• by Diane Mermigas , August 11, 2008

Venture capital firms are locked and loaded, and engaged in target shooting. Hitting the bull's-eye will be challenging until valuations, revenue flow and the stock market settle down, paving the way for profitable returns and exits. And that could take at least another year.

The imposed breather is not all bad.

It has given all concerned time to think through where value propositions are headed in the next phase of digital development. The seasoned media, technology and Internet executives who direct these funds can strategically launch the next big ideas and capitalize on the economic disruption.

Start-ups and rollups are the name of the game, although investing is more cautious and conditional--and more fluid than private equity banks and even individual angels.

The entrepreneurial spirit and flying under the radar to identify growth businesses could be part of what spurred venture capital funds to raise $9.1 billion from their investors in the second quarter, up 3% from a year earlier. The number of venture capital firms raising funds declined 14% to 71, about one-third of which raised money for the first time. VC investments were flat at $7.4 billion in the second quarter, with more of the money shifting from early-stage and start-ups to late-stage companies that cannot be sold off or go public. Despite new lows in VC confidence, many venture capitalists are actively seeking diamonds in the rough.

"There are no big exits, and the middle is getting squeezed, but there are lots of good things going on," said Jonathan Miller, who launched Velocity Interactive Group several years ago with former Fox Interactive Group CEO Ross Levinsohn. Velocity is raising its second $300 million fund and investing in publishing, ad networks, inventory management, marketing services and other digital applications. Velocity has invested in six early-stage video, publishing, and digital ventures, collectively representing about $30 million.

Miller is on the boards of some of the investments such as Publish2, a journalist aggregator, search ad company Clickable, online video production Broadband Enterprises and Crowd Fusion, a publishing platform. Despite all the talk about Miller's eventual involvement with Yahoo or Microsoft, he is the quintessential venture capitalist when it comes to identifying and growing new enterprises.

As the VC return on investment time lines are elongated, there has been a clear flight to quality, and a move to sell off what isn't working and consolidate what is. With that done, successful enterprises like Facebook cannot cash out because of a nonexistent IPO market, which is why the company is allowing its employees to sell and deal their stock. Two of the rare IPOs of late have been private equity investors Kohlberg Kravis Roberts and Blackstone Group.

"The capital efficiency time line for selling companies is being stretched to 2009-2010," said Dennis Miller, a managing partner at Boston-based Spark Capital. "As long as you can have a longer horizon, this is actually a good time for investing." Spark has made five new investments in the last six months from its second $360 million fund in such services as Twitter, the online investment service Covestor and Organic lighting-related TJet Technologies.

The same uncertainties that are vexing Yahoo and Microsoft are having A trickle-down effect on the stall across early, middle and late-stage companies engaged in a survival of the fittest. As a result, some VCs are shifting direction to push a specific agenda.

Kleiner Perkins Caufield & Byers, whose money and insights founded the Internet, has turned much of its new investments to the green market, although it has a specific fund just to support the development of new iPhone applications.

Google is expected to direct its new venture capital group on telecommunications companies that will support its Android mobile platform and the mobile advertising to drive it. Its communications investments already include Meraki Wireless, a WiFi operator and Xuniei, a Chinese peer-to-peer service.

Other areas that are getting attention from all VCs and their new foreign investor partners include social media, social networking, marketing services, information, search and even cloud computing.

The blog PaidContent was recently acquired by Guardian for more than $30 million, making for a nifty return on less than $1 million reportedly provided by initial, sole funders Greycroft Partners. Smart, measured growth and fund-raising by blog founder Rafat Ali was key.

Web companies such as LinkedIn--which is profitably achieving its goals--could be safe bets, although Google recently backed off its bid for Digg because of what sources said was an unjustifiably high $200 million asking price. "There won't be a lot of $5 billion or $6 billion exits on a $500 million investment any time soon," quipped one VC investor.

The biggest obstacle to more deals is the need to reestablish justifiable valuations, which are tied to erratic revenue flow and tight financing. "We're seeing asset deflation of historic proportions," said Pimco Managing Director Bill Gross, who estimates $1 trillion in losses from the credit crunch. The risks associated with capitalizing existing companies--especially those caught in the tech sea change--have many investors sitting on the sidelines.

The deterioration of Google's $1 billion investment for 5% of AOL in late 2005 provides a prime example of that asset deflation. Google conceded in a Securities and Exchange Commission filing this week that it "may be impaired." Google's stake could be worth only about $500 million if AOL's valuation has been slashed in half to $10 billion. Some analysts believe it is less than that, based on its most recent quarterly performance.

Still, that hasn't dissuaded cash-rich traditional media companies from buying online Web businesses to extend their brand franchises and revenues. For instance, Comcast has acquired Daily Candy for $125 million, and AOL paid $850 million for Bebo.

As long as online advertising continues to grow at a slower--but still impressive--estimated 20% this year, digital businesses can continue to thrive in trying times. Everyone is hoping for a Sequoia Capital ending to their VC investment. In 2005, Sequoia invested $3.5 million in the video-sharing startup YouTube, although it had no clear path to making a profit. And that didn't keep Google from buying it for $1.65 billion about 18 months later. After all, the estimated $150 billion in available funding has to go somewhere.