VCs’ Confidence Crisis

In our industry, we live on innovation, and innovation takes capital — something that has been in short supply over the last couple of years. Venture funding took a massive hit in 2009, but there are signs that the trend might be bottoming out. If it is, we might all learn to exhale again.

According to an article at BloggingStocks.com, a recent report “… from PricewaterhouseCoopers and the National Venture Capital Association (using data from Thomson Reuters) pegs total investment in startups for the fourth quarter of 2009 at (US)$5.02 billion, a decline of 2 percent from the third quarter. Year-over-year, it represents a plunge of 14 percent. “

Most revealing was this: “For the entirety of 2009, VC investments fell 37 percent to $17.7 million, its lowest level since 1997. Essentially, VC activity receded to pre-dot-com boom levels. At the peak of the dot-com economy, VC funding was more than five times greater, reaching $100 million in 2000.”

Yikes! 1997! How many of us were doing what we do now then? Those 13 years are an eternity in this business.

But, as they say in the infomercials, there’s more. According to an article in siliconvalley.com, “The $17.7 billion in new investments in startups contrasts with $15.2 billion in new commitments to venture funds during 2009. The amount of commitment was nearly $21 billion below the $36.1 billion raised in 2007, before the start of the financial crisis, and $13.3 billion less than the $28.6 billion raised in 2008, when pension funds and university endowments curtailed their venture investments.”

Did I read that right? The VCs took in less than they invested?!

Cycle of Innovation

It would take a lot for me to lament the plight of venture capitalists, and we are not there yet, but this data does give me some major concern for those people trying to start companies to invent the future. Clearly we are in a VC slump, and it is just as clear to me that there is a certain seasonality to this kind of investing.

Big investment is driven by major changes or transformations in the economy. You and I might not see or understand these transformations, but it is the job of venture capitalists and others to look for telltale signs and act accordingly. For instance, when the CPU chip was invented or on-demand computing came about, the inventions spawned multiple category invention to take advantage of the original innovations.

The CPU chip cratered the cost of computing, making all manner of devices possible that were once limited by cost. The chip also made it possible for subsequent generations of dreamers to think up more ways to use computing power. The net result was a virtuous circle of innovation, investment and new products.

Crisis of Confidence

Today’s relative plunge in investment is more than an indication of tight credit or a recession. I think there’s more going on. By definition, the money you give to the VCs is money you have a reasonable expectation of losing. If one in 10 VC investments pans out to the point of a liquidity event — such as an IPO or acquisition — French champagne flows. However, more typically, everyone is drinking diet sodas with pizza in an all-nighter to get a product to work.

So my point is that if money is not flowing into VC funds, it is not the result of a credit crisis, because venture investment is discretionary. It is more likely a crisis of confidence and a crisis of new ideas and that won’t be repaired by pouring money on Silicon Valley.

To be sure, there are ideas out there, and a sure sign of a recovery happens when investors start coming back. For me, I like to watch what’s happening to later-stage companies, the ones that need a B or C round of funding. At least in SaaS computing, that seems to be where money is going. I don’t have more than anecdotal evidence — i.e. what people tell me, not official statistics — to back this up.

Nonetheless, it would make sense. B- and C-round companies are much more mature and closer to the liquidity event horizon, hence the possibility of a payout is closer. However, there are only so many companies, and there is still a good deal of cash to be invested, so sooner or later, investors will again have to look at A round opportunities.

While many fields might get a share of the VC pie — green tech, bio tech and others — I think there are still great opportunities in CRM. I believe we are at a point when much of what we do will need to be rethought. A new level of sophistication in our business processes supported by a consolidation in software functions beckons. I just wish it would hurry up.