Venture firms have too much capital

Aug. 4 - With the stock market reeling and the late-90s tech bubble still unwinding, this is not a great time to be launching a technology start-up. Deal making is so slow, in fact, that venture capital firms are giving money back to investors — uninvested.

AFTER RAISING some $150 billion during the speculative fever of 1999 and 2000, venture capital firms now have the unexpected problem of not knowing what to do with all that cash. Some $90 billion — more than all the money raised during the rest of the decade — is sitting on the sidelines, according to Jesse Reyes, who tracks venture funding at Thomson Venture Economics.

As a result, venture capital firms have begun telling investors they’re not going to need all that money after all. The list of firms returning unspent money to their investors include some of the venture capital world’s leading firms, including Accel Partners, which has downsized a $1.4 billion war chest by $450 million, according to Reyes. Kleiner Perkins sent back $160 million of $630 million it raised; Austin Ventures released $670 million of a $1.5 billion fund.

In the first quarter of this year, nearly $5 billion was sent back to investors — more than was raised in new investments, according to Reyes. That’s the first time, in the two decades the numbers have been collected, that that the industry has seen a net outflow of money back to investors, who are mostly institutional money managers

The givebacks represent an immediate loss to the venture capital industry. Though the money is actually held by investors until it’s needed it for investment, venture firms charge of a fee of about 2 percent on cash that has been committed to their fund. With billions lying around unspent — but still subject to fees — investors began complaining.

“It’s not obvious where that money will get deployed,” said Ed Kania, a partner at FlagshipVentures. “There are no hot sectors. There are no obvious revolutions occurring.”

You can also blame the collapse of the telecom industry and sharp cuts in spending by businesses for the dearth of new deals to invest in.

Gone are the days when emerging companies with a bold idea got funded with the hope of, someday, finding a market. Today’s start-ups need to show backers exactly how they’re going to get into the black — quickly.

“There’s this incredible concept called cash-flow positive,” said Kirk Walden, who follows venture capital spending at PriceWaterhouseCoopers. “That will keep you afloat for a pretty good while.”

And with so few survivors from the dot-com era still standing, venture capitalists have become understandably gun-shy.

“There’s a general loss of confidence by firms and individuals at their ability to pick winners,” said Kania.

That’s also because most of the new deals that do get done are going nowhere. New companies now find that public stock offerings, once the source of the moonshot IPOs that inflated the tech bubble, are no longer an option, according to David Menlow, president of the IPO Network.

“This is a horrible time for any company to come public because the valuations are so low,” he said.

Meanwhile, large corporations — traditionally buyers of hot new companies — aren’t biting, as they sit on their capital until the business outlook becomes clearer.

All of which has left emerging companies stuck in limbo. They’ve raised money and gotten started, but now they have figure out how to hold on until the IPO market improves.

“It hasn’t been a lot of fun,” said Todd Dagres, a partner at Battery Ventures, who says the slump has forced even the most promising emerging companies to make heavy budget cuts.

“The hope is you’re going to be one of the few left standing,” he said. “But you can’t effectively cryogenically freeze a company; it’s a living thing.”

How long will emerging companies and their investors have to keep hunkered down? Even the most optimistic observers say it will take at least another 18 months for the venture capital world to stabilize. Most agree it will take five to seven years before investors see anything like the 20 to 30 percent annual returns venture firms have historically offered.

Meanwhile, a lot of emerging companies that have yet to break even — and probably never will — are still living off dwindling piles of cash raised during the boom.

“There are still roughly 1000 companies that are going to go belly up,” said Dagres.

A few new companies are getting funding. The list, for example, includes software firms that offer customers quick gains in productivity. With low overhead, emerging software firms have a relatively quick incubation period before they start generating profits — or fold for lack of business. But much of the venture capital industry’s attention is focused on keeping their existing portfolios of companies alive.

The bleak outlook for venture capitalists is also expected to shrink the numbers of players in the field. But that process could also take years as VC firms continue to invest large piles of money raised during better times.

Insiders say firms will likely see departures from two distinct camps. One includes veterans who are rich enough to retire and just don’t want to slog through a long, painful period before the industry recovers. The other group includes newbies who flocked to high tech corridors from Silicon Valley to Boston after cashing in their own dot-com windfalls.

“The amateur hour is over,” said Dagres. “You can’t force large sums of money into investment-stage companies with five general partners and a dog.”