Poor investment returns have had a similar effect to cold water – the VC industry is shrinking. As a follow-up to comments I posted this past weekend, I wanted to look deeper into recent fundraising data and see what other implications one might draw.

Since 1980 the VC industry has raised $495 billion across 4,333 funds or 1,670 firms (firms typically raise more than one fund). Today the industry is thought to actively manage right around $200 billion of capital and industry analysts estimate that there are about 770 active firms in the US today. There are 415 firms which are members of the National Venture Capital Association (where I am a board member).

VC funds tend to be fully committed within the first three to four years of being raised, although it may actually take quite a few years—upwards of eight to 10 years to be fully invested (because of reserves for follow-on investments in existing companies) and at least that long to be fully liquidated. Most VC funds have a contractual 10-year life. Firms are deemed active if they have raised a new fund in the prior eight years, per the NVCA.

In 2010 nearly $21.8 billion was invested in 3,277 deals but only approximately $12.3 billion was thought to have been raised by VC’s to invest—thus the shrinkage issue. Between 2007 and 2009 roughly 100 venture firms left the industry each year—in 2007 there were just over 1,000 firms—-not terribly surprising given the global economic meltdown. Perhaps a more interesting metric, though, is the number of funds raised; the high water mark in 2000 saw 635 new funds raised (six hundred and thirty five—over two per day not counting weekends), which declined to 157 in 2010. In 2000 all those funds invested in 7,970 deals – simply staggering.

More stats. Since 2004 more than $166 billion was raised by VC’s and $168 billion was invested (since 2005, $149 billion raised, $147 billion invested) so things seem to be in reasonable balance. The analysis is tricky because how long it takes to actually invest a fund once raised, but the industry has a nice ability to recalibrate itself quite quickly.

So as the economy recovers we would naturally expect to see the amount raised and the amount invested to converge – but we did not see that in 2010. In fact – other than for 2001 – we have never seen such divergence. What happened?

The venture industry this year reported for the first time 10 year returns data—which was quite negative—while expected, sent shockwaves through the LP community. As of September 30, 2010 the … Next Page »

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The Q4 2010 VC funding data were released late last week—and the headline was quite upbeat. VCs invested $5 billion in 765 deals in this past quarter, which while essentially flat quarter-over-quarter, brought the full year totals to $21.8 billion invested in 3,277 companies. In 2009, VCs put $18.3 billion into 2,927 companies. It’s easy to conclude that with volume up, the VC industry is on the road to recovery, but a new issue is emerging—the dreaded shrinkage.

The headlines turn out to mask some fascinating insights when one looks closer at the detailed data released in the MoneyTree Report prepared by PricewaterhouseCoopers and the National Venture Capital Association (NVCA), based on data from Thomson Reuters. Just a couple of tidbits…

Sector Rotation: Software is back—by a lot. In Q410, software as a category attracted $1.23 billion across 218 deals, far above the $853 million put into 72 deals for “industrial/energy” (which is effectively the cleantech category), which took the #2 spot. More notably, biotech—which had been #1 or #2 quite consistently over many quarters—dropped to #3, with only $685 million invested in 94 deals. Medical devices fell even further ($400 million and 71 deals). For the entire year software saw a jump of 20% in dollars invested over 2009.

Healthcare Investing: With biotech and medical device investments falling, the question that jumps off the page is, “Are we seeing the impact of the uncertainty of healthcare reform on the healthcare sector?” I think so. VCs do not like regulatory uncertainty, especially when coupled to extraordinary biological uncertainty. This downward investing trend is very disturbing, and without sounding too dramatic, if it continues, it will affect the quality of people’s lives.

Is Cleantech Back?: While the sector more than doubled from Q3 to Q4 this past year ($418 million to $853 million), I think it is premature to declare victory here. Clearly VC sentiment has rotated away from large supply side investments (generation and distribution look more like biotech’s risk profile). However, cleantech plays were strong in demand side management (usage monitoring, efficiency, which look more like software/hardware risk profile). Notably, the average dollar invested in cleantech in Q4 was nearly $12 million per deal, which is almost twice the $6.6 million for all deals in that quarter. Still, the field feels very capital intensive for VCs, whose own industry is shrinking. Which is my next point…

Shrinkage: This is something I have been tracking closely for the last few quarters. For the quarter, VCs invested $5 billion against what I would guess will be less than $3 billion raised in new funds when the reports come in. For the year, the numbers look like $21.8 billion invested, as compared to probably around $12 billion raised (this number won’t be reported for some time still). Arguably, the VC industry shrunk by $10 billion in 2010. That’s maybe not big a deal when you consider that in the U.S. the VC industry manages more than $200 billion—but much of that was raised and invested a decade or so ago. When—and how—this trend will be reversed is on everyone’s mind.

Stage Rotation: The shrinkage is evident in the allocation by stage of deal—more dollars are going into earlier stage companies, and these rounds tend to be much smaller in size. Seed and Early Stage deals captured nearly 30 percent of all dollars invested in Q4 (which was nearly identical to 3Q data). I also happen to believe that the level of Seed and Early Stage investing is wildly under-reported. This is not the case in the Late stage category, which dropped from 35 percent in Q3 to almost 24 percent in Q4; that difference showed up in Expansion stage (Series B), which went from 33 percent to 43 percent quarter-over-quarter. This makes sense, as we saw the advent of Super Angel and MicroVC models 12+ months ago—and many of the companies founded by those investors were out raising follow-on Series B rounds this past quarter. And with smaller new funds being raised in this environment, VCs are looking to invest less money per deal, which tends to push them to earlier (and smaller) round sizes. Notably, there were nearly 30 percent more new companies raising VC dollars in 2010 than 2009.

Boston Vs. New York: I was reluctant to wade into this debate, but here I go. New York had a very strong fourth quarter, but not strong enough to eclipse Boston (by metro region) for the year. In 2010, there were 313 deals that raised $2.12 billion in Boston as compared to 350 deals that raised $1.87 billion in New York. If you expand the Boston aperture to New England, the numbers are 387 and $2.54 billion, respectively. In terms of deals and dollars, Boston and New York were basically the same in Q4, though, so quite clearly New York is catching up to Boston as a region, which very directly reflects the explosion of digital media and Super Angel activity in NYC. Average deal size in NYC is much smaller than that for Boston.

All in all, a reasonably good quarter. What the data do not comment on are liquidity events—which is the real elephant in the room. Until we can show predictable, repeatable liquidity, the VC industry will shrink. That hurts anyone playing in the Innovation Economy.

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1. Prediction in Vogue: 2011 will be the year of the “Super Angel”

Reality: Given all the angel investment activity, and the fact that it has never been easier to start a new company (low cost of computer power, plenty of talented people, plenty of real estate, etc), too many “me too” companies will be started, leading to too many companies dividing up small and emerging markets. And because angels do not typically have the ability due to their size to support numerous companies over many rounds, many angels will experience an unacceptably high loss ratio. This will cause many of them to dramatically slow down their new investment pace so that they can support their more promising companies.

2. Prediction in Vogue: China is the center of the VC-world

Reality: While the growth rates and level of investment activity in China are very seductive, the recent dramatic IPO activity harkens back to NASDAQ 1999 and will in hindsight be considered the high water mark for VC activity in China. Notwithstanding all the euphoria in China and its robust IPO market, the broader index of leading Chinese public companies is up only 3.3% year-to-date. The dramatic capital inflows—which have masked many structural issues in the Chinese economy—will lead to increasing rates of inflation and other social dislocations. Given the poor operating and financial conditions of many Chinese enterprises, banks will find it difficult to raise interest rates to contain inflation, which will lead to an unexpected and dramatic reduction in lending activity.

3. Prediction in Vogue: Twitter is worth much more than $4 billion

Reality: Ultimately all companies must create economic value that earns a return acceptable to the underlying invested capital. It is one thing to “build an audience,” but ultimately investors will demand that all of these social media properties generate a cash-on-cash return to invested capital. The fear is that Twitter will prove itself to simply be a micro-broadcast network; this realization will send shudders throughout the social media world and will undermine all the hyper-valuations we are seeing today in this sector. And what percent of tweets are actually read anyway?”

4. Prediction in Vogue: The VC industry has weathered the worst of it and is poised for recovery

Reality: While the VC industry has certainly suffered mightily, it is still not clear the worst is behind it. Starting in early 2008—and probably lasting through 2011—we will have witnessed an industry being cut more than in half. In 2008, VC’s raised nearly $28 billion; in 2010 the figure may only be $12 billion. There are nearly 500 VC firms listed as members of the National Venture Capital Association (where I am a board member); arguably less than 20% of those firms can predictably and reliably raise new funds in this environment.

5. Prediction in Vogue: With the general economic recovery, the pace of new VC investments will significantly increase

Reality: While the absolute number of new companies funded may increase given the prominence of “Super Angels,” marginal VC firms—many of whom are late in their current fund’s investment phase—will be reluctant to make new commitments. This will be exacerbated by the need to unexpectedly put more capital into existing portfolio companies, stressing capital reserve assumptions. Q3 2010 saw $4.8 billion of new investment commitments, which was meaningfully more than the $3 billion raised by VC firms in that same quarter; as the industry invests this “capital overhang,” new investment pace will moderate unexpectedly quickly.

Michael Greeley’s blog, On the Flying Bridge, can be found at www.ontheflyingbridge.com.

[Editor's Note: This is part of a series of posts from Xconomists and other technology and life sciences leaders from around the U.S. who are weighing in with the top surprises they've seen in their respective fields in the past year, or the major things to watch for in 2011.]

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What a fascinating week to be traveling in Asia. President Obama is here for the G20 Summit—as is Tiger Woods—and, frankly, I am surprised at how tough the local press is on both men (at least one is well deserving of the criticism, though). The juxtaposition to when I was here right after President Obama won the election—and could do absolutely no wrong—is striking.

Undoubtedly this part of the world is booming—and even that is an understatement—but I want to offer up a more nuanced perspective on what is going on here. I grew up in Hong Kong and have been blown away by the transformation this place has witnessed since I was a child. I arrived late last night from Australia, and it was like midday on the streets. The sense of vitality and optimism is present everywhere and with everyone I speak to.

I just listened to David Bonderman, founder of TPG Capital, share his impressions of the region for private equity and venture investing as the keynote speaker at the Asian Venture Capital Journal’s annual investor conference. He was followed by a parade of industry luminaries—both GPs [general partners] and LPs [limited partners]. The over 1,000 participants here are all trying to figure out how to play “the Asian angle.” Bonderman left the audience with a fascinating observation—there are 243 cities in China with over 1 million people—implying that the growth will continue for a long long time.

To a person here, there is great enthusiasm. The top line growth—both in GDP and capital flows—is staggering and well documented. And it appears to be happening across nearly every industry sector. For instance, the head of Astra Zeneca China stated that the Chinese pharma industry has grown at 20 percent per annum the last four years and is not expected to slow any time soon (it is now estimated to be $20 billion).

But let me offer some concerns that I have been thinking about which may check some of the unbridled enthusiasm.

• Too much of a good thing is often a bad thing: There is estimated to be around $40 billion of committed but un-invested private capital in Asia right now (which compares to around $400 billion in the U.S.). Recall that private equity is effectively “temporary capital” and at some point seeks to be monetized. There is a velocity with this capital which can whipsaw a marketplace. The dynamics and expectations around private capital may be novel and entrepreneurs in region may not fully understand these behaviors.

• Overbuilt: This observation relates to the first concern and that is—can the region absorb these rapid capital inflows? Apparently there are now over 100 car companies in China; that simply is an inefficient approach to building an auto industry and will lead to painful—and inevitable—consolidation. It is widely believed that most private Chinese companies are only marginally profitable—or worse yet, consistently lose money. As the dramatic inflows of equity continue, the return on equity will be modest to unattractive. At some point investors will seek better returns elsewhere. The situation has worked in China to date because the inflows have masked poor underlying operating performance.

• Liquidity: There is a robust and emerging (i.e., untested) local IPO market coming of age. Importantly, though there is scant evidence of a meaningful local M&A marketplace, double digit million sales are considered very rare. This is due to a relative dearth of local public companies and an immature acquisition financing market. There are ultra-low interest rates (real interest rates are probably negative); this is leading to certain asset bubbles—particularly in real estate and public equities. This is not sustainable.

• One Child Policy: I can’t help but think that the labor market demographics will be challenging over the next decade or two with a rapidly aging population having to be supported by the generation created under the “One Child” policy. Just something to contemplate.

• Management Talent: A common concern expressed by local investors has been the consistent lack of proven management talent (this, unfortunately, is not necessarily unique to Asia). Scaling a private business profitably is very challenging and it is a relatively recent phenomenon in Asia to have privately backed companies needing to manage such growth.

• Revolution of Rising Expectations: The ever-present political and social concerns remain and will be exacerbated by any disruption to these enormous capital inflows. There has been a reasonably predictable cycle of economic shocks to the Asian markets—and while the enthusiasm espoused this week make these concerns feel quite remote, don’t those fears always seem remote?

One last observation: it certainly appears that the U.S. VC industry has successfully exported itself to Asia—although most of the GPs here are not expats. This has troubling implications for the U.S. VC industry: If fundamental R&D is outsourced to Asia, then who do we invest behind? We need policies that will ensure that the U.S. maintains its leadership position in innovation.

I love it here. Don’t get me wrong. The upside is enormous and real, but there are also real structural issues that seem to be overlooked in the current dialogue.

[Editor's note: This article appears with a different headline on Michael Greeley's own blog, On the Flying Bridge.]

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Building a sustainable innovation ecosystem is hard and will require patience married to a sense of real optimism. It will require numerous centers of innovation: academic settings, corporate research labs, world-class hospitals, all operating with an entrepreneurial culture.

All this cannot simply be mandated, but rather it comes about over generations of startup success stories. It also will require plenty of capital—both angel and venture funds—as well as a deep roster of service providers (lawyers, accountants, consultants, and bankers). That is why it is so hard to build. A few specific things to consider:

• Trumpet your successes: Identify the areas where Detroit/Michigan can dominate and then feature them. Obviously, the historic success in the automotive industry augurs well for the exciting robotics and industrial automation fields; Detroit should own that industry in the eyes of venture capitalists. Where else can you be dominant in the early stage marketplace?

• Engage the Old Guard: Executives who have successfully built entrepreneurial businesses should be encouraged to serve as mentors and, importantly, as angel investors. Incent them to invest in the next generation of entrepreneurs. The angel communities in Silicon Valley and Boston are robust and are a wealth of insights and capital for those just starting out.

• Eliminate any friction in the system: Anything that impedes matching capital to brilliant people with innovative ideas undermines the entire process.

• Make it really easy to keep students engaged: Your next great entrepreneurs are in your high schools and colleges—show them why they should stay and create networking events and open houses at startup companies across the region. Reach out to students who have already left to study elsewhere and make it clear to them that “Detroit is open for business” and that they should come home.

• Above all, patience: This will be hard and take time but the rewards are tremendous. Each successful startup can generate dozens to hundreds of jobs and, in turn, each company will spawn more startups, creating a virtuous cycle of company creation.

Welcome to the Future. Welcome to the Xconomy, Detroit…

[Editor's note: To help launch Xconomy Detroit, we've queried our network of Xconomists and other innovation leaders around the country for their list of the most important things that entrepreneurs and innovators in Michigan can do to reinvigorate their regional economy.]

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Even though Oscar buzz is not yet in the air, it is pretty clear what film titles will rule in 2010. So sit back, grab your popcorn…the envelopes please.

Precious: The statuette goes to this film about the Greenback, which continues to be really hard to come by. The venture industry weathered a swift-yet-painful contraction in 2009, which shows little sign of letting up. In 2008, the U.S. venture capital industry raised nearly $30 billion; although the 2009 data are yet to be compiled, it appears that last year the industry will have raised less than $15 billion—which may be the new annual reality. For entrepreneurs, this contraction will continue to make capital precious and hard to access.

New England-based companies raised nearly $3 billion in 2008; my guess is that this number will look closer to $2 billion in 2009. The New England Venture Capital Association, which I currently chair, had 138 dues-paying members two years ago; right now, we have 108 members. Fortunately for New England, more than 20 percent of all venture capital is managed by firms based in Massachusetts.

It’s Complicated: The star of this film: the local business environment, which will continue to be tricky to navigate. While there is abundant innovation and a number of high-quality entrepreneurs in the market, it is hard to handicap which compelling and profitable investment themes will emerge. Last year investors thought 2009 was going to be the “year of cleantech,” but instead of (global) warming, that investment theme seemed to have cooled. I continue to see great opportunities in the convergence of the IT and life sciences sectors, which New England is uniquely positioned to exploit. There are also wonderful opportunities in cloud computing and with new advertising technologies, but all of this is complicated by the absolute dearth of liquidity.

2012: And the Academy is pleased to recognize this blockbuster, which unfortunately may portend that the real economic recovery is still a few years away. All of us are desperate for predictable, sustainable, and meaningful liquidity. Many of our portfolio companies are at a point of maturity, where in more normal times they would either go public or be sold at attractive M&A prices. Average holding periods have extended to more than eight years, which is unprecedented; normally VC’s expect this to be between four and six years. There will be around a dozen venture-backed IPOs in 2009; this would be closer to 100 in more normal years.

And honorable mentions go to….

In the Air: This flick recognizes that all of us will have to work much harder this upcoming year just to stay in place!

Blind Side: Although this title better describes how we all felt (blind-sided, to be more exact) in the fall of 2008, we should expect that there well may be additional economic shocks as we collectively crawl out of this turmoil.

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In the past few months I have had the opportunity to interact with a number of state and federal officials as the financial crisis has unfolded. And for the most part my faith in the system has been renewed.

In my capacity as chair of the New England Venture Capital Association, I have met a number of times with Governor Deval Patrick of Massachusetts, and in fact I chair his recently formed Entrepreneurship Committee for the Mass IT Collaborative. I have also worked closely with his Secretary of Economic Development, Greg Bialecki, who is working very hard on a number of important initiatives to drive local job growth and company formation. As a board member of the National Venture Capital Association I have also met with Representative Barney Frank to review possible federal regulation of the venture capital industry as part of the pending overarching regulation of the financial services industry.

And what I found was a group of legislators very concerned and engaged in finding constructive solutions—and I appreciate better the big sticks they wield. As the crisis began to unfold last fall the meetings went along the lines of “What is going on? How bad is this going to be?” Now that we seemed to hit a point of some stability, the meetings now are much more focused on finding solutions and launching programs to bolster the innovation economy. For instance, Secretary Bialecki was instrumental in securing initial funding for MassChallenge, an exciting initiative to bring entrepreneurs and investors together.

Admittedly my initial interest in being involved was to see how the VC industry might play a role in seeing as much of the federal stimulus moneys make their way to our portfolio companies as possible. I had suggested to Governor Patrick that a group of VCs advise in the allocation of stimulus dollars on a local level. Notwithstanding the enormity of the stimulus spending, it turns out to be reasonably difficult to pull levers which would quickly get funds to our companies.

My other interest in being involved was much more parochial. I was worried that the government would paint with too broad of a regulatory brush as it tried to “fix” the hedge fund industry and perhaps inadvertently slap around the VC industry as well. The idea that the VC industry somehow caused systemic risk to me was ridiculous—we do not use leverage, do not have public securities, ask our investors to lock up for 10 years, do not use derivatives, etc)—yet there was emerging rhetoric about the risk VCs brought to the financial markets.

On this score I was very pleased with what I heard from key government leaders, particularly Representative Frank. There is great understanding of the important role that the venture industry plays—most officials clearly understand that it is the new companies which create the jobs and growth—and importantly that the VC industry is fundamentally different from the hedge fund world and does not inherently pose great risk.

As I said to Governor Patrick in my office a few months ago, since we started Flybridge Capital Partners nearly 8 years ago we have helped to start almost 45 companies which at the end of 2008 employed 1,231 people.

So maybe I am wrong—we do have a very highly leveraged model.

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Yesterday, I participated in a very exciting event that culminated with the announcement by Massachusetts Governor Deval Patrick of an important funding program—a $1 million annual business plan competition called MassChallenge.

The essence of this announcement is to match the next generation of young aspiring entrepreneurs with numerous sources of capital, most likely local venture capitalists. The Governor has committed the State to match dollars committed by private sector investors to the top entrepreneurs who survive the MassChallenge screening process.

During the course of the events yesterday, my good friend Andy Ory (CEO of Acme Packet) and I moderated a panel stocked with local success stories: Desh Deshpande, Paul Sagan of Akamai, Bob Hower of Advanced Technology Ventures, Scott Savitz of Shoebuy.com, and Brian Shin of VisibleMeasures. We explored what was and was not working in the region as we try to build great venture-backed companies.

One consistent theme that the panel identified was the lack of broad-based mentorship to help this next generation of great entrepreneurs get started. So here is the commitment that Andy and I made to the audience: we will recruit 12 great successful CEOs to work with 12 VCs to mentor 12 promising young entrepreneurs to launch 12 new companies over the next 12 months. (Admittedly, I stated to the audience that it would be 20 companies in the first year, but upon reflection the alliteration of “12″ worked much better).

Office Hours: So what I will pursue over the next few months with Andy Ory is to see if we can establish “office hours”—that is, can we get a dozen successful CEOs in town to commit to open up their calendars and Rolodexes to a dozen promising entrepreneurs. Ideally these CEOs would serve as non-executive chairpersons and possibly provide some initial capital, but more importantly, they would provide guidance and advice. VCs get paid to see new opportunities, so it should be reasonably straight forward for me to line up the investors (maybe I will lean on the board of New England Venture Capital Association, which I happen to chair). And working with organizations such as MassChallenge, as well as our own deal flow, we should be able to identify a dozen great opportunities that merit funding.

I will keep you posted on our progress.

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There is a lot of great stuff going on in Boston right now. Granted, there are still many signs of paralysis throughout the system, but there are also many high-quality entrepreneurs in the marketplace attempting to change the world with exciting, innovative solutions to some very large problems.

June 2009 has been dubbed “Innovation Month in New England,” so I thought I would tick off some of the investment themes we are excited about today.

* My favorite theme is the convergence of IT and life sciences (we dub it “technology for healthcare”), as that manifests itself in smart devices, important advances in healthIT, and the promise of personalized medicine and sophisticated diagnostics. The parallel developments in bio-informatics, computing power, material sciences, microfabrication, power management, and imaging modalities have dramatically advanced our ability to diagnose, manage, and cure many chronic diseases. I am particularly intrigued with the “connected health” paradigm—and who will be the winners and losers as this model becomes a reality.

* I am spending a lot of time with robotics entrepreneurs these days. There are exciting and very obvious applications in the industrial, manufacturing, medical, and consumer markets. And Massachusetts has a world-class robotics ecosystem already in place.

* Developments in mobile applications as well as wireless infrastructure are very exciting.

* We are seeing a number of important consumer infrastructure opportunities which will better optimize the allocation of advertising dollars and improve marketing efficiencies. We are particularly excited about advances in video infrastructure and distribution.

* Tech-enabled business services, particularly in the financial services industry, show great promise. Banks and insurance companies simply need to be more efficient in how they do business.

* We still see compelling opportunities in the enterprise software space, although admittedly fewer than in years past.

* Since 9/11 we have observed that the government—on a massively parallel basis—has been subsidizing numerous technologies in the name of homeland defense through non-dilutive grants and contracts. We have been pursuing an investment thesis which is centered on the ability to redirect some of these technologies to large industrial or commercial applications.

* We have been pursuing a number of exciting opportunities in the platform semiconductor space, which drives many of our other investment themes above.

* And lastly—and most recently—we elevated cleantech as a new investment theme. We do so cautiously, recognizing the many challenges these companies now face. Our principal focus is on demand-side energy management, which is more akin to business models found in the above themes. We have avoided supply-side, generation companies, which require extraordinary amounts of capital, have very significant technical risks, uncertain business models, and extended development timelines.

We are always happy to engage with great entrepreneurs, particularly if they are focused on some of the themes above. Several important events in June will take on these issues, including the Xconomy Summit on Innovation, Technology, and Entrepreneurship, or XSITE 2009, an all-day conference at Boston University on June 24. Many of these themes will also be discussed at an event Scott Kirsner is hosting on June 25, also at Boston University. Please come and join in the debates.

[Editor's note: This column also appears, in slightly different form, on Michael Greeley's blog, On the Flying Bridge.]

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I am at the annual meeting of the National Venture Capital Association being held in Boston lastthis week. The tone was remarkably upbeat—but only for those firms with either a new fund or who somehow avoided making a lot of overvalued investments during the last few years. There was a lot of rhetoric about how/when/whether the world will improve, whether VC’s will make money in cleantech, and when LPs will begin to wade back into the asset class.

But I did learn a number of things I did not know when I woke up…

* Revenues at VC-backed companies accounted for 20.5% of the nation’s GDP

* VC-backed companies represented 8.6% of all employment

* There are 12 million jobs at public companies which were once VC-backed

* Once companies went public, headcount grew 92% (94% in the 1980′s, 76% in the 2000′s – not a great trajectory admittedly)

* There were 1,171 new VC-backed companies in 2008

* Unfortunately there were only 6 IPO’s in 2008 and 341 M&A transactions that same year

* It now takes on average 9.6 years to get VC-backed companies public (or 6.5 years for an M&A transaction)

* $4.5 billion is being spent now from the stimulus package on “smart grid” technologies

* One in three people have been meaningfully helped by VC-backed biotech companies (staggering)

* WalMart recently lowered the cost of generic drugs to $4 which they believe served to take more costs out of the healthcare system than any single act of healthcare legislation

* Shockingly this year the 65,000 annual H-1B visa cap was not hit in the first week of being available (not happened before) which speaks to the limitations instituted that foreigners are not able to displace US workers

* There is now great anxiety that the federal government will regulate the VC industry given the “concerns” that the VC industry may create something called “systemic risk”

The industry I work in has certainly been an engine of innovation and job growth; to hear some of the specific statistics only reconfirms that understanding. It also underscores the need to get the VC ecosystem back on track and should provide caution to the government to be careful on how it feels it needs to regulate the industry.

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For the last six months VCs thought they were really funny whenever they used the phrase “flat is the new up.” This crept into the VC lexicon at the beginning of the current crisis to refer to the small victories investors boasted about when raising capital for their portfolio companies. Actually the reality is quite different—companies should be considered fortunate to just raise capital, at any price, in this environment.

So I really want to be upbeat—believe me. I had six board meetings this past week. In large measure, most of our portfolio companies are performing reasonably well—product development milestones are being met, bookings and revenue forecasts are being hit, our management teams are executing effectively. Unfortunately, in some cases these companies are simply worth less than what we valued them at when we made our initial investment; that does not in any way suggest they are bad companies or will be bad investments.

The 1Q09 venture funding data (the focus of my last post) strongly suggests that investors are simply not making new commitments. CEOs need to carefully manage their investor syndicates because those are the people who will fund their next round. What struck me this week was how supportive most of my co-investors want to be for the companies that need to raise capital now. This is fundamentally different from the last bubble, when so many venture-backed companies were just not performing and were abandoned by their investors.

So I make two specific suggestions to CEOs. One, sort out with your existing investors what reserves have they set aside for your company, reconfirm what milestones need to be met, and agree on when the company simply must be managed to breakeven—that will define your operating and financing plan. Pretend your investors are your customers and you are designing a product for them to buy.

Two, you need to cut costs again—and I don’t suggest this lightly. A dollar saved is equivalent to meaningfully more than a dollar raised given all the “costs” (time, effort, fees) to raise capital. Don’t over-engineer the product, don’t over-hire the sales force, do consider a 10 percent across-the-board salary reduction in exchange for more equity. When we get out of the crisis, you can turn on the spigot again and spend money.

And my advice to my VC colleagues: when the tide recedes it is time to go down and pick up the shells…

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So the first quarter venture funding data were just released and the news for entrepreneurs was decidedly bad. It is pretty clear the party for “easy money”—particularly for cleantech companies–is emphatically over. Venture-backed companies raised only $3.9 billion in Q109, which is basically half what they raised this time a year ago. New England companies raised only $375 million. There were slightly fewer than 500 deals nationally this past quarter–and some analysts calculated that almost two-thirds of those investments were “insider-only” financings. Therefore, the rate of new company formation arguably has fallen dramatically. Anecdotally, not much appears to have changed in this current quarter, as the environment continues to be reasonably hostile to entrepreneurs and VCs alike.

Leading the downward spiral were consumer services and cleantech deals, down 70 percent and 59 percent, respectively, from the prior quarter. Right on their heels were information technology and business services investments (down 52 percent and 50). Perhaps somewhat surprisingly, healthcare was down a more modest 34 percent on a dollars invested basis; this is surprising because there are nearly 125 public biotech companies with less than a year of cash, and that does not even account for the many multiple hundreds of private biotech companies presumably still seeking capital—which, one would have thought, would have scared away investors.

But what should we have expected given the calamitous fall and winter of 2008? Clearly there was going to be an “echo boom” from the meltdown that was going to wash over the venture capital market. And these corrections are going to continue to be painful. One should expect unprecedented company closures over the next 12 months—particularly in the supply-side cleantech sector. The legacy company burn rates, lack of follow-on equity and debt capital, undefined business models, $45 barrel oil, and significant technical risks weigh heavily on many cleantech businesses now.

So where does that leave the New England marketplace? Amongst the rubble I see some good news. In difficult periods the venture marketplace tends to contract back to regions of historic strength. New England has always been a distant but steady number two to Silicon Valley. Over the last year this region has attracted between 10-15 percent of all venture capital (the Valley was between 35-40 percent). Of particular note, though, is that many venture firms in this region (Charles River Ventures, Atlas Venture, New Atlantic Ventures, .406 Ventures, RockPort Capital Partners, just to name a few) have been able to raise new funds—admittedly smaller than prior funds—which is clearly not the case for firms in secondary markets.

New England has a very diverse set of venture funds. The New England Venture Capital Association (of which I am the current Chairman) boasts 137 member firms, of which approximately 50 have made more than three new investments in the last year. This is a broad and diverse investor base which mirrors the many industries represented in this region, and it should serve us well in the days ahead.

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So to bastardize an expression of one of my forefathers, Horace Greeley, everyone should at some point in the near future “go (to the) Far East.” I am traveling through the region as I write this and am constantly amazed by the vitality and energy in all of my meetings. This enthusiasm is present even in the face of what are clearly signs of turbulent economic times ahead.

I grew up for a number of years in Hong Kong, which is where I started my trip earlier in the month. For all its chaos and over-crowding, the former British colony “just works”—and perhaps even more so now that the Chinese have reclaimed this gateway city into the mainland. The level of entrepreneurial activity is overwhelming—everyone I spoke to wants to start a company, has a brother/uncle/grandparent/niece/roommate who has/is/will start a company. Even the expat spouses are starting companies—and these are people living the charmed life of deep-pocketed expense accounts. What is so extraordinary is that the people of this generation of Asians are doing things that their parents could not have even understood—much less fathomed—only a few generations ago.

I had the great fortune of meeting a handful of other regional country investors the last few days as well. It is clear that the broader economic issues—energy prices, commodity prices, broader inflation, extraordinary weakness in the U.S. dollar, volatile interest rates, credit and liquidity concerns—are having profound impacts on the near-term public investment climates throughout the region. As I write this, the Shanghai stock exchange is down nearly 8% for the day. New investment pace has slowed, broader growth rates are off measurably, IPO activity is nonexistent, regional M&A volumes are way down.

But the entrepreneurial enthusiasm appears unwavering. It is clear that people here feel they are establishing the next generation of great companies that will go on to be local and regional winners—much less companies that will compete aggressively on an international scale. And the private investment markets still are showing great fortitude: in Vietnam alone $5.5 billion dollars was raised by 50 new private equity and venture capital funds established last year—this for a country which has only 200 public companies listed on the local stock exchange.

It is not just the regional pride of hosting the Olympics in a matter of weeks which is getting them through the turbulent economic conditions—or the unfathomable devastation caused by the earthquake in Sichuan province or the typhoon in Myanmar—but the sense that Asia is coming of age. I tell my children constantly that although we today think of the centers of the world to be Boston/New York/San Francisco, the centers when they come of age will Beijing/Shanghai/Bangalore—and it takes being here to realize that.

So as Xconomists, what are we to do? Well, in this case, ignorance is not bliss. We risk being eclipsed in a very real and painful way if we continue to be complacent about our competitive position. We are not just competing with the Valley to build the next great Web 3.0 or medical device companies, but a whole host of cities many of us have never seen—much less are able to point out on a map.

I did not set out to develop a set of “cure all” strategies—maybe in my next posting—but rather share my observations from the economic front-lines. And it is rather scary…

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This will be a big year for us in the exponential economy—will we have a recession? Will oil stay above $100 a barrel? Republican or Democrat? Patriots, Celtics, and Red Sox all in one year? While all of these issues are of the utmost importance, I offer up a set of predictions about issues that will have a big impact on our local economy. Here we go…

1. Investor Liquidity Will Continue to Improve: Last year 86 venture-backed companies were taken public, raising $10.3 billion. This compares very favorably to 2006 (57 companies and $5.1 billion, respectively). There were approximately $40 billion worth of venture-backed company M&A transactions last year. Notwithstanding the credit crisis and the volatility in the public capital markets there continues to be attractive growth exhibited by venture-backed firms; this augers well for continued liquidity. And we need this liquidity to make the VC model work.

2. There Will Not be “Too Much” Venture Capital: In 2007, the global venture capital industry raised nearly $40 billion (approximately $25 billion of which was in the U.S.). This was up from $37 billion in 2006. The amount of money raised by venture funds was roughly equal to the amount of VC money invested; the system seems to be in balance. And if there was too much money in the system, why is it still so hard for entrepreneurs to raise capital?

3. But We Will Continue to Face a Shortage of Good Deals: There are 750 active venture funds in the US, 100 of which are in New England. Every venture capitalist is looking for the next big thing—and we all copy each other. Within months, every great idea that gets funded is faced with a handful of copy-cat companies. This has the unfortunate consequence that all hot categories quickly become over-funded, which ultimately drives down investor returns. It is really hard to find a great deal—they are most likely way off the beaten track.

4. More Billion-Dollar Venture Funds Will Be Raised: Counter to the protestations of many venture capitalists who complain that the venture capital model just does not work for billion-dollar funds, many senior VC partners will continue to raise large funds because the fees are just too attractive to pass up. On the margin, however, those funds will tend to over-invest in later Series B and C rounds, which will further depress overall VC returns—because start-up investing (Series A) consistently shows better returns than mid-stage or late-stage VC investing. Yes, the attractive returns will continue to be in the early-stage marketplace.

5. The VC Shake-out Will Continue: With more modest returns in 2008, we should see further rationalization of the venture capital industry. The New England Venture Capital Association has nearly 100 member firms although arguably only a fraction of those firms are considered active. (As President of the NEVCA my sense is that two-thirds of the member firms have made more than one investment this past year.) As high as the barriers to entry are to the VC industry, the barriers to exit are equally as high. Keep in mind that limited partners are often committed to VC funds for between 5 and 10 years. But given all the new firms created earlier this decade, many will struggle to raise successor funds in 2008 and will simply cease to be active investors.

6. Some Cleantech Companies Will Crash Land: 2008 will be a year that we really begin to see the challenges of building successful cleantech companies. No space has been hotter over the last few years. The first nine months of 2007 witnessed $2.9 billion invested in this category, which frankly did not exist in any meaningful way earlier this decade. Some investors will learn painfully that questions such as “Does the technology actually work?”, “Who is the customer?”, and “What is the business model?” are not trivial issues after all.

7. Yes, There Will Actually be Some Bad Deals in China: And I do not say that lightly, as I grew up in Hong Kong (and love that part of the world) and IDG Ventures (where I happen to work) is a leading investor in China. But, quite simply, too much capital has been invested there by foreigners who either do not have the appropriate local infrastructure to manage those investments or have been caught up in the Middle Kingdom euphoria. There will be an absorption issue—can the local economy productively deploy that much capital? Will there be a post-Olympics shake-out? Undeniably there will be, although China will be an important and attractive market over the longer term (as measured in decades). Fittingly, last year was the Year of the Pig, and 2008 is the Year of the Rat.

8. The Convergence of IT and Life Sciences Will Continue to be Important: Notwithstanding the rhetoric around the possible misuse of genetic data, powerful innovations will occur at the intersection of IT and life science technologies. Novel intelligent medical devices will continue to be developed. Advances in engineering, fabrication, energy, material sciences, and computing power will continue to converge to create products that will improve patient care and enhance quality of life. And New England is in a wonderful position to exploit this convergence.

9. The Social Networking Phenomenon Will Get New Legs: As evidenced by Microsoft’s investment in FaceBook, or Google’s new OpenSocial platform, social networking will continue to become more mainstream and will pervade the enterprise. As these platforms become more open to third-party developers, and the cost of starting Web 2.0/3.0 companies continues to drop, many creative entrepreneurs will develop products to monetize this phenomenon.

10. We Will Enjoy Continued Strength in the Local Innovation Economy: Over time, outsized rewards are realized by those who innovate. This year should be a productive one and will set us up for a great decade ahead. And besides, it is not like I could play for the New York Giants—although they may be looking for a new quarterback at some point in 2008.

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At the outset of my career I had the great fortune of working with Bruce Wasserstein on Wall Street who made his reputation imploring CEOs that they should “dare to be great.”

Now as President of the New England Venture Capital Association (and a General Partner at IDG Ventures) I am focused on why we VCs don’t dare to be great and consistently, predictably build billion-dollar companies in New England. This “billion dollar dilemma” has many root causes and the solutions will be complex but I applaud Xconomy for at least providing a forum to debate these issues. This is a problem which needs our attention to ensure long-term viability for this region.

I see two fundamental cultural biases at work here. There is strong bias against failure—the scarlet letter is F. I see it when VCs consider candidates when recruiting for portfolio companies—boards and investors struggle to look past a failure notwithstanding other successes on the resume. My guess is that West Coast investors are more forgiving. Out there, unsuccessful entrepreneurs dust themselves off the next day and get back in the game.

The other bias which I find disturbing involves risk tolerance. My East Coast colleagues—I fear—have a stronger aversion to investment risk than my friends out West. Most successful venture funds will write off 20 percent of the capital they manage. In fact if you are not losing enough money you may not be taking enough risk—and our investors pay us to take calculated risks. While unbounded optimism is dangerous, there is a pervasive sense among West Coast VCs that all their portfolio companies will be enormously successful and have a chance of “returning the fund.”

Ironically, investment-returns data from Cambridge Associates suggests that performance by East Coast VCs over the long term is actually better than that of West Coast firms (nearly 150 percent Internal Rate of Return for New England-based funds versus 85 percent IRR for California firms over the last ten years). Results over the last five years are quite different, though (-4 percent IRR versus 6 percent, respectively). My fear is that we are not backing as readily the “out of the box” opportunities which become the companies that establish new industries. Facebook was started by Harvard students yet was backed primarily by West Coast VCs and is now resident in the Valley—that is very disturbing.

There are a number of structural issues at work as well but I will highlight just a couple—and it is not all about how bad the weather is here. The proliferation of “non-competes” makes it exceedingly difficult to recruit for early stage companies and fosters an environment which shuns startups. These employment terms are much less prevalent out West, underscoring the West Coast entrepreneurial culture. New England is also in some sense saddled by its historic industrial successes. Old line industries have been challenged to retrain workforces and reorient business models in the face of new technologies. New England was dominant in the data communications industry yet today many of the new Internet-centric businesses are based elsewhere.

New England continues to be dominant in one particular industry—the life sciences. Arguably there is no better place in the world to launch a life science company. The entire ecosystem surrounding these ventures is robust and improving. Governor Patrick’s recent billion dollar initiative will help to support future vitality. The continued health of the hospital systems and strength of the academic centers are crucial. And our ability to attract major R&D labs of multinational pharma companies will ensure the health of the ecosystem.

Arguably there are important parallels between life sciences successes and the next great wave of innovative companies in the “cleantech” field. These businesses share long product development timelines, important chemistry and biology innovation, the need for creative sources of funding and partnerships, and complex distribution and customer relationships. As much enthusiasm as there is in cleantech, there is also keen investor debate as to whether this will be a near-term profitable investment area. There is no doubt that the overarching trends are real and the needs for innovative solutions are acute; but will these early companies be good investments? Not clear yet.

But what is clear is that New England needs to support this field. Arguably all of the regions in the country started at some level of parity earlier this decade. But there are troublesome signs that the cleantech ecosystem out West has rallied quickly to foster a very friendly startup environment. It would be a tragedy, given the historic dominance of the life sciences, and the strengths of Harvard and MIT, if New England was not able to maintain a position of leadership here.

So we need to dare to be greater. I fully accept the solutions are difficult to identify, much less implement. For instance, I would like to see New England retain more of its young technical talent (we should offer more affordable housing to all recent grads who want to work in the high tech and life science industries). I would also like to see greater support for commercial infrastructure. I would like to see Harvard be more accommodating to its faculty and students who want to start companies (probably another column altogether).

Maybe I will finally draw up that VC Christmas wish list this year…

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…is coming soon.

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