Are VC’s losing their mojo?

It's time to talk about Decision 2008, and I don't mean who should be president. The more pertinent decision for entrepreneurs is how to fund their startups.

There’s no simple formula to determine whether you should bootstrap, raise angel money or take a venture capital round, and a changing landscape has complicated the decision.

Angel investors are committing larger amounts of capital in more-sophisticated financing rounds.  At the same time, some venture capital firms are moving downstream, putting smaller amounts of  money to work while fighting to get in earlier on the best deals. And the falling cost of starting a company has let many Internet engineers move forward with developing and launching a product even before they have to raise money.

With Web 2.0 entrepreneurs gaining more ownership, and thus more power to make decisions, it seems big money has lost its sex appeal. It has me wondering: are venture capitalists losing their power and prestige?

"Entrepreneurs can now dictate the terms and they’re getting multiple term sheets,” says Bill Rodini, Managing Partner at Revolution Partners, an investment bank specializing in mergers and acquisitions and private capital fundraising.

Because the pendulum is swinging towards the entrepreneurs, venture capital firms are forced to compete for fewer deals, Rodini says.

"There is a lot of money out there and a limited number of high-quality deals, so it’s inevitable that the power shifts. What happens over time is that this competition reduces returns because VC’s are paying more for these deals,” he says.

Could valuations go through the roof, just like our gas prices have lately?  Given the valuations placed on companies like Ning and Slide, some would argue that they already have.

And that's with some of the best-known VC shops sitting on the sidelines.  

“The typical big venture capital shops aren’t thriving in the interactive space,” said Sarah Lacy, author of Once You’re Lucky, Twice You’re Good: The Rebirth of Silicon Valley and the Rise of Web 2.0. ”Just look at Ning, which was bootstrapped, and Slide, which used one venture capital round and then went to work with partners on Wall Street.”

One VC sees it as the sign of a healthy marketplace. 

“I don’t necessarily see a shift in power, but rather a checks and balance between the venture capitalist and the entrepreneur,” said Jai Choi, Principal at Partech International, which is invested in RockYou and Spoke Software. “It’s a simple concept of supply and demand. The options available to consumer Internet entrepreneurs have allowed a more balanced view of capital and resources.”

Startup founders, such as Triggit’s Susan Coelius Keplinger, are grateful for this longer list of options. Triggit secured a seed round in the form of a convertible note from Bay Partners, a San Francisco venture firm.  

“We decided not to pursue a full round because of all the complexities involved in such a decision. From valuation, to board seats and control, we realized Triggit was not ready for that step,” said Keplinger.

“A convertible note provided a great alternative – a smaller amount of money but it still enabled us to get our feet wet with the venture community and begin pumping larger sums of money into our company.”

This “pump a little, drive a little, pump some more, drive some more” strategy is one of the interesting trends I’ve witnessed recently. Another, likely caused by the recession, is creative sourcing. Similar to how Internet startups are able to quickly secure revenue from various sources, it seems they’re also learning how to build an investment structure from different sources, thereby forcing the venture capitalists to strengthen their offers and prove their value-add. As long as these sources don’t conflict, this combo platter could play out in everyone’s favor.

Hope Schultz, founder of WebVet, an online resource for pet owners, pointed out another trend: a huge difference in attitude between east coast investors and west coast investors.

“It seems east coast venture capitalists prefer more conservative, realistic projections and west coast venture capitalists want projections of a $100 million business in five years. East coast investors freak out when they see the ‘hockey stick’ projections,” said Schultz.

It’s up for debate what will happen to the once-hot Silicon Valley venture funds in the next few years. Some expect the large, reputable funds will weather the storm because of the intellectual capacity of their team, while others believe success depends on specific strategies, market coverage or geographies.

Partech’s Choi thinks that the venture capitalists who are more mindful of customer service will be the ones who survive long-term.

“My personal belief is that this is a service-driven business. We‘re not celebrities or rock stars; the entrepreneurs are,” said Choi. “We get a bad wrap due to the confident nature of partners and investment professionals.”

Thank you Jai – you said it so I didn’t have to.