Northwest VCs See Existential Threat, and a Change in the Entrepreneurial Mindset

Xconomy Seattle — 

Money keeps going in, but it isn’t coming out. If you’re a venture capitalist, this is what you call a serious problem.

Innovation will go on. So will entrepreneurship. But when I spoke to a handful of venture capitalists yesterday morning about the trends in their industry, and about their role in financing startups, they were fairly candid that they need to start hitting some paydays soon, or find new strategic paths pretty quick, if they themselves are all going to make it.

This didn’t strike me as some kind of self-pity, or grandstanding act, but rather sounded more like a sober analysis of what needs to change in order for this high-risk, high-reward group to survive amid the context of all the other places where people can put money—stocks, bonds, money markets, real estate, etc. Since we’ve had VC on the brain from national and local quarterly reports this week, I sought some color commentary from three of the more active VCs in Seattle—Andy Dale of Buerk Dale Victor, Greg Gottesman of Madrona Venture Group, and Thong Le of WRF Capital.

Dale had sort of a good news/bad news take on the VC industry. On the good side, he found that 10 of the 15 members of the Evergreen Venture Capital Association made investments during the quarter, so that at least suggests they aren’t in “Walking Dead” territory, as PE Hub’s Dan Primack likes to put it. Polaris Venture Partners saw one of its portfolio companies, Woburn, MA-based, go public. Probably the most encouraging thing he cited on the Northwest investing scene came in May when the Alliance of Angels assembled a $4.25 million seed fund for startups at their most formative stages.

Then again, there was plenty to worry about. There weren’t many first-time financings, and most money went to follow-on deals, Dale says. But the real part that keeps the VCs up at night, is still that they lack much realistic hope for an “exit.” The market for initial public offerings still hasn’t perked up, and few big companies have been willing to pay much to take over small, innovative startups. A year ago, VCs had some hope that hedge funds or larger private equity players might swoop in and create demand to buy companies at a pre-IPO stage, providing returns on their investments, but that idea has fizzled now that those asset classes are fretting over the prospect of increased regulation from Washington DC. There really aren’t many places a VC can turn to make a buck, from the sound of it.

“The real question is how are we as venture firms going to get returns for our investors,” Dale says. “It’s a critical issue for all of us. If we don’t generate returns for our limited partner investors, it’s tough to justify the asset class.”

So VC funds are carefully watching their cash balances, trying to wring maximum bang out of the bucks they have left, knowing full well that they might have a hard time raising their next fund. Edgy as the feeling may be, the mood among VC’s seems to be better now than it was in late 2008 and the first couple months of this year, Madrona’s Gottesman says.

“There was a time then, I don’t care which sector of the financial industry you were working in, you had to wonder if the sky was falling on the overall economy,” Gottesman says. “But the sky hasn’t fallen.”

OK, so what are the VCs doing to adapt? They’re doing what they always do—watching trends in innovation, looking for big moneymaking opportunities. And there are still innovative things to capitalize on. The shift toward cloud computing, in which businesses rent low-cost, high-powered remote servers to do Internet business, instead of paying for equipment themselves, represents a “fundamental change” in how companies can make an impact with less capital, Gottesman says. Another seismic shift is happening with social networking, in which savvy companies are using Twitter and Facebook and other sites to better engage with customers and build their brands.

Before I could even ask the obvious follow-up—about how those companies don’t yet make money—he beat me to the punch. “The thing that still keeps me up at night are the exit markets,” Gottesman says. “We have not had a strong IPO market for a very long time. The M&A market is still soft too,” he says.

So this is forcing VCs to do more than the usual amount of penny-counting on the financial statements of their portfolio companies. The emphasis, in the IT world, is now on finding ways to get a product on the market and boost revenue earlier in a company’s life, in order to slow the cash bleeding while product development continues, Dale says. “Get to market quick, and get paid, versus trying to perfect it first,” Gottesman says.

Animoto, a recent Madrona investment, is an example of what the firm is looking for in the current cash-constrained environment. The New York-based company has a product, and was profitable at the time it collected more capital for expansion, Gottesman says. Madrona was impressed by its “early customer traction,” as he put it. Same goes for Seattle-area startups Apptio, AdReady, and BuddyTV. “All of them are trying to do more with less,” Gottesman says.

The same cash-conservation ethic has spread to life sciences, even though the sector traditionally requires much more capital and longer product development timelines, Le says. VCs have gotten more serious about the “virtual” company model, in which a small group of core managers control a company’s IP and strategy, while outsourcing all kinds of essential tasks that require infrastructure and equipment, like animal testing. WRF participated in one of these investments, San Francisco-based Hyperion Therapeutics, which nabbed $60 million for late-stage drug development, even though the company only has about 10 employees, Le says. (Another recent virtual company hit, BiPar Sciences, was a big winner earlier this year for Paul Allen’s Vulcan Capital).

“People are now looking for more capital-efficient models,” Le says. “Gone are the days when you could raise $100 million and hope for a 4-to-6 time return.” Instead, biotech startups are looking to find ways to get partners to pay more of the R&D bills, until they can generate enough evidence their drug or device works, and that it can go on to win more venture funding.

All of this scrounging around for cash is having a psychological effect on entrepreneurs, and it may not all be bad for innovation from the sounds of it.

“The mindset of the entrepreneur has changed,” Gottesman says. “In IT, there’s more of a sense that you need to get to cash flow positive as quickly as possible. It’s a control-your-own-destiny mentality. That’s versus the attitude you might have seen in frothier times, which was that there’s always more money around the corner, so grow, grow, grow at all costs.”

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