Same old tune: VC outlay drops in Q3

Although there are signs that the broader economy is gaining strength, venture investment continued to dip in the third quarter.

Venture investing has dropped since last year by anywhere from 32% to 38%, whether you base the assessment on commitments made or you add up the total of the checks written.

For instance, Dow Jones last week reported $5.1 billion invested in 616 deals during the third quarter, compared to $8.2 billion invested in 663 deals in the same period last year.

Similarly, the MoneyTree report from the National Venture Capital Association and PricewaterhouseCoopers, based on data from Thomson Reuters (publisher of PE Week), reported that VCs nationwide invested $4.8 billion in 637 deals in Q3, down from $7.1 billion invested in 907 deals in the same three-month period last year.

Funds are tending to be smaller, and investors are putting less of their money into startups than they used to, says Mark Brooks, managing director of San Francisco-based Scale Venture Partners.

Although the broad economy is gaining momentum, Brooks notes, VCs overall are holding onto their portfolio companies for longer now because public investors are still not willing to take a risk.

Companies also have to meet more milestones than they used, he says. A company that would have raised a $40 million round of financing in the past might get it now in two $20-million tranches, depending on the milestones that management teams achieve.

The picture is even bleaker when looking at brand new deals, or first-round financings for startups.

U.S.-based venture firms invested $2.19 billion in 462 first-round deals in the first nine months of this year, the worst nine-month period since a stretch that includes the third and fourth quarters of 1994 and the first quarter of 1995, when VCs invested $1.77 billion in 480 first rounds, according to data from Thomson Reuters.

The third quarter also marked the third consecutive quarter that came in below $1 billion for first-round deals. The last time we had three consecutive sub-$1 billion quarters was from the fourth quarter of 2002 to the second quarter of 2003. Even during that dark period, venture firms put more money to work in brand new deals than they are today.

The biotech sector continued to receive the most venture dollars in the third quarter, as VCs put $905.1 million to work in investments, although this was down 25% from the same quarter last year, according to the MoneyTree report.

Meanwhile, investments in the cleantech sector—which includes alternative energy, recycling, conservation and power supply companies—totaled $897.5 million, down 14% compared to Q3 in 2008.

Internet company investments fell 22% year over year to $842.6 million, while software company investments sank 52% to $622.4 million during the period.

Looking ahead, one question of concern for VCs is what the federal government will do with health care reform. Proposals being considered in Washington, D.C., now include taxing insurance, medical device and big pharmaceutical companies to fund the cost of insuring more people.

Scale Venture Partners wants those taxes to be paid by big, profitable companies, not startups, Brooks says.

The government could also cut costs in the health care system, but details on how to do that have been scarce. Brooks says he’s betting that it will take the government several years to finish health care reform, which means Scale’s companies will be exposed to whatever happens in Washington, D.C. over the next decade.

Scale looks for cost innovation, not just technical innovation, Brooks says. Chrysalis VenturesDavid Jones says that his firm does the same.

“At some point, the government will move from new benefits to cracking down on how to get value for every dollar spent,” says Jones, managing director at Chrysalis.

VCs say there are some positive aspects to the investing drought.

For firms that do have money, it’s a good time to put capital to work. Fewer VCs means access to better deals.

“It’s rare that someone will turn down a meeting,” Brooks said, and there’s more time for due diligence on companies, which is especially important in areas where VCs may be dealing with government regulation and other complex issues.

These companies are also likely to emerge stronger when they finally do go public or get acquired.

Lawrence Aragon contributed to this story.