VC industry facing host of challenges

When Adeo Ressi opened up membership in TheFunded.com after an invite-only trial period, 1,000 entrepreneurs signed up to the venture capital rating Web site on the first day.

The chance to spout off about venture capital firms and their partners proved irresistible to startup executives who routinely have to parade from one firm to the other, hat in hand, asking for capital.

As personal experiences poured in about broken promises, canceled meetings or ones that venture partners spent checking BlackBerry messages while ignoring a presentation, Ressi saw confirmation of his thesis for starting TheFunded.com. After three decades in which venture firms held all the power in the fund raising game, the time had come for a change.

"The VC industry is broken," according to Ressi, who was once almost ousted by a board of directors he’d helped recruit from a prior company he founded.

Ressi was referring specifically to the dismissive way that many venture capital firms treat entrepreneurs seeking funds.

But a growing pile of evidence suggests that problems in the venture capital industry go beyond arrogance and lousy communication skills.

The second quarter of 2008 was the first in 30 years wherein not a single venture-backed company executed a successful public stock offering. That’s zip. Nada. Not a single instance of the most-profitable exit for VC firms.

The number and value of acquisitions was also down significantly from the year before, according to the National Venture Capital Association.

Worse still, venture firms are facing more competition for early-stage investments from angel investors -- and from each other, as more VC money was raised in 2007 than at any time since the bubble years. That’s driving up the price of equity.

Paying more up front, and getting fewer big exits, is depressing fund returns, with the internal rates of return, or IRR, of many funds, coming in negative in 2007, according to data reported by the University of California last September. And things have only gotten worse since then.

This comes as a growing number of funds that were raised during the boom time of 1998-2000 are at or near the end of their 10-year investment cycle.

And because many companies in those portfolios that haven’t already been acquired, gone public or turned cash-flow positive are going to need more money, venture firms will have to take out loans to keep their funds going.

In a sign of how bad things have become, the market for secondary loans and investments made to venture capital funds and startup companies is booming.  

"You're starting to see a contraction in the venture business," says Nick Sturiale, a managing director with the Carlyle Group, the global private investment firm that manages $100 billion worth of companies and capital. 

"I think you're going to see a lot of annex funds," says Sturiale, raised by second- and third-tier firms that are unable to raise new funds.

The key metric for the health of the industry, according to Sturiale, is how many partners are receiving so-called carry checks, which are paid out only after a fund makes enough profit to pay out the firm's limited partner investors.

"You probably have less than 30 guys who have gotten a carry check this year," said Sturiale, formerly of the venture firm Sevin Rosen Funds.