Tech Venture Capitalists Feeling the Pain

You know things are bad when venture capital is panicking.

Venture capitalists live at a higher altitude than most investors -- they take the long view. With the glaring exception of the dot-com boom (which they helped create by pumping half-baked startups into the stock market), they have always shrugged off wild market swings.

But last week, Sequoia Capital, one of the most respected venture shops in Silicon Valley, called in entrepreneurs and CEOs of its portfolio companies for an emergency meeting to, as blog GigaOm put it , "buckle down for what could be the worst economic downturn of their relatively short lives."

Sequoia, which backed Apple ( AAPL), Electronic Arts ( ERTS), PayPal, Yahoo! ( YHOO) and Google ( GOOG), among others , did this once before, during the dot-com bust. This time, details and Powerpoint slides soon appeared on the Web, and the message was stern enough to sober up anyone.

There are all kinds of scary phrases that CEOs never want to hear, like: "death spiral," "years to recovery," and "spend every dollar as if it were your last." There are also words startups hoped they'd never hear from a VC, like "need for profitability," "must-have product" and "become cash-flow positive as soon as possible."

"Get real or go home," one Sequoia executive told the assembled crowd, sounding a bit like a coach at halftime to a losing team. "We're talking survive. Get this point into your heads," barked another.

Until very recently, venture capitalists were shrugging off the credit crisis. The last market blowup had Silicon Valley as ground zero, they reasoned, so now it's someone else's turn. We'll ride this one out as Wall Street suffers.

And they had a point. For the past few years, money was flowing around so freely that any decent venture firm raising a fund had no problem raising cash, and some were even turning it away. Having learned the hard lessons, most were more selective about what startups they backed, and therefore relatively confident if a recession hit.

Still, there were bad signs. A University of San Francisco survey of Silicon Valley VCs showed confidence among them has been falling for a while.

For a few years, the IPO markets hadn't been terribly friendly to venture-backed startups -- even after some of the more onerous aspects of Sarbanes-Oxley were rolled back. Now the climate is looking even drier.

According to Renaissance Capital, global IPO activity slowed to only 20 companies going public in the third quarter, raising $9.3 billion. That's down from the year ago figure of $34.8 billion and the recent high of $94.3 billion in the first quarter of 2008. So in less than a year, money raised by IPOs around the world has plunged more than 90%. And that was before the global market selloff.

U.S. venture-backed companies are also making up a smaller piece of that pie. In the first quarter of 2008, only five venture-backed companies went public, but at least that was five more than went public in the second quarter, according to Thomson Reuters. (Data for the third quarter isn't available yet.)

Some VCs have been worried about a prolonged IPO drought. In a release decrying a "capital market crisis" for startups, National Venture Capital Association Chairman Dixon Doll said, "Imagine the implications if Genentech ( DNA), Google, or Intel ( INTC) decided to forgo a public offering and become acquired because the public market option was unappealing. The 'next Genentech or Google may be making that decision right now."

The merger market will probably be just as meager soon. Sure, we'll see a pop in buyouts once tech stocks bottom -- Microsoft ( MSFT) is reportedly waiting to re-pounce on Yahoo! and is also sniffing around Research In Motion ( RIMM) -- but most of the deals will be fire sales, which are very bad for VC returns.

Then there's the liquidity question. As Fortune writer Michael Copeland explained, when a venture firm closes a fund it simply collects pledges, not the actual cash itself. They later dial up their limited partners for that cash. But a lot of those investors are over a barrel and can't -- or won't -- pay up. So some funds, mostly the less prestigious ones, won't have the money they thought would carry them through the hard times.

Sequoia won't likely have that problem. Burn a firm like Sequoia, and it will cost you beyond the next few years. Rather, Sequoia's 12-step meeting was an attempt to shake things up and see what rises to the top -- that is, to see which companies can generate cash, and which simply burn it.

But many VC firms are facing a scarcity of capital to fund startups and all are facing a scarcity of exits. It's like a baker with little flour to bake goods, but not enough customers to buy the baked goods anyway. It sort of balances out, but it's not good for business.

More from Opinion

IBM's Earnings Beat Is Only Slightly Encouraging

IBM's Earnings Beat Is Only Slightly Encouraging

Why Google's $5 Billion EU Fine Is Good News for Samsung

Why Google's $5 Billion EU Fine Is Good News for Samsung

Clorox Gets Downgraded to Sell at Goldman Sachs

Clorox Gets Downgraded to Sell at Goldman Sachs

Roku's New Wireless Speakers Are Innovative, But Not for Everyone

Roku's New Wireless Speakers Are Innovative, But Not for Everyone

4 Potential Reasons Why Netflix Missed Its Subscription Guidance

4 Potential Reasons Why Netflix Missed Its Subscription Guidance