Fear and doubt spread in Silicon Valley

March 18, 2008
Tom Abate, Chronicle Staff Writer

The investment banking crisis on Wall Street is already drying up the flow of capital to Silicon Valley, and while money should find new ways to reach local startups, a cash drought of unknown duration and severity is under way.

That’s the synthesis of interviews with a half-dozen sources, each of whom have what valley people call “skin in the game” – personal financial stakes in the startup economy that depend on Wall Street firms like Bear Stearns to keep the whole system working.

“I’m on the board of one startup that is closing a $1 million financing March 31 and we’re making certain to get in touch with all the investors to ensure an orderly closing,” said Jon Fisher, a serial entrepreneur who recently sold a software startup to Oracle Corp.

Although logically the turbulence in New York’s money markets should not affect such a tiny deal in Northern California, the fact is that the financial ecosystem of Silicon Valley is much like the water cycle – lake water evaporates and rises to form clouds and rains down to fill the lake again.

In the startup economy, the lakes are the venture capital funds that raise money to create startups, which then go public or get sold to a bigger firm. Confidence takes the place of evaporation to keep the cycle going. At the moment, however, confidence has all but evaporated.

“There’s so much fear and doubt out there,” said Sam Colella, a founding partner of Versant Ventures, which invests in biotech and health care startups.

Colella, who has been a venture capitalist for 22 years, said right now the financial picture is fine in the health care sector that is his bailiwick, but he’s been around long enough to know how the confidence crisis can spread.

It all goes back to how the money gets recycled through the startup economy, and a good place to start is with the venture funds that raise money from institutional investors like pension funds that like to sweeten their returns by betting a little bit of their hoard on high-risk but, one hopes, high-return VCs.

The venture capitalists then invest in startups that spend the money to build their companies. Spending the money is the easy part. But VCs eventually want to get their money back.

“Three to five years is about the time we like to stay invested,” said Arno Penzias, a Nobel Prize-winning scientist and partner in New Enterprise Associates, a venture firm that invests in alternative energy, among other markets.

And in order to recoup their investments, the venture capitals turn to big investment banks like Bear Stearns and smaller boutique banks to do one of two things: sell the startup on Wall Street through an initial public offering or sell it to a big company like Oracle through the merger-and-acquisition process.

Both types of transactions are called liquidity events in valley-speak. Brenon Daly, who tracks IPOs and mergers in the technology and telecom industries for the 451 Group in San Francisco, said both the avenues VCs use to achieve liquidity have been drying up for months.

“The IPO market is dead,” Daly said flatly. Acquisitions had been strong through 2007, when big firms spent $476 billion to buy 3,559 smaller firms in Daly’s market, but a good chunk of that activity was buyouts by private-equity firms like the flailing Carlyle Group, now caught in the credit crunch. So that means fewer M&A buyers in 2008, he said.

No wonder Mark Cannice, a professor at the University of San Francisco who regularly surveys the sentiment among VCs, started to detect a drop in their confidence through much of last year. That means they’ll be throwing around less of the money that startups use to fund everything from new hires to paper clips.

How long or tough this cash drought will be not even the insiders can guess, but already the regional ecosystem is sprouting new boutique investment banks, like Catapult Advisors in San Francisco, to help VCs bring their startups to the fabled liquidity event.

“We’re lickin’ our chops to fill in if Bear Stearns drops the ball,” said Catapult Managing Partner Ron Lissak.

But what no one knows is how long it will be before the larger investment community, everyone from the individual to the pension fund, regains its appetite for the sine qua non of high returns – Wall Street risk.

“I’m starting to be concerned about what may be the next shoe to drop,” said Colella, the biotech guy.

So for now it looks like it’s a hard rain that’s not gonna fall on Silicon Valley.