The tech sector's silent alarm: Venture capital drying up

The tech sector is experiencing a crash -- not of stock prices, which rebounded somewhat on Wall Street on Tuesday -- but in its ability to take new companies public.

So far this year, there have been just six venture-backed Initial Public Offers (IPOs); last year, there were 86, according to the US National Venture Capital Association (NVCA). The recent collapse of investment banks Lehman Brothers and Bear Stearns is exacerbating the problem.

Last week, the NVCA's board, whose members include leading venture capital firms, agreed to create several blue ribbon committees to investigate the causes behind the dramatic decline in IPOs. Whether the falloff is due to regulation that emerged after the dot-com bust or the recent failure of investments banks, the committees are charged with recommending fixes that would get venture capital flowing again.

If there are no IPOs, "the economy as a whole starts to stagnate, because these are the companies that really create jobs and move the economy at the end of the day," said Mark Heesen, president of the NVCA.

There were no venture-backed IPOs issued in the second quarter of this year -- the first time that's happened since 1978. In announcing those results in July (download PDF), Heesen said it indicated a serious problem for the economy. "We view this quarter as 'the canary in the coal mine."

Two months later the world found out what killed the canary.

PricewaterhouseCoopers, in a report released Monday (download PDF), said the venture-backed IPO market is now at a 30-year low -- even though venture capital firms are continuing to invest and "raising funds at a steady pace." That means it may take longer for a company to move to a public offering, but the firm will be "even more stable" once the IPO takes place.

Venture capital can be a risky business, with IPOs often the payoff for an investment. So it's not surprising that venture capital firms have continued to make substantial investments in new firms, such as Facebook. In the second quarter of this year, venture capitalists invested US$7.4 billion in 990 deals, with the software industry getting 219 deals valued at US$1.25 billion. But if it becomes increasingly difficult to take companies public, it may become harder for start-ups to get funding.

In the dot-com era, Silicon Valley's tech industry had ready access to boutique investment firms that were ultimately taken over by the big New York firms, said Mark Jensen, national managing partner of Deloitte's Venture Capital Services. With Lehman and Bear Stearns now gone, "that's a radical transformation on Wall Street that we're just beginning to see and think about what the consequences will be."

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Jensen said he has clients who are now considering taking offerings to foreign exchanges in a bid to raise capital. New firms may also draw money and acquisitions from sovereign wealth funds from other countries such as Persian Gulf nations. "This is an issue that needs to be addressed - it speaks to the overall competitiveness of the United States," said Jensen.

Venture capital has been flowing in India, which is also seeing large growth in venture-back firms.

For technology users, according to Frank Scavo, president of IT market research firm Computer Economics, the issue of IPO funding is a strategic one. If small innovative technology companies can't be funded, larger vendors won't face as much pressure to similarly innovate "and they will have a more dominant position than they have today." That, said Scavo, is a long-term view.

For startups now in search of funds, private equity firms like Warren Buffett's US$5 billion investment, via his Berkshire Hathaway, in Goldman Sachs, means money for investments is still available, said Scavo.

The dot-com boom, which lasted from the mid-1990s through about 2001, saw the influence of hundreds of venture-backed firms that led to IPOs. Access to capital gives these firms the financial heft they need to challenge established firms with new technologies and approaches. Many venture-backed firms failed in the dot-com era, but some of the successes were spectacular. The best-known example: Google, which was founded 10 years ago and went public in 2004.

In the short-run, demand for technology will continue, even among technology-intensive financial services companies facing other financial woes, said Scavo. "You can't just stop spending on IT," he said.

But if companies can't get access to the credit they need to buy large systems, "you may see a pullback on new initiatives...," said Scavo. Nerves will also play a role. "The events of this week make everyone nervous and when executives are nervous they tend to defer decisions on spending," he said.

Another potential source of funding for tech firms is the US government, especially if it boosts funding in alternative, clean-energy technologies. But those investments "could conceivably be a casualty of roaring budget deficits," said Stephen Levy, director and senior economist of the Center for Continuing Study of the California Economy (CCSCE).