How VCs Are Coping With the Downturn

Editor's note: This was originally published on RealMoney. It is being republished as a bonus for TheStreet.com readers.

You can almost see the IPO market crash into a wall. Bankers pulled off 22 deals in the first quarter of 2008, according to IPOhome.com. That figure fell to 14 in the second quarter and to just seven last quarter. Now, the lights have been turned out. There has not been a single major deal since August, and the freeze is likely to persist through at least the first half of 2009 as well.

That has left many to wonder how venture capitalists, or VCs, will cope. When they placed their bets in recent years, they were counting on an active IPO market to take their investments off their hands. Now, they are faced with the prospect of ponying up more dough just to keep these investments afloat. For any investments that are already operating at break-even and don't need more cash right now, their VC backers are highly grateful.

I had a chance to chat with a San Francisco-based industry veteran who advises companies on their business development strategies and who keeps a close eye on the action in the VC community.

So how do the VCs find exits for their holdings in this environment? You can forget about small start-ups linking up with each other. They often have redundant technology platforms and offer little in the way of synergies. More importantly, it is hard to find the right price to set a deal, and backers are loath to put in yet more money to give these combined entities enough cash to await an eventual opening in the IPO market.

Yet an industry watcher I spoke with says that the VCs have another appealing exit strategy, and you'll be hearing a lot more about it in coming months: strategic buyers. Distinct from "financial buyers" such as private equity that is just looking for a profit, strategic buyers can look at these small VC-backed start-ups as a way to pursue new growth opportunities.