Canaan Strings Together Some Good News, Just as the Pressure Mounts on VC Model

Xconomy San Francisco — 

Every time I walk into a venture capitalist’s office these days, I essentially ask a polite but pointed variation of the same question, which boils down to this:

Are you toast? Or are you becoming toast?

Luckily for the folks at Canaan Partners, they have had some incremental good news from their portfolio, which suggests this venerable fund has as good a chance as any to be one of the survivors of the existential crisis in venture capital. Wende Hutton, a general partner with Canaan who’s been on board with the Menlo Park, CA firm since 1993, walked me through a laundry list of 14 encouraging news events from the first quarter, including three portfolio companies that are lined up to go public.

“We have had a lot of good news in our portfolio, particularly in the healthcare side,” Hutton says.

The timing couldn’t be better for a fund like Canaan to generate some good news. Venture capital has endured what some call a “lost decade” of lousy returns, which has put more pressure on VCs than ever to justify their existence to their big pension and endowment backers. Few VC firms dared to try to raise new funds in 2009 and 2010, when those pensions and endowments were feeling stung by losses in the stock market. Many VCs are expecting a mad dash on the fundraising circuit this year and in 2012, and those who don’t have a good story to tell are likely to wither and die. Estimates are that at least one-fourth or one-third of firms will simply fade away because they can’t raise more money.

Canaan has seen its share of cycles. It got started in 1987, and has raised a total of $3 billion through eight funds. The latest, a $650 million fund, was pulled together during a fortuitous moment in February 2008, before Bear Stearns, Fannie, Freddie, AIG etc. made the financial news pages into a horror movie.

When the stock market crashed and sent its shock waves through venture capital, Canaan was able “to take our foot off the gas,” Hutton says. That meant it treaded extra carefully in certain sectors that were hardest hit, and continue to reserve its capital for portfolio companies that really were hitting their milestones, Hutton says.

Wende Hutton

That might buy some time, but there’s no getting around the fact that some serious returns are going to have to materialize in the not-too-distant-future if funds like Canaan want to stay relevant in the future.

That’s why the latest news flow is so important—and perhaps why Hutton didn’t hide away from my meeting request. Three of Canaan’s portfolio companies—San Diego-based The Active Network, Westport, CT-based Advanced BioHealing, and Sunnyvale, CA-based Cortina Systems—have filed prospectuses with the Securities and Exchange Commission to go public. There’s no guarantee that any of these companies will generate liquid returns, but they all have a chance to do that in 2011. All three companies say they have generated more than $100 million in revenue in the past year, although only one (Advanced BioHealing) turned a profit in the most recent year, according to regulatory filings.

Besides the obvious potential for returns from those companies, the healthcare portfolio has shown some other encouraging signs. Five of Canaan’s life sciences companies secured non-dilutive financing during the first quarter, which essentially provides cash that helps make the companies more valuable without diluting the value of VC ownership stakes. Examples include Theraclone Sciences‘ potential $632 million partnership with Pfizer, a $10 million investment from the Bill & Melinda Gates Foundation in Liquidia Technologies, and a $118 million award for VaxInnate from BARDA, a biodefense research group within the U.S. Department of Health and Human Services.

“To us, this reflects that these companies are perceived as having high value programs,” Hutton says.

Canaan aims to put about one-third of its capital into healthcare, and it’s clear that healthcare has got its work cut out if it wants to compete with tech as a sector. New drugs and devices take a lot of capital, and a long time to pan out, if ever. That’s not exactly a recipe for success when VC firms are looking for returns next quarter or next year—not five years from today.

Compounding matters, the life sciences IPO market has rewarded those brave enough to take the plunge with pretty anemic valuations. There have been a few lucrative acquisitions lately—BioVex, Calistoga Pharmaceuticals, and Plexxikon to name a few—but most of the time really successful biotech investments generate 5- to 8-fold returns on investment, Hutton says. That means the winners aren’t that huge, and they often don’t hit big enough to offset all the losses that make a fund look bad.

“You might get several 3-to-5x returns in a biotech portfolio,” Hutton says. “You need several of those, because it’s not like what you might see in IT, where one Facebook can wipe away a lot of ills. We don’t have that luxury. We’ve got to drive value throughout the healthcare portfolio.”

That’s why looking at the whole portfolio is important. While encouraging, none of the companies mentioned above has yet matured to generate liquid returns that pensions and endowments want to see.

Here’s basically how the math has to work. In a fund like Canaan’s most recent one, with $650 million, it plans to make about 40 investments in private companies. The usual VC rule of thumb is that at least one out of every 10 should be a hit. So that means Canaan needs to have at least four or five hits in its current portfolio, and, one would hope, an internal rate of return that can stack up favorably against the S&P 500. One of the keys here, Hutton says, is to show that the firm doesn’t strike out very often.

“We think there’s still a great story to tell in venture if you can produce multiple winners in a single fund. That’s a believable story,” Hutton says. “If you have one winner against a bad backdrop, it’s hard for investors to say that’s a model that will work for them. One winner is hard to invest in.”

When I asked Hutton if she thinks there will be four or five winners in the current Canaan fund, she didn’t duck the question

“We think there will be a lot more than that,” she says.