Venture Capitalists Decrease Risk Appetite

August 19, 2009 Updated: August 19, 2009

WASHINGTON—After getting burned at the hands of the present economic downturn, most venture capital (VC) firms are curtailing their investment plans for the near future.

That’s bad news for aspiring entrepreneurs looking for startup capital, especially in today’s tough credit environment.

“In general, VCs are decreasing their overall investing dollars, focusing on their best companies and increasing their allocation to later-stage investments,” according to a recent Deloitte & Touche white paper titled “Global Trends in Venture Capital 2009 Global Report.”

Venture capital has not dried up, but firms are more cautious now and tend to select industries and regions showing the greatest promise.

Beginning stage startups—popular during the heyday of the dot-com era—are now considered too risky for most VCs.

“Our firm is interested primarily in potentially great companies that already have some revenue traction,” Patrick Sheehan, partner at the Environmental Technologies Fund, explained in the Deloitte report.

Sheehan said that his company has changed its strategy and will focus on companies that have a proven track record. Venture capitalists perform market analysis to gauge customer interest in the product and carry out additional relevant analysis to assure that they are dealing with a viable product and not one that is here today and gone tomorrow.

The clean technology and life sciences industries, which include firms that produce windmills, alternative fuels, pollution and recycling products, medical devices and biopharmaceuticals, are perceived to be more promising to venture capitalists than they were four or five years ago.

“Young entrepreneurs who thought they could get rich quickly with just a good idea are now gone and those now left standing recognize the challenges and tenacity needed to establish and build a sustainable business,” Mark Heesen, president of the National Venture Capital Association (NVCA), said in the Deloitte report. NVCA represents 450 venture capital firms in the United States.

Heesen said that today’s entrepreneurs have a better understanding about the economic side of the business, what is going on worldwide, and competitive factors. It has come home to those angling for venture capital that the market is volatile and brings great risks.

Venture Capital Going Global

Entrepreneurs in Israel and the United Kingdom are in luck. Close to 70 percent of venture capital firms surveyed by Deloitte said that they would increase capital investments there.

Asian-Pacific companies will also have more access to venture capital, according to 61 percent of the respondents.

Gone are the days when Silicon Valley is seen as the only birthplace for new ideas and new technologies.

“Firms are now looking at the whole world in terms of their investing priorities. The world has gone global in venture capital and the firms are adapting their strategies accordingly,” Mark Jensen, managing partner at Deloitte, suggested.

Many venture capital firms claim that they are losing interest in investing in the North American region and point out that their interest leans toward investing in India and China.

The investment firms see a decrease in their “traditional investor base—commercial banks, investment banks, corporate operating funds, insurance companies and public pension funds—[which seem] to be drying up,” the Deloitte report suggested.

Fund Raising Activities

“The slower venture fundraising activity is no surprise given the current environment,” Heesen said in a NVCA statement. “The final manifestations of the bubble burst combined with a troubled exit market make it a very difficult time to raise money.”

Heesen suggested that venture firms will keep a slow pace into and even past 2010 before they achieve their former activity levels.

Funds for the media and entertainment industry have dried up, with a 48 percent decline in funding activities. In 2008, around $600 million were invested in that sector. This has trickled down to less than $200 million by mid-2009, according to statistics from MoneyTree.

During the second quarter of 2009, $3.7 billion were invested in 612 transactions, versus $3.2 billion in 603 transactions during the first quarter, suggesting almost no improvement in investment activities.

The majority of funds went to cleantech and biotechnology firms. Biotechnology and medical device industries realized a significant increase in activities, increasing by 47 percent and accounting for $1.5 billion with 160 transactions during the second quarter.

The semiconductor industry experienced a 5 percent decline in funding activities, the lowest activity in 10 years. The telecommunications industry experienced a 13 percent decline in funding activities over the same period in the prior year.

“The fact that several venture-backed companies successfully entered the public markets and performed well is encouraging,” Heesen said. “However, we remain concerned about the extremely thin pipeline of companies in registration as it indicates that it will be some time before we can even be in a position to return to healthy IPO activity levels.”

Does Location Matter?

“From Silicon Valley to Herzliya, Israel, venture capital firms are concentrated in very few locations,” according to Working Knowledge, the publishing arm of Harvard Business School, in a recent report.

The major U.S. venture capital firms are located either in Boston, New York, or San Francisco and the Silicon Valley.

The location matters, as venture capital firms keep tight control of their investments, tightly monitor the companies they invest in, and are often on the boards of the funded companies, actively involved in selecting management.

“The ability to monitor the portfolio company, to coach the management team, and to provide introductions may depend upon the ability to interact frequently with the company,” the Harvard experts said.