VC Funds: Built to Last - Industry Trend or Event

Their dot-corn investments may be going belly-up, but venture capital funds will be around for years. That doesn't mean things will be easy.

A LOT HAS CHANGED IN THE WORLD of Internet finance since NeoCarta Ventures raised its first fund last December.

Earmarking $275 million for Internet companies, NeoCarta may have been late to the VC game, but its managing directors had plenty of experience: D. Jarrett Collins and Karin Kissane were principals of TTC Ventures, the VC arm of the Thomson Corp.; Thomas Naughton and Tony Pantuso were formerly vice presidents at GE Equity, the private equity subsidiary of General Electric.

But NeoCarta had precious little time to put that money to work. Net stocks peaked only a few months later. The IPO market has since slowed to a trickle, making it harder for VCs to cash out of their investments. They now have to be more discriminating when choosing companies to back.

Unlike many of the Net startups going out of business, though, most VC firms are structured to stay solvent during economic downturns. Instead, firms like NeoCarta that have raised money in the last year face a grueling, if less dramatic, challenge: They need to show returns on their investments in a tough market before they can raise more money.

And for many companies relying on VC funding, the days of progressively larger rounds of investments are over. "Any company that does a flat round should consider that a victory," says NeoCarta's Naughton.

Conventional wisdom suggests that, as Internet startups are sent to the scrap heap -- Digital Entertainment Network, Eve.com, Scour and Urban Box Office Network have declared bankruptcy or gone out of business in the past few weeks -- the VC firms that backed them will follow.

But the fact is, VC firms aren't in danger of joining the failed dot-coms. Venture capital firms usually have about 10 years to manage their portfolios before returning money to the limited partners that invest in them. There are only a few ways that a limited partner can take invested money out of a venture fund before then.

Most VC firms sign agreements with partners that contain trigger provisions, says Jesse Reyes, a VP at research firm Venture Economics. A typical agreement says that if a fund loses 65 percent to 85 percent on its investments, a limited partner can pull out. Some provisions also say partners can pull out if a venture firm loses key personnel.'

Many VCs have been growing ever judicious about their investments this year. Instead of writing checks to startups and waiting for an IPO, VCs are going back to the time-honored practice of rolling up their sleeves and getting involved in a startup's operations.

"The job over the last five years has turned into identifying companies for the public markets," says Andy Rappaport, a partner with August Capital, a venture firm with investments in music sites Uplister and Listen.com.

Not anymore. Rappaport and other VCs say the business is in a transitional phase between the crazy days when anyone could call himself a venture capitalist and a pre-1997 sensibility of long-term mentoring of startups, using seasoned backers.

There's still too much money in the market to declare the Internet's go-go years over, but the market correction is forcing a sobriety that many VCs from the traditional firms actually find appealing.

Of 50 dominant VC firms, "none of those firms goes away," says Jon Feiber, a partner with Mohr Davidow Ventures. "There is a flight to quality in an industry contraction. So most of the strong firms get stronger in a downturn, not weaker."

Most of those established venture firms are based in Silicon Valley. And the partners at these firms have long relationships with the representatives of the traditional limited partners, like pension funds and endowments. Observers say that while the industry as a whole was hit hard by the Internet market downturn, it's not likely these limited partners will abandon venture capital because their returns have averaged 20 percent a year over the past two decades.

"Endowments, pension funds and other traditional limiteds that have been behind the older venture firms will continue to invest," predicts Jeff Brody, a partner at Redpoint Ventures.

Not all funds will be so lucky. Brody adds that the institutional investors newest to the game of investing in venture capital funds will be the first to back out. And until the IPO market turns around, many venture firms will need to nurture their portfolios, which can act as a constant drain on existing funds. Without new money, their startups could languish.

"Some people who thought venture capital was something they wanted to get into will all of a sudden think that investing in startups isn't what they thought it was," says Michael Rolnick, a partner at ComVentures. "The commitment to helping a company grow for three years is much different than investing and waiting for an IPO a year later."

Although there's little chance even newer firms could close outright, it's possible that when some of the newer Internet-dependent venture firms go out to raise another round of funding, they'll end up empty-handed.

"The last time this happened was in the 1980s," says Venture Economics' Reyes. "The IPO market went through the roof, but in 1987 the industry hit the bottom part of the cycle. Some firms couldn't raise money and simply disappeared."

One such fund was Acorn Ventures, a firm headquartered in the Houston area in the 1980s and early 1990s. Acorn was headed by former astronaut Walter Cunningham, who piloted Apollo 7.

But which firms will disappear this time around is a question VCs won't touch. But they will offer a profile: Inexperienced investors who raised money in the last two years from new limited partners and invested it primarily in consumer Web companies.

Luckily for some of the new funds, the VC world is changing back to calmer times when firms didn't rush through an entire fund in 12 months.

"In the last couple of years, it has taken firms only about a year to invest a fund, but it's changing," says Redpoint's Brody. "I like that better because I'd rather raise money every three years than fly all over the U.S. every year raising money."

That's good for firms like NeoCarta. Naughton says his firm differs from other newcomers because its partners have experience from other established firms. Also, Kissane and Collins once worked at NeoCarta's biggest limited investor, Thomson.

NeoCarta is currently "examining" raising another fund, according to Naughton, but still has half of its $300 million left from last year. He adds the firm is focusing on helping its 25 portfolio companies become profitable. But does the firm feel the need to get at least some of its companies public before it goes out to raise another round?

The issue "is in the back our minds," Naughton says. "But we're not willing to sacrifice being patient."

And while NeoCarta probably can't raise the kind of money Redpoint does -- Redpoint's partners are refugees of legacy firms Brentwood Capital and Institutional Venture Partners -- NeoCarta partners will have time to develop a few more hits. It could be worse: At least NeoCarta is already in the game.

"I wouldn't want to be out raising money for the first time right now," says Naughton.

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