• by Diane Mermigas , November 17, 2008

Venture capital, as distressed as other financing vehicles these days, could be a critical link to sustaining recession-time research and development that will assure the next wave of lucrative innovation.

While such eventual sources of new revenues may not be top of mind for executives beset by losses and ravaged margins that are expected to worsen in 2009, they will offer a competitive edge in better times. "It's really ugly out there now, and everyone is getting hit. But this isn't the first time there's been panic and struggle. And when we come out the other side, we'll have something to show for it," said Ross Levinsohn, founding partner of Velocity Interactive Group and former chairman of Fox Interactive Media.

At a time when as many as 80% of startups could fail, investing in startups that naturally align with media's evolving interactive future is imperative. For instance, most of Velocity's 10 investments this year (much of the funding for which comes from large media players) are related to and help advance the state of Web video and advertising over a five-year time frame. The danger for the industry over the next year is that as capital slows, so will innovation.

While venture capital was never more important as de facto research and development for the industry at large, the inability to bring entrepreneurial start-up companies full circle and allow initial investors to exit through merger, acquisition and public offerings will be more challenging over the next 18 months. That also means a slowdown in leveraging grassroots innovation into thriving new businesses and viable Web 2.0 business models.

There are signs that some venture-capital firms are straining as some of their investors--including some pension funds, endowments, private equity and hedge funds--have difficulty meeting their funding commitments. In other cases, some VC startups are falling short of their initial growth timetables and valuation targets. As a result, many VCs are reducing costs at and reassessing their portfolio companies to determine how they should retrench. They are generally holding off on new investments. That has prompted some of the Web's most free-spirited, free-wheeling entities to merge and consolidate without having to rely solely on new outside funding.

According to PricewaterhouseCoopers, venture-capital firms invested $7 billion in 904 deals in the third quarter, down 7% from the prior year. Internet-related investments ($1.1 billion on 194 deals) declined 36% from the second quarter of 2008, underscoring that VCs are becoming more selective and not completely drying up.

While VCs are not exactly "broken," as some industry-related Web sites declare, it's clear that they are only investing the ROI they can recover during this recession. Some VC executives point out that this may result in existing VC-backed startups getting more time, attention and funds to work through the survival process. Others have been quick to point out that more VC funds have been raised than are being invested, and that expectations are often unrealistic. For the first time over the past five years, the amount of VC returns has fallen below the amount of funds invested.

Jason Calacanis, a well-regarded and outspoken Internet entrepreneur and blogger, has penned emails to his followers in recent months about what he calls "the startup depression." "The severity of what has happened can't be underestimated. There will be no white knight. Even the massive coordinated government action...has done nothing to stop the panic. The bottom line: there is zero chance of a short- or medium-term rebound. As a startup, you are officially on your own," he writes.

Calacanis warns about startups flying blind and going into "a death spiral" because they are trusting their visionary instincts instead of their metrics (revenues, burn rate, earnings). Hence, belt-tightening and layoffs are seen even in Silicon Valley.

The good news, Calacanis says, is that "folks are going to be spending a lot of time online, playing video games and consuming things that are not expensive. They are going to be looking for experiences over expenses." That could mean a lot more Texas HoldEm on Facebook and the iPhone. Free time will render more imaginative uses of social networking and blogging. Some more good news: because advertisers are reducing their use of print, broadcasting and outdoor in the recession, they will increasingly turn to and be satisfied by the measurable uses of the Internet to target consumers.

Still more good news: There are no longer going to be 10 companies pursuing one vision. Less fighting means more market share and less competition for great developers. The best things that startups and VC portfolio companies can do during economic turmoil is to grow talent, improve execution and find and "ride" revenue streams. Even for Kleiner Perkins Caufield & Byers--the mother of all VCs that was an early investor in Google, Amazon and AOL--that means setting your future funding sites on one of the few sure investments: green technology and clean tech.

Sequoia Capital, the granddaddy of VCs, offered its own analysis of the current "death spiral," and this antidote: What began as an instructive bare-knuckles presentation dubbed "R.I.P. Good Times" for its portfolio company executives last month has since become an industry-wide call-to-arms and a financial wake-up call for tech companies. The presentation ends with this advice: Get real or go home.

The truth is that no one ever thought that Internet or digital-related endeavors would be so vulnerable. But their vulnerability is largely due to so-called new media's dependence on the same revenue sources as more traditional media: advertiser and consumer spending. That is why VCs whose managing executives are grounded in the realities of media advertising and content will likely weather this storm as they monetize social networks, niche communities, streaming video, mobile wireless and other digital conventions. That in itself could turn out to be an ironic benefit. Too many VCs have mistakenly focused on those conventions without understanding what ultimately binds and drive them.