly, some credible authors have suggested that things are so bad that a federal bailout may be in order.

What is really happening in the VC industry? It is indeed quite likely that it is in the process of a very substantial reduction in size, perhaps the first in the history of the industry. However, the specific catalyst for this reduction is not directly related to the issues just mentioned. In order to fully understand what is happening, one must look upstream from the venture capitalists to the source of funds, for that is where the wheels of change are in motion.

VC firms receive the majority of their money from large pension funds, endowments, and foundations that represent some of the largest pools of capital in the world. This "institutional capital" is typically managed by active fund managers who invest with the objective of earning an optimal return in order to meet the needs of the specific institution and/or to grow the size of their overall fund.

These fund managers have one primary tool in their search for optimal returns: deciding which investment categories (referred to as "asset classes") should receive which percentage of the overall capital allocation. This process is known in the financial field as "asset allocation."

Asset allocation is the strategy an investor uses to choose specifically how to divide up capital among asset classes such as stocks, bonds, international stocks, international bonds, real-estate funds, leveraged buyouts (LBOs), venture capital, as well as other obscure classes such as timber funds.

Some of these asset classes, such as stocks and bonds, are known as "liquid assets" because these instruments trade on a daily basis on exchanges around the world. For these assets, investors can be quite sure of the exact value of their holdings, as the price is set continuously in the market. Also, if they need to sell, there is a ready market to accept the trade.

Illiquid assets, also known as alternative assets, include all the other investment classes that do not trade on a daily exchange. These "private" investments (as compared to "public" liquid investments) are considered higher-risk due to their illiquidity, but also are expected to earn a higher return. Some hedge funds are included in alternative assets either because they themselves invest in illiquid investments or because they put strict limitations on the trading capability of the institutional investors, rendering themselves "illiquid."

Asset allocation is a well-studied area within the field of finance. A prototypical United States-based asset allocation model might allocate 25 percent to U.S. stocks, 30 percent to U.S. debt, 25 percent to international equity and debt, and let's say 20 percent to all alternative assets. Within alternative assets, LBOs might be 60 percent, and venture capital could be as low as 10 percent (of the 20 percent). As a result, venture capital could be as low as 2 percent of an institutional fund's overall capital allocation. Most people fail to realize just how small venture capital is in the overall scheme of things.

Very generally speaking, experts and academicians have considered it "conservative" to have a smaller allocation to all alternative assets reflecting the risks of illiquidity, the inability to ascertain price, and the higher difficulty in analyzing the nonstandard vehicles. It is a fairly straightforward, conservative investment approach to favor liquidity and certainty over absolute potential upside (this is the same argument for holding bonds over stocks).

Over the past decade or so, a large number of very influential institutional funds have substantially increased their allocation in alternative assets. In some extreme cases, these investors have taken this allocation from a conservative amount of, say, 15 percent to 20 percent to well more than 50 percent of their fund.

Many people suggest that David Swensen at Yale was the original architect of a strategy to adopt a much higher allocation to alternative assets. Regardless of whether he was the leader, several funds simultaneously adopted this higher-risk, higher-return model. (For a more detailed look at how this evolved and why, see The Wall Street Journal's "Ivy League Schools Learn a Lesson in Liquidity" and Forbes' "How Harvard Investing Superstars Crashed." For an even deeper dive, including comparative asset allocation models, see MoneyShow.com's "Tough Lessons for Harvard and Yale.")

Contributing to this dynamic on the field, the early movers to this model were able to post above-average returns.* Also, due to the high disclosure policy of most universities, these above-average performances were often touted in press releases. This "public benchmarking" put further pressure on competing fund managers who were not seeing equal returns, which, as you might guess, led to them mimicking the same strategy.

As a result, alternative assets have grown quite substantially over the past 10 years. This is perhaps best seen in the size of the overall LBO market. The included chart shows the money raised in the LBO market over the past 30 years. As you can see, the amount of dollars pouring into this category over the past five years is nothing short of breathtaking.

The market contraction of late 2008 and early 2009 severely compromised the high-alternative asset allocation strategy. The liquid portion of the average portfolio contracted as much as 30 percent to 40 percent, which had two resulting impacts. Initially, this resulted in most fund managers having an even higher portion of their funds in illiquid investments. Ironically, this was largely an accounting issue.

Most likely, the illiquid pieces of their portfolio had declined just as much, but as illiquid investments are not valued on a day-to-day basis, they simply were not properly discounted at this point (over time, they would and are eventually coming down). But with one's fund already down 30 percent or so, no one is eager to further decrement the value.

Despite that this may have only been an "accounting" issue, it presented a problem nonetheless, as many fund managers have triggers that force them to reallocate capital, if they go above or below a certain asset allocation. This is one of those policies that encouraged selling at a point that may be the exact wrong time, contributing to further declines.

A second and more complicated problem also emerged. It turns out that when an institutional investor "invests" in an LBO fund, it doesn't actually invest the dollars all at once. Rather, it commits to an investment over time, which is "drawn down" by the LBO manager (venture capital works in the same way, but once again is a much smaller category).

As these funds substantially increased their commitment to the LBO category, they were de facto increasing a guaranteed negative cash flow in the future to meet these draw-downs. Now, with portfolios out of balance, and lack of new liquidity events from the markets for mergers and acquisitions and IPOs, these funds have cash needs (to meet the draw-downs) that are not offset by cash availability. If anything, the universities and endowments these managers represent want more cash now to deal with the difficult overall economic environment.

To meet these new liquidity needs, an institutional investor could:

1. Sell more of its liquid securities. This is problematic because it further compromises the target asset allocation.
2. Try to sell the LBO commitments on the secondary market. As you might suspect, the secondary market is extremely depressed. Some have even suggested that due to the forward cash need on an early LBO fund, an institution might have to "pay" to get out of the position and to encourage someone else take on the future cash commitment.
3. Default on the commitment. While this does have penalties in most cases, it would not be out of the realm of possibilities for this to occur, if the investor has lost faith in the manager, and it is early in the fund (with more cash needs in the future).
4. Try to raise more capital. Not surprisingly, donations to foundations and universities are down dramatically due to the overall decline in the capital markets. This makes this strategy unlikely.

As you can see, none of these options is overly compelling.

If this is not bad enough, many institutional fund managers and the groups to which they report (such as a board of trustees) are now second-guessing the high-alternative asset allocation model. As a result, they may desire to return to the more conservative and more traditional asset allocation of 10 percent to 20 percent allocated to alternative assets.

Ironically, they are in no position to rebalance their portfolio precisely because they lack incremental liquidity. Think about it this way: it is very easy to shift a portfolio from liquid assets to illiquid. You simply sell positions in highly liquid securities, and buy or commit to illiquid ones. Going the other way is not so simple, as there is no ability to conveniently exit the illiquid positions.

This is a very long explanation, but the punch line is that as these large institutions adjust their portfolios and potentially abandon these more aggressive strategies, the amount of overall capital committed to alternative assets will undoubtedly shrink. As this happens, the VC industry will shrink in kind.

How much will it go down? It is very hard to say. It would not be surprising for many of these funds to cut their allocation in the category in half, and as a result, it shouldn't be surprising for the VC industry to get cut in half also.

One could argue that poor returns in the VC industry comprise the primary reason the category will shrink and that, as a result, the VC industry could be cut even further--or perhaps even go away. There are two key reasons that this is highly unlikely. First, one of the key tenets of finance theory is the Capital Asset Pricing Model. The CAPM model argues that each investment has a risk, measured as beta, which is correlated with return versus that of the risk-free return.

Venture capital is obviously a high-beta investment category. As of August 3, the S&P 500 has a negative 10-year return. As a higher-beta category, no rational investor could reasonably expect the VC industry as a whole to outperform in a catastrophic overall equity market. In fact, the expectation would be for lower returns than the equity benchmark.

This multiplicative correlation with traditional equity markets is the exact same reason that venture capital outperformed traditional equities in the late 1990s. The bottom line is that no institutional investor should be surprised by the recent below-average performance of the entire category, all things being equal.

The second reason the category will not be abandoned is contrarianism. Most students of financial history have read the famous quote attributed to Warren Buffet, "We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful."

One of the biggest fears of any investor is to abandon an investment at its low point, and then miss the corresponding recovery that would have helped offset previous poor returns. While this mindset will not guarantee the 100-year viability of the VC category, it should act as a governor on any mass exodus of the category. The more people exit, the more the true believers will want to double-down.

So when will this happen? One thing for sure is that it will not happen quickly. The VC industry has low barriers to entry and high barriers to exit. Theoretically, a fund raised in 2008, where all the limited partnerships (LPs) have no plans to commit to their next fund, may still be doing business in 2018. VC funds have long lives, and the point at which they decide to "not continue" is usually when they go to raise a new fund. This would typically be three to five years after they raised their last fund, but could be expanded to five to seven years in a tough market.

In some ways, the process has already started. Stories are starting to pop up about VC funds that were unable to raise their next fund. Also, some entrepreneurs are starting to discuss favoring VCs in whose longevity they can be confident. All in all, one should expect a large number of VC firms to call it quits over the next five years.

How should Silicon Valley think about these changes? It is important to realize that there are approximately 900 active VC firms in the United States alone. If that number fell to 450, it is not clear that the average Silicon Valley resident would take much notice. Another interesting data point can be found in the NVCA data, outlining how much money VCs are investing in start-ups (as opposed to LPs committing to VC firms).

VC firms invested about $3.7 billion (PDF) in the second quarter of 2009. Interestingly, this number is about half of the recent peak of about $8 billion per quarter. It is also quite similar to the investment level in the mid-1990s, prior to both the Internet bubble and the rise of the aggressive asset allocation model. So from that perspective, this, meaning the investment level we see right now in the second quarter of 2009, may be what it is going to be like in the future.

There are many reasons to believe that a reduction in the size of the VC industry will be healthy for the industry overall and should lead to above-average returns in the future. This is not simply because less supply of dollars will give VCs more pricing leverage.

We have seen over and over again how excess capital can lead to crowded emerging markets with as many as five or six VC-backed competitors. Reducing this to two or three players will result in less cutthroat behavior and much healthier returns for all companies and entrepreneurs in the market. Additionally, at a stabilized market size of well more than $15 billion a year, there should be plenty of capital to fund the next Microsoft, eBay, or Google.

* To date, it is unclear if these "above average" returns were a result of the liquid half of these portfolios or the illiquid half. As we mentioned earlier, it is extremely difficult to ascertain the actual value of an illiquid investment. In many cases, the institutional fund manager relies on the investment manager of the asset in which the firm invested to prescribe a value to the investment, even though it may be highly biased. If it turns out that a large portion of the "above average" returns of these early adopters of this more aggressive strategy were on the illiquid side, we may have yet another example of the dangers of mark-to-market accounting.

The venture capital industry took another big hit in the first quarter of the year, according to new data from Dow Jones VentureSource.

Venture capitalists invested just $3.90 billion in U.S. companies during the quarter, a 50 percent decline from the almost $7.78 billion invested during the same quarter last year, according to VentureSource. In terms of actual venture deals, 477 were completed, well below the 706 completed last year and the lowest quarterly deal total since 1996.

Hit particularly hard was the information technology industry, which saw its lowest level of investment since 1997, with $1.68 billion invested in 231 deals for the first quarter. That's a 52 percent drop from the $3.48 billion invested in 370 such deals during the same quarter last year, according to the report. That's also the lowest deal level for the IT industry--the software sector included--since 1995, the report says.

"Technology companies have long been the primary focus of venture capitalists," VentureSource's Director of Global Research Jessica Canning said in a statement. "But with a nonexistent IPO market and corporations paying less for venture-backed technologies, the incentive for investors to back new or unproven business models is just not there."

The report also documents another plunge for the green tech and clean energy sectors, with $189 million in 15 deals during the first quarter, down 59 percent from the $457 million invested in 24 such deals last year.

The report isn't quite as bleak as one released for the fourth quarter of last year from Thomson Reuters and the National Venture Capital Association, which noted a decline in VC funding of 71 percent from the fourth quarter of 2007.

Also for the first quarter of the year, VentureSource earlier this month reported a 65 percent fall in liquidity for VCs.

Updated at 10:35 p.m. PDT with confirmation from Google.

Google has launched a venture capital arm to invest in a diverse array of industries, including the consumer Internet, software, clean tech, and health care.

The fund, which was announced late Monday in a company blog, will be headed by William Maris, an investor and entrepreneur who was hired by Google last year to help set up the venture, and Rich Miner, former manager of Google's mobile platforms group.

Google Ventures, as the fund is called, is expected to receive a $100 million investment from Google in the first year, according to a report on The Wall Street Journal's Web site.

"Central to our effort will be our fellow Googlers, whom we view as a critically important resource to help educate us about potential investments areas and evaluate specific companies," Maris and Miner said in the jointly penned blog.

The new venture will put Google--a company better known for buying companies than investing in them--in the more-formal role of helping get start-ups off the ground. Other Silicon Valley companies with extensive VC track records include Intel, Hewlett-Packard, and Motorola.

Google acknowledged that its timing is awkward, but noted that it also sees opportunity in the current economic climate.

"Economically, times are tough, but great ideas come when they will," the pair said. "If anything, we think the current downturn is an ideal time to invest in nascent companies that have the chance to be the 'next big thing,' and we'll be working hard to find them."

Venture capitalists have put a virtual lock on their funding, doling out a mere $3.4 billion during the fourth quarter of 2008, according to a report released in January by Thomson Reuters and the National Venture Capital Association. The meager performance pales in comparison with the $11.7 billion distributed to start-ups a year ago during the same period, a decline of 71 percent.

During the same period, venture capital investments in IT companies specifically plunged 40 percent to $2.18 billion, the worst level in a decade, according to figures from VentureSource.

Israeli venture capitalists are expected this year to raise $300 million, setting the stage for a second consecutive year of decline, according to figures released Wednesday by the IVC Research Center.

Israeli venture capital funds are expected this year to post a 62 percent decline over last year, when $793 million was raised.

And should Israeli venture capital funds generate only $300 million, it would put it on par with levels not seen since 2003 to 2004.

Last year, Israeli venture capital funds declined 30 percent over the previous year, when $1.14 billion was raised.

But despite the two years of declines, IVC reports that roughly $1 billion in capital still remains available for investment. Of that pool of funds, approximately $400 million is targeted for first-time investments in high-tech companies. The remainder is set aside for follow-on investments in those companies.

Israel over the past decade has also attracted the attention of U.S.-based venture capitalists looking to invest in start-ups operating in the Middle East high-tech center.

Hey buddy, can you spare a dime?

Venture capitalists put a virtual lock on their funding during the fourth quarter, doling out a mere $3.4 billion, according to a report released Monday by Thomson Reuters and the National Venture Capital Association.

The meager performance pales in comparison to the $11.7 billion distributed to start-ups a year ago during the same period. That's a decline of 71 percent. Funding is down nearly 60 percent from the previous quarter.

During the fourth quarter, venture capitalists launched 33 follow-on funds and 10 new funds, resulting in a 3-to-1 ratio for follow-on to new funds. That compares with a 2-to-1 ratio during the same period a year ago.

Mark Heesen, NVCA president, said in a statement:

The drop in venture capital fundraising activity in the fourth quarter is not surprising for two reasons.

First, the market uncertainty has compelled firms that were planning to raise a fund in late 2008 or early 2009 to hold back on fundraising efforts until economic conditions improve and institutional investors can recommit with confidence. The second and less obvious reason is that many venture capital firms raised money in the last two years and are focused on deploying those funds With some notable exceptions, we can expect this slower pace to continue well into 2009.

Such doom and gloom also engulfs venture capital spending as it relates to the tech industry, which posted its worst fourth-quarter performance in a decade, according to a recent report by VentureSource.

Venture capital for IT companies fell 40 percent to $2.18 billion in the fourth quarter, compared with the same period a year ago, according to VentureSource.

Venture capital investments in IT companies plunged 40 percent to $2.18 billion in the fourth quarter, their worst level in a decade, according to figures released late Friday by VentureSource.

The data further confirms concerns entrepreneurs have already been raising about a funding pullback by VCs over the second half of the year and dire warnings by the VCs themselves, such as Sequoia Capital's infamous R.I.P. PowerPoint presentation.

IT Venture capital dropped to $11.64 billion for all of 2008, down 14.5 percent from the previous year, according to VentureSource. During the past year, IT investments posted growth in the first quarter and a slight decline in the second, but significantly dropped off in the second part of the year, VentureSource said.

Software companies, which continue to capture the largest slice of IT venture investments, dropped 16.4 percent during the year, to $4.73 billion in funding.

Venture investments in communications and networking start-ups fell 32.3 percent to $1.68 billion in 2008, while investments in semiconductors dropped 23.5 percent to $1.25 billion year over year. Electronics and computer companies, meanwhile, saw venture investments fall 15.5 percent over the previous year, reaching $1.31 billion.

Despite the doom and gloom of 2008, the Web-savvy information services sector posted a 16.9 percent year-over-year gain in venture investments last year--to the tune of $2.67 billion. While that sector managed to shine through most of the year, venture investments did fall off 30.5 percent to hit $513.2 million in the fourth quarter.

HALF MOON BAY, Calif.--When bonds are paying yields like stocks and blue-chip companies are severely undervalued, who wants to invest in equities, let alone an IPO?

Those are just some of the challenges companies face in attracting investors in this current economic climate, noted panelists Tuesday during the AlwaysOn Venture Summit West conference here.

Despite the dire economic climate and the market meltdown, the panelists noted "good companies" will still have an opportunity to go public--it just may take longer.

Investors, such as mutual funds, asset managers, pension funds and hedge funds, are holding a significant amount of cash on the sidelines, as a defensive move to guard against clients pulling money out of the funds they are invested in and as a means to keep their powder dry, noted Leslie Pfrang, a managing director and head of specialist sales at Deutsche Bank.

And investors apparently don't mind that their funds are holding onto such a large hoard of cash instead of investing in equities, given cash is now considered an asset class, noted John Rende, a partner with Weintraub Capital Management. Rende and Pfrang were both speakers on "The Buy Side Today" panel.

With the harsh economic climate washing out a number of companies that had hoped to launch an initial public offering, the survivors will likely lead to a bumper crop of stronger and more profitable IPOs, said Lise Buyer, founder of IPO advisory firm Class V Group, who also served as a speaker on the "Are the IPO Glory Days Over Forever" panel.

"Everyone should act as though there will not be another round of funding," Buyer said. "You should operate with what you have, because it may be all you get."

And as older, or late-stage, private companies seek to land another funding round, Josh Tanzer, managing director of private equity firm Revolution Partners, advised companies to demonstrate to potential investors that they not only have momentum in growing their revenue but also momentum in profitability.