Local venture capital 'insulated' from crisis?

But consumers likely to feel pinch soon, banker says

On a day when the U.S. House of Representatives rejected the Bush administration's $700 billion financial bailout plan, investors said the venture-capital industry that helps drive Palo Alto's local economy may escape crisis.

"This doesn't impact our industry directly. We're not expecting to see all our portfolio companies fail because of this," said Emily Mendell, a venture-capital industry representative.

It won't be a replay of 2000's dotcom-bust for venture investors, according to Mendell, the vice president of strategic affairs for the National Venture Capital Association. Rather, this credit crunch stems from the failure of mortgage-backed securities. It isn't a product of weaknesses in privately-held, venture-backed companies, Mendell noted, calling venture capital somewhat 'insulated' from market turmoil.

Venture investors are long-term investors, she pointed out, able to wait until market conditions improve before moving a company towards an initial public offering or a merger or acquisition, the traditional exit routes.

Green technology and biotechnology in particular may have up to 12- or 14-year periods of development before investors have planned to reap returns, she said.

But the massive engine of innovation and investment that thrives in Silicon Valley is unlikely to be completely untouched by market troubles.

Because of weak markets, the current drought of initial public offerings — at its lowest since 1978 — may continue, Mendell said. Venture investors would rather hold onto companies than try to go public in a hostile climate. And the larger firms that acquire startups may tighten belts by backing off from buying new companies. As a result, returns on venture investments could slide, as venture investors continue to prop up their holdings with cash infusions, Mendell said.

And some analysts are pointing out venture-capital firms can no longer depend on cash from troubled institutional investors such as AIG, Fannie Mae and others.

The cold climate could cause angel investors to hesitate as well, according to Gadi Behar, head of Los Altos-based angel group Silicom Ventures. The wealthy individuals who invest in startups won't necessarily pause because of personal market losses and smaller personal bank accounts, he said. But they'll wonder whether now is the right time to invest in startups, given the horrendous market climate for public offerings.

"Some people have lots of money and a few million won't make that much difference to them but it's the atmosphere," Behar described.

The Dow Jones Industrial Average plummeted 780 points following the House's rejection Monday.

Personally, Behar and other angels in his group have recently transferred investments from high-risk areas into lower-risk areas such as Treasury bonds, he said, following a springtime talk from local investor Pat Mackim. Mackim predicted bank and market failure, and while the angel group was incredulous, they were also cautious, Behar said — and reshuffled their portfolios.

Wealthy Valley denizens will eventually want to spend again, however, Behar predicted. If the cost of investing in startups drops low enough — with more supply than demand — the local innovation economy could reach an inflexion point, where investors suddenly start seeing cheap startups as bargain-basement deals. In as little as a year, local startup prices could bottom out and then rebound, the angel investor said.

Beyond that, Behar said the investment community was taken aback by the scale of recent failures, including Lehman Brothers, Freddie Mac, Fannie Mae and A.I.G., among others, as well as the conversion of investment-banking powerhouse Goldman Sachs into a deposit-taking bank.

"I think we're all in a shock period right now. The size of the problem ... takes time to digest," Behar said.

In discussions with European and Asian investors, the Israel-born Behar said the loss of confidence in American markets was striking.

"They trusted the financial system in the United States and now they don't know if they trust it anymore. Is the United States going to lead in the future? I don't know."

One Valley company has already announced layoffs. Santa Clara-based Nvidia, a visual-computing software firm, announced last week it would let go 360 workers worldwide as a result of "current business realities."

The effect on local consumers may also be significant.

Paul Seto, a local banker, said that the local banking community had already been feeling the credit squeeze, which affects new mortgages and lines of credit for local companies.

"We will feel it locally," Seto said, with the credit market all but frozen. "Lines of credit will be reduced for companies" and people will have greater difficulty getting mortgages for new home purchases.

"It's a question of how severe it is and how long it will last," Seto said. "It will take a while for credit to loosen."

Local banks may not have the liquidity to support new mortgages and consumer loans. But the average person may not be aware yet of the severity of the credit crunch, he said, although "the average person sustains the economy."

Local venture capitalists did not respond to requests for comment for this article.

Venture analyst Mendell sounded an optimistic note, however, suggesting that laid-off tech workers could turn around and invent the Next Big Thing with newfound free time.

"There's no recession of good ideas. There's always opportunity here. It could set off a whole slew of entrepreneurs who get laid off from their jobs and decide to take a risk and start their own business."


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Posted by Searchquan
a resident of Duveneck/St. Francis
on Sep 29, 2008 at 10:10 pm

One out of 30 Bay Area tech VC firms returned profits to investors during the good years of 1995-2005, so perhaps a crappy economy will get their a$$es in gear and actually help the fat'n'happy VC community get off their rumps and BE somebodies.

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Posted by stephen levy
a resident of University South
on Sep 30, 2008 at 11:50 am

It is a mistake to think that Palo Alto is immune from the financial system stresses. The tightening of credit and the continuing home price declines affect families and businesses in PA as across the nation. PA is much more than the high tech VC world.

Moreover the real danger going forward is that the financial and housing market stresses are reducing household wealth and beginning to lead to a downward spiral in spending and investment. That is the real reason for the rescue efforts that the House voted down yesterday.

While many people view the rescue plan as targeting Wall Street and not affecting them, this is a mistake in thinking.

While there are alternative ways to provide support to the financial system and economy (besides the rescue package voted on yesterday), some kind of government effort in support of stabilizing the economy is appropriate. It is "Main Street", not only "Wall Street" that is increasingly at risk from inaction.

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Posted by Gary
a resident of Downtown North
on Sep 30, 2008 at 12:39 pm

stephen levy,

You mention "alternative ways to provide support to the financial system and economy ".

Could you provide some examples? For example:

Mark-to-market reform?

Fannie/Freddie reform?

Cutting capital gains/business taxes?

Allowing normal bankruptcy proceedings?

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Posted by Liza Loop
a resident of Mountain View
on Sep 30, 2008 at 7:59 pm

Momma always said: "The stock market is a way of gambling. Never invest more than you can afford to lose." So I don't feel sorry for myself or for other investors. If we don't understand the risks we are taking, we shouldn't be gambling. Profit is, after all, payment for risk. Most VCs, as well as professional investors, know this. They diversify, that is, spread their money around so that not everything they collect is likely to become unfashionable at the same time. They are investing from "surpluses", not their primary residences or their kids' college funds.

But what about those poor folks who are losing their homes? Well, when I applied for a mortgage two years ago the bank's agent encouraged me to lie. She, like many others, was promoting the myth that we "deserve" to receive credit no matter how risky our ongoing ability to repay the balance plus the interest. Because the creditor (a bank or mortgage institution) is not a person we know and encounter as we lead our daily lives, it's easy to feel we are entitled to use its money. But in reality, when we take out a home mortgage, we are not diversifying our investments; we are gambling with our base of support. That home is the largest and most necessary thing we own. We're betting our future income against the pleasure of living with another bedroom or a bigger back yard now. If we lose the bet, we often lose the base from which we do our jobs and with our childrens education. Should we hold someone else responsible and ask our government to bail us out? Or maybe we could learn to resist the perpetual credit myth.

Overextended "main street" homeowners aren't the only ones who have succumbed to the "take-a-risk" myth. Bankers, business executives and even my mortgage broker have become caught up in the atmosphere of little white lies, exaggeration of "value" and not-so-accepted rules of accounting. We've mistakenly thought that, because there's so much credit (read money) around, there must be "value" somewhere to back it up.

Actually, when you look at what is disappearing, you find that the homes are still standing. The cows are still giving milk. The labs and manufacturing operations that the Venture Capitalists are investing in still have inventory on the shelves and thoughtful people to occupy the desks. What has changed is that we are all "poorer" in terms of dollars and cents.

So maybe the Silicon Valley VCs have a lesson for the rest of us in these uncertain times. Invest for the long term and don't panic if your wealth as measured in dollars ebbs and flows. Keep thinking and working even if it looks like your aren't making any money. Be savvy about when to build up product, know-how and capital and when to cash in on that accumulated real wealth. Diversify. If the price of lettuce is skyrocketing, buy a pack of seeds and grow lettuce in old tin cans and milk cartons on your window sill.

And take a little more of my old Momma's advice. "The world doesn't owe you a living," she said. At this point in history, I'd like to add a maxim I didn't learn from her. "Work smarter, not harder." Our challenge today is to stay cool, evaluate and optimize our non-monetary resources and let those flighty financial markets settle down over time. We need to be honest, realistic and generous with those around us. Generosity means giving when we can from what we have in plenty. It has nothing to do with overextended credit and high interest. We are better off without them.

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Posted by confused by bailout
a resident of Duveneck/St. Francis
on Sep 30, 2008 at 10:38 pm

Steve -

OK, as I understand our economy, risk is associated with return. The more risk you take, the bigger your return. Likewise, risk regulates behavior - to avoid a loss you don't want, you avoid a risk.

Some institutions have taken great risks and received great profits for awhile. They have losses; their owners lose money instead of gaining it. That is the way our market controls risk, by allowing risk-takers to lose money.

Now, there is a push to mitigate the losses those risks have brought. They were not hidden risks, nor are the losses out of proportion to the gains over the last 15 years of high risk investment.

Isn't this weakening the strongest regulation in the market - the punishment of excess risk by loss? There are typically ways to avoid congressional regulation (loopholes, earmarks, corruption, and simple law breaking). But there is no sustainable way for participants to avoid the regulation of the law of risk and return. Now, congress - and you - suggest interference, to weaken the impact of this law.

How could that possibly be good for the long term health of our economy? Isn't that like a parent suspending rules and bailing out their kid from trouble they brought on themselves? And isn't that just obviously the wrong thing to do?

Unless we've been attacked by financial terrorists, this makes no sense and is promoting indulgence and dependence on our government for our well being. The wrong thing for a healthy economy, is it not?

This assistance would be more credible if it went elsewhere than to those who took great risks and lost. Take this money and put it in public works to reduce unemployment and dependence on foreign energy sources or something. But to mitigate the loss to those who took risks not only appears damaging in the long term, it doesn't seem likely to be effective in the short term at addressing any fundamental weaknesses in our economy.

What's up here?

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Posted by Cecelia
a resident of Palo Verde
on Oct 1, 2008 at 11:33 pm

referring to the foregoing article: we are suffering from a drought, not a draught. Where, or where, have English language skills gone? Probably to the clever spell check provided by our friend the wordprocesser. Trouble is, the user has to under the context. I forgive you if you went to school in California. You can't help it.

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Posted by Feeling a little petty
a resident of Menlo Park
on Oct 2, 2008 at 9:38 am

This is not directly on topic: while I understand this is a Palo Alto-based publication, I get tired of the Palo Alto-centric lines such as this,"... investors said the venture-capital industry that helps drive Palo Alto's local economy may escape crisis."

The majority of the Valley's VCs aren't in Palo Alto. What they do is part of what drives PA economy - as well as the rest of this area, which includes many, many cities.

Main Street and Wall Street do exist hand in hand, whether your small business is partially dependent upon people who've done well w/their wall street investments, or your rent is tolerable because your landlord has diversified investments and isn't looking just to you for part of their income.

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Posted by Smug aren't we?
a resident of Another Palo Alto neighborhood
on Oct 2, 2008 at 11:49 am

The I.P.O. market has basically dried up. Cleantech needs huge amount of capital unlike dotcom or software companies. They are hardware and need to build factories and manufacturing. How much has nanosolar raised over its lifetime?

The financial crisis affects a fair percentage of startups and therefore V.C.'s. Those without large capital requirements can hunker down longer than others which need capital.

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Posted by Jimbo
a resident of Old Palo Alto
on Oct 6, 2008 at 2:22 pm

Bailouts are cool

Sorry, but further commenting on this topic has been closed.

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