The 2008 Venture Capital Outlook

(page 2 of 2)

And the median time from a startup's founding to its IPO stretched to nearly eight years during the first three quarters of 2007, up from about six in 2005 and four in 1999. That means VCs will need to crack the whip on underperforming investments. "You've got to force them to make a move or get rid of them," says NVCA President Mark Heesen.

A tepid IPO market makes it harder to reap the kind of returns that VCs count on to offset the bad bets in their portfolio. They made at least 10 times their initial investment on just 27 of 135, or 20%, of their portfolio companies that were sold for disclosed amounts through Dec. 21, according to the NVCA and Thomson Financial.That's slightly higher than in 2006 but well short of the 45% of deals in 2000 that yielded a tenfold or higher return.

Reining in Rollups

That sluggish IPO environment has another effect as well: It reduces VCs' leverage to get the best prices for their companies out of big corporate acquirers like Microsoft (MSFT) and Cisco Systems (CSCO). "It's the IPO exuberance that drives up the value on the M&A side," says Davidson at VantagePoint.

True, tech vendors are still paying top dollar for startups that specialize in hotly contested areas such as online advertising and virtual-machine software, which can reduce the number of servers companies need to maintain. Yahoo's (YHOO) $680 million acquisition of Internet advertising startup Right Media netted its backers 45 times their initial investment, and Microsoft, Google (GOOG), AOL (TWX), and IAC/InteractiveCorp (IACI) have been heavy acquirers in the sector. On Nov. 5, Dell (DELL) paid $1.4 billion in cash for storage company EqualLogic. Standard & Poor's, which, like BusinessWeek.com, is owned by McGraw-Hill (MHP), predicts technology companies' 2008 operating earnings per share will rise by 24% (BusinessWeek.com, 12/14/07) compared with a 15% gain for the S&P 500.

However, tighter credit has curtailed "rollup" buyouts in which private equity firms purchase a tech company that's strong in a given area, then buy smaller startups that complement it to create a new company. That has closed down one avenue for VCs to cash out of their positions. "There's certainly going to be less leverage available," says Farrington. "Money won't be as easy in the future, and that usually hits the M&A market at some point."

Working Out the Business Model

As VCs try to sell or take public their best-performing Web companies, and foster new ones for the future, they'll need to keep a close eye on how the performance of the U.S. economy affects online spending. If consumer sentiment keeps eroding and business confidence slips, investors could discount Web startups on lower expectations for growth. "When you're buying a startup, you're buying the future," says Will Price, a managing director at Hummer Winblad Venture Partners. "If there's a fall in business or consumer sentiment, there could be a falloff in the online ad market. The difference between a company growing at 50% and 15% is huge."

Here's something else to consider about those hot Web companies: Some still haven't settled on a business model. Social networking site Facebook's rough start with its Beacon purchase-tracking ad system, (BusinessWeek.com, 11/30/07) for instance, may dampen enthusiasm for companies that are banking on selling ads on the networks. "People are going to have to be extremely careful about how they monetize these Internet communities," says StarVest's Farrington. "People are going to have to be careful about killing the goose that laid the golden egg."

Ricadela is a writer for BusinessWeek.com in Silicon Valley.