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Silicon Valley Venture Capitalists’ Confidence Declines to Lowest Level in Five Years

Written by Mark V. Cannice, Ph.D., Associate Professor of Entrepreneurship, University of San Francisco, as part of the Entrepreneurs Report (Winter 2008)

Confidence among consumers, executives, and other constituents of our market economy has been closely monitored for years, as confidence is thought to be a necessary element for the proper functioning of our capitalist system. Over the last 18 months as the credit crisis has taken hold, confidence in our financial institutions clearly has been tested and continues to be questioned. While the sentiment of consumers and managers does play a significant role in our prosperity, confidence among the professional investors who advise and finance the high-potential new ventures that propel entrepreneurial growth is also critical to the long-run health and competitive advantage of the U.S. economy, as it is their investment decisions that determine, in large part, the pace of innovation in our nation. However, confidence among professional venture capitalists had not been systematically tracked.

Beginning in early 2004, I began to gauge venture capitalists’ confidence in the future high-growth entrepreneurial environment in the San Francisco Bay Area with a quarterly survey and report. My expectation was that an ongoing indicator of VC sentiment could be informative to entrepreneurs who are seeking equity financing and also provide key insight to the functioning of our high-growth entrepreneurial economy. To date, I have completed 20 of these quarterly surveys and reports and thus can provide trend data in Silicon Valley venture capitalists’ confidence in addition to the current absolute level. Further, most of the responding venture capitalists provided additional insight into the reasoning behind their sentiment.

The Silicon Valley Venture Capitalist Confidence Index (Bloomberg ticker symbol: USFSVVCI) for the fourth quarter of 2008, based on a January 2009 survey of 33 San Francisco Bay Area venture capitalists, registered 2.77 on a 5 point scale (with 5 indicating high confidence and 1 indicating low confidence). This quarter’s reading fell from the previous quarter’s reading of 2.89 to a fifth consecutive new low since the Index was originated in Q1 2004 and indicates a continuing downtrend in venture capitalists’ confidence.

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The deepening global financial market turmoil and economic decline remained at center stage as a negative influence on venture capitalists’ confidence for the recent quarter. In particular, the beaten-down financial markets and the resulting negative impact of the liquidity prospects of most venture-backed portfolio firms weighed on confidence. This protracted delay of most liquidity events (both IPOs and M&As) has led to significant strain on the venture business model for the near term. While these ongoing concerns did predominate, a fundamental belief in the power of innovation, the prowess of entrepreneurs, and the unique strength of the Silicon Valley ecosystem for enterprise creation remained strong. In fact, several venture capitalists saw this harsh economic time as an ideal moment for thoughtful innovation and the creation of new products that would more directly solve customer needs. Timing, though, does appear to be central to sentiment. That is, while most respondents anticipate that 2009 will be another difficult year, the prospect of pent-up demand for new entrepreneurial ventures and investment alternatives is expected to surface by 2010. While the exact nature of the reemergence remains to be seen, lower valuations of new ventures, a laser focus on positive-cash-flow operations, and the long-term perspective of patient venture capital bodes well for an eventual recovery. Still, with the quarterly confidence index at its lowest point in its five-year history, the coming months and quarters appear to present a very challenging venture environment.

Caution has grown with the continued unraveling of the broader financial system, but hope for the medium term remains. Kirk Westbrook of invencor was concerned over the ongoing economic environment but impressed by the robust government response. He stated, “Although I believe the global economy slid to the edge of the precipice during Q4 08, I am encouraged that the atypical and expeditious reactions by governments around the world may have prevented a fall into a much darker, 30’s era economic crevice. . . . Disciplined cash focus will be mission critical, but those concerns that are good at both the management and the articulation of the value proposition will likely see opportunity in a less-cluttered environment as they move toward mid-2009.”

Stemming from the public market decline is the decreasing availability of liquidity events for venture-backed firms. To this point, Igor Sill of Geneva Venture Management argued, “We have certainly hit the low ebb of a very dry cycle period for venture liquidity as measured by IPOs. . . . With this liquidity void, we will see few, if any, new venture firms emerging, and frankly, few fundraising efforts from established firms. Some will even close down. We’ll be trying to salvage, sell, or merge the promising start-ups and dispensing with those requiring too much runway and capital to break even. As for new start-ups getting first-round funding, it will be tough going.”

Some responding venture capitalists envisioned that a new direction for the venture capital industry may emerge from the macro economic malaise. For example, Joe Mandato of De Novo Ventures stated, “Given the uncertainty in the environment, the industry is trying to figure out what its course should be in the face of this environment.” And Dan Lankford of Wavepoint Ventures explained, “[T]here is a good chance that the venture industry is ‘de-evolving’ toward its roots of small, early-stage funds where the partners made most of their money from capital appreciation.”

A Darwinian perspective was offered by some venture capitalists who expect that the current harsh environment will help identify the strongest firms with sustainable business models that make for good venture investments. For example, Eric Buatois of Sofinnova Ventures said, “In these difficult times, only strong and motivated entrepreneurs building companies on very strong foundations will get funding. We are likely to see very strong companies created in the next two years.”

And confidence in the ability of entrepreneurs to continue to innovate and in the Silicon Valley ecosystem remained strong. For instance, David Spreng of Crescendo Ventures declared, “Silicon Valley innovation and entrepreneurial spirit will help America lead the way out of economic crisis beginning in 2009, sooner than most people think.” And Shomit Ghose of Onset Ventures reasoned, “The macro economy is looking like the ‘08 Detroit Lions, with no hope of recovery till 2010 at the earliest. But Silicon Valley continues to produce entrepreneurs with the talent and drive of the ‘72 Dolphins. There are daunting challenges in the next 18 months, to be sure, but there’s also reason for optimism over the long term.”

To conclude, the continuing fallout from the credit crisis and downward economic spiral (lack of exits, squeezed capital commitments, and fewer customers for portfolio firm products) has led to the lowest level of venture capitalists’ confidence in the five-year history of this quarterly survey. Expectations for an ongoing malaise in the public capital markets and a shrinking economy portend a continued difficult operating environment for new growth enterprises and their venture backers. As some respondents have suggested, the intense economic pressures on several aspects of the venture business model may necessitate an eventual adjustment to it. And entrepreneurs, given lower public valuations, a longer holding period to liquidity, and fewer bidders, can expect more modest valuations for their enterprises. However, current increasingly stringent financing criteria and lower valuations may mean that many of today’s investments eventually will earn significantly positive returns. Further, a confidence in the resilience of entrepreneurs and the unique support structure of the Silicon Valley entrepreneurial ecosystem remains strong. This underlying confidence coupled with the belief that even stronger enterprises, tried by fire in this harsh environment, will emerge more vibrant and sustainable when the broader economic environment finally recovers, leaves cause for optimism in the long-term resilience of the Silicon Valley venture capital and entrepreneurial machine.

The complete Q4 report and historical reports may be seen at www.Cannice.net.

Dr. Mark Cannice is an associate professor of entrepreneurship at the University of San Francisco, where he has taught since 1996. He also is the founder and executive director of the USF Entrepreneurship Program. Mark publishes a quarterly report on Silicon Valley VC confidence that has been widely referenced in the business media (including the Wall Street Journal, New York Times, Bloomberg, Reuters, Investor’s Business Daily, USA Today, etc.), as well as a similar report on China VC confidence. His articles on venture capital and technology management appear in numerous academic journals; he has co-authored a textbook in global and entrepreneurial management (published by McGraw Hill in four languages); and he is a contributing writer for The Industry Standard.

Mark can be contacted at cannice@usfca.edu.