What Will VCs Do Now?

April / May 2009 By: Dean Takahashi Volume 7 Number 2

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Ajay Chopra, a general partner at Silicon Valley venture capital firm Trinity Ventures, is fond of the old saying, "When the tide goes out, you can see who isn't wearing any underwear."

In Silicon Valley, the recession has brought about a great sorting. We can see who has underwear, and who doesn't. The picture isn't pretty. It's getting tougher and tougher to raise money. The mood is one of extreme caution. The outlook for some sectors such as web advertising sales is getting worse, prompting some startups, such as Home-Account, a mortgage financing web site, to do the unthinkable: abandoning the ad-based model and charging subscriptions instead.

In 2008, venture capitalists invested $28.3 billion in 3,808 deals. That was down 8 percent in dollars and 4 percent in deals from 2007, according to PricewaterhouseCoopers and the National Venture Capital Association. That was the first decline since 2003, and 2009 is widely expected to be worse than 2008.
Christine Herron, a principal at First Round Capital, says she starts off each board meeting by asking how much cash a startup has and how many weeks it will last.

"It tells you how many weeks you have to get done the things you need to do," Herron said during a panel at the recent DEMO tech conference in Palm Desert, Calif.

The VCs are flying toward quality, or the best companies. Chopra said the name of the game now is capital efficiency. Startups have to go a long way with what they've got, perhaps as much as 18 months. Companies with traction, sound business models and some runway will look attractive. Chopra says his limited partners aren't paying him to sit on money. Proven entrepreneurs with good ideas are worth betting on. The companies need to have a plan for two or three years down the road.

Eric Zimits, a managing director at Granite Ventures, said that limited partners aren't paying the VCs to hide under desks. He is more sensitive to the environment, capital intensity, co-investors. Basically, he has to make sure that the people he is in the boat with are going to stick it out for the long run.

And Michel Wendell, general partner at Nexit Ventures, said that VCs are still looking for companies who don't need to have a product on the market in the next 12 months. That is to say, if a company gets a seed round now, it won't be surfacing with a product for some time. The companies that need more funding to get a product to market in the near term are the ones that are in a tough spot, Wendell said. Those companies will have the hardest time raising money and will have an equally hard time launching a product right now. Within the telecom sector, Wendell said that WiMax was obviously taking a hit, as evidenced by Intel's decision to write off $1 billion in its investment in WiMax service provider Clearwire.

Chopra invested in MyNewPlace, an apartment finder company. Trinity figured it would be a good investment in 2007 because people were just beginning to lose their homes to foreclosures. Another one is Bill Shrink, which helps you shrink your various monthly bills based on your usage behavior. It can cut your mobile phone bill, for instance, by making recommendations for better rate plans.
Zimits said that the telecom had a lot of momentum going into the dotcom boom.
Then it all fell apart and slowed down. The internet is still growing, but not at a pace that justifies wild enthusiasm for some of the infrastructure players. He said there is still a lot of opportunity in the mobile device markets.
Carriers are managing the relative openness of their networks very carefully so that they don't become marginalized as owners of pipes. Mobility, home entertainment services, connected TV and home networks look interesting to Zimits.

Upgrading the internet so it can handle the delivery of high-definition video over the web is an area where Chopra has invested. Most of those investments are in software companies that don't require tons of capital. Zimits said that he believes that viewers are ready to watch video from the web on their TVs. They don't mind going to sites like Hulu.com or YouTube where they can bypass traditional programmed content.

Wendell said that the question is what's the business model that can properly deliver that content to consumers. People now want the freedom to consume content any way or anywhere they want. Those who limit the free flow of content are standing in the way.

Wendell believes that open source companies will be trendy. His firm invested in Funambol, which uses open source technology to make email available on thousands of handsets as cheaply and efficiently as possible. Zimits recently invested in Lucid Imagination, based on the Lucene open source technology behind enterprise search. A lot of big enterprises, like Netflix, have built their products around open-source search based on Lucene. Lucid Imagination helps support companies using Lucene.

Granite invested in Quantance, an analog chip maker. VCs are running away as fast as possible from chip investments. But Zimits bet on them because they are in the analog/RF chip space, where the skill of the chip designers is really important, not the number of chip designers. Quantance got its first chip done with just a dozen people. The key is that the talented veterans are able to be creative and capital efficient.

Zimits said that the definition of early stage companies has changed and VCs are now steering toward some of those companies now, since those companies won't depend on launching in a healthy market for a few years from now. Chopra said that early stage companies are competing with late-stage, heavily discounted deals now. Wendell says his venture fund is also starting its own companies, writing the business plans, and getting the ideas into good shape.

While getting eyeballs and users was the name of the game in the past few years, now the big emphasis is on getting customer traction and profitability.

There are some islands of stability. The video game and virtual world industries raised more than $885 million in 2008, according to VentureBeat. Game sales grew 13 percent in January at a time when almost all other industries were shrinking. That has led to more VC activity in the game business.

Tim Chang, a principal at Norwest Venture Partners, says some parts of the market are cooling off, such as the market for placing ads inside games. That market saw its mad rush of startups a few years ago. In the past year, a lot of casual game companies—€”making games for short duration play, aimed more at mothers than hardcore gamers—€”have received a lot of funding. So have online fantasy worlds and social games.

As VCs flee other areas such as enterprise software and chips, Chang says more of them are pivoting into games, temporarily flooding the market with cash. But despite this dumb money coming into games, Chang is bullish on the sector. He thinks that the combination of traditional games and social networks will produce big success stories, and he is confident that the iPhone game market will become a juggernaut. Too bad the game industry can't save the whole tech industry. But at least it can distract us all from our sorrows.

Dean Takahashi is lead writer for digital media at VentureBeat.com and reports from Silicon Valley for Innovation.