VCs keep close eye on market dynamics

Venture capitalists like to take the long view on investments. They can nurture a company for years before taking it public. Unlike daytraders or short-term investors, they don't have to think about one-day market movements.

Still, even VCs were thinking hard about the stock market Tuesday. The Nasdaq Composite Index dropped as low as 3649 during trading Tuesday, registering a drop of almost 14 percent from its Monday closing level of 4223, before bouncing back to 4148 for a 1.77 percent decline for the day.

The market's downturn cost venture capital firms tens of millions of dollars in stock losses on paper. Stock declines generally don't cause VCs acute pain unless they drag on for months, creating an unfriendly environment for their preferred exit strategy, the initial public offering. But if that happened, they would need to rethink their approach to investing.

"Weeks like this change the market dynamics," says David Cowan, a partner at Bessemer Venture Partners. "Capital won't be as available to unprofitable companies."

A 14-percent drop in four hours raises some scary questions. For instance, what will happen if the Great Internet Stock Rally does halt? And are investors becoming more demanding about Internet business models?

"The market's move is consistent with the perspective that very few brands have been created on the Internet and that the business models that come with the brands are not gaining traction," says David Sanderson, president of U.S. operations of eVolution, which is helping traditional companies build Internet operations. "The market's downturn is forcing investors to take a hard look at those questionable business models."

Although it made sense under earlier conditions for Net companies to spend lavishly on marketing and branding and leave tomorrow to worry about profits, VCs are losing interest in financing such firms. "Businesses are going to have to change their plans," Sanderson says.

How that might affect the pace of deals and their accorded value is a matter of debate among venture capitalists and those familiar with the industry. On the one hand, venture capital firms might become more discriminating and do fewer deals. This tightening of capital could lead entrepreneurs to accept lower valuations of their companies.

"The venture capitalists have been spending money like drunken sailors," remarks Robertson Stephens founder Sandy Robertson, who now heads buyout fund Francisco Partners. A drop in the market, if it sticks, is likely to have a sobering effect on venture capital, he adds, noting that there would be a trickle-down impact psychologically, with both investors and entrepreneurs accepting that new private companies' values had to fall.

But on the other hand, Cowan points out that so much money has flooded into venture capital firms that there would be a situation of too much money chasing too few deals. None of these firms, he notes, "are going to give the money back."

Still, the fallout in the stock market today didn't have venture capitalists hiding under their desks. Some dismiss the day's results as just another fluctuation. Others say they knew all along that a downturn had to come sometime.

"No one gave us a license to print money," says Jay Hoag, a partner at Technology Crossover Ventures who sounded surprisingly chipper Tuesday morning even though his firm's portfolio had dropped by millions.

Indeed, Hoag even saw an upside to the situation. Technology Crossover Ventures, which invests in both public and private companies, used the drop in the market to acquire a number of technology companies it thought had fallen too far but that had earlier been too expensive for the firm to buy.

"This was a great opportunity," he says, adding that both private and public companies suddenly low on cash might give Technology Crossover Ventures more-favorable terms in return for an investment.

A deeper drop in the public markets could lead other venture firms to use some of their fund money to invest in companies they helped to finance in early private rounds. When the market crashed in 1987, Robertson recalls that many venture firms invested in public companies they had backed earlier. And Cowan also notes that when the market for biotech companies crashed in the early 1990s, Bessemer invested in some publicly traded biotech firms rather than finance private ones.

Jim Evans contributed to this story.

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