You know it's a nasty downturn when the venture capitalists throw up their hands and surrender cash to their investors. And many venture funds have done just that, returning so much money -- $5 billion in 2002 -- that net fundraising fell to its lowest level in 11 years.

The trouble is, VC outfits still awash in cash from the late '90s can't find enough places to profitably invest all of it.

The trend underscores the turmoil in the venture industry, which typically earmarks around 90% of its funds toward tech. With few big money-makers in the pipeline, the venture industry is struggling through a painful shakeout, with many funds expected to go under.

In a reflection of the more sober outlook, today venture investors home in on areas with high-margin prospects such as software, while snubbing the capital-intensive telecom and hardware plays popular in the boom. VCs have also ditched boom-era expectations for multiple hundredfold returns in just a couple years. Now 30% to 40% is considered a more reasonable return, generated over as much as five years.

"The bubble had the effect of making people

think about funding as short-term investments, which had never happened before," says Jonathan Silver, managing director of Core Capital, a VC firm. "I think all of that bubble excess has now been wrung out of the system, and we're back to looking for ways to commercialize important technologies."

In fact, though many venture funds have been devastated over the past few years, the industry hasn't stopped spending. Last year, VC firms forked over $21 billion to start-ups, a healthy level by historical standards. "If you set aside the bubble years of 1999 and 2000, VC has steadily risen over the past 20 years, from tiny amounts of money -- in the range of $500 million a year in the '80s -- to today's $21 billion," says Kirk Walden, director of venture capital research for PriceWaterhouseCoopers.

"If VCs were bearish on technology, they would not be investing in new companies that have not received venture funding before," points out Walden. "And in fact, they continue to do that, at a proportion that's about the same as over the last two or three years." First-time recipients account for about a quarter of funded companies.

Less Upfront

But in a reflection of the industry's renewed pragmatism, the substance of investments has changed markedly from a few years ago. The portion of investments earmarked for capital-intensive industries like telecom has dwindled, as venture capitalists set their sights on areas that demand less up-front investment in exchange for fatter returns, like software.

In 2002, the biggest portion of new money went to biotech and medical devices, which accounted for 22% of VC funding, up from 13% in 2001. Software was close behind with 20% of investments, while telecom accounted for 14% and networking for 11%.

Venture capitalists say some of the most promising areas of investment are Web services, enterprise software and biosciences. E-commerce and online content, erstwhile darlings of the boom era, remain in the doghouse.

One surprising takeaway: Despite renewed emphasis on investments with solid fundamentals, funding continues to flow to early-stage start-ups that may be years away from marketing products. Ted Schell, a partner at Apax Partners, says about a third of the firm's investments are earmarked for such companies -- a portion that hasn't really changed over time. To some degree, he says, investors must take it as an "article of faith that if the technology is really good and as disruptive as they think, when it goes to market in two or three years, we'll be at a different point in the economic cycle" and the companies will have a decent shot at selling their products.

Nano, Nano

Among early-stage companies, Apax has investments in start-ups focusing on Web services, nanotechnology and genome research. In Web services, Confluent Software markets a platform to make it easier for different types of software applications to talk to each other; Nanomix, a nanotech outfit, boosts the sensitivity of chemical sensors.

Nanotechnology, a blanket term for applications based on tiny devices measuring in the billionths of a meter, has been attracting a fair amount of investment attention. Out of the $21 billion in venture capital funding for 2002, nano and micro technologies received around $700 million in investments, estimates PricewaterhouseCoopers.

Still, some venture capitalists are taking a wait-and-see approach. "Many people are beginning to invest in nanotechnology. I'm not convinced," says Silver. "I think there will be many opportunities two or three or four years from now as it becomes more commercially viable."

Another area with plenty of buzz is security -- but unlike nanotechnology, there's a ready market for network security applications. Last year, security-related technology garnered $900 million to $1 billion in venture investments. Silver's Core Capital has a stake in two such companies: Ecutel, which sells Virtual Private Network (VPN) software to connect on-the-go employees to their office network, and Sourcefire, which provides network security against hackers.

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Still, investors can't single out any one technology that offers hell-for-leather, boom-market growth prospects. "Everybody would love to find the next personal computer or the next Internet, except without the hype. But I'm afraid I don't know what that is, and I don't know that anybody else knows yet," says Walden.

Pink Slips Instead of Cash

Silicon Valley's focus is again on technology, meaning the slide rule set is slowly resuming its historic place in the pecking order, having been overshadowed by management types in the late '90s. "In a world where substance matters more than style, engineers will do better than biz development people," sums up Roger McNamee, co-founder of Silver Lake Partners, a venture capital firm with stakes in

Flextronics

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,

Riverstone Networks

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, among others.

VC firms, too, will have to undergo a right-sizing similar to the tech industry's. "I think by the time the dust settles, 50% of all venture funds will go out of business," predicts Silver. "There's still more of the shakeout to come."

Though they've lowered their sights, VC firms still haven't found enough promising investments to spend down the massive backlog of cash accumulated in the boom years -- estimated at between $40 billion and $70 billion.

As much as anything, the overhang shows the chasm between late-90s tech hopes and early 2000's investing reality. It will take probably at least a few years to close the gap, as venture firms scout out candidates that meet their tightened standards.

But the positive takeaway is that, amid a far more discriminating investment climate, venture investing is becoming rational again.

Down the road that means good news for tech investors, because venture capitalists say the quality of start-up ideas and entrepreneurs is on the upswing. "What VCs see is much more attractive than it was a year or two ago," says Silver. "Valuations have come down to a range that's much more reasonable. There are more opportunities to invest in companies that have fixed their business models, that have shrunk costs and developed real customers."

"We still turn down far more

proposals than we fund," says Schell. "But we see far less that are irrelevant, unsubstantiated dreams."