Venture Capitalists Wary of Economy, But Don't Expect Another Bubble Burst Just Yet

Analysts say Web 2.0 and green tech could see more sluggish funding as venture capitalists worry about exit strategies.

Don't worry too much, all you would-be Mark Zuckerbergs. With some economists citing signs of a possible recession, people following venture capital markets say that there will be some belt-tightening on investments —especially in Web 2.0 and green technology —but it won't be another dotcom bubble bursting.

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According to Mark Hessen, president of the National Venture Capital Association , a trade organization in Arlington, Va., clean tech could be the first area to experience decreases in investment because environmental causes usually takes a back-seat during a recession. "Things like clean tech, in many cases, are nice things to have, but they're not required," Hessen says. "If times get more tough, it might be on the chopping block a little more."

Hessen adds that Web 2.0 start-ups could also see declines in funding. "I do think they get affected in the respect that most of those [Web 2.0] companies have a specific agenda, which is to get acquired by companies like Google, Yahoo and eBay."

Even assuming a company like Google continues to invest robustly (and keeps acquiring companies at a rapid pace), Jeffrey Sohl, director of the Center for Venture Research at the University of New Hampshire, says smaller or mid-sized firms will have less to spend on startup acquisitions. That will slow the market for such deals, as those companies would be more affected by a tanking economy. "Those companies are going be affected a lot if we go into recession," he says. "For many investors, that exit [strategy] could dry up."

On the surface, venture capital fund-raising hasn't been this exuberant since the dot-com bubble. According to a recent report by NVCA and Thomson Financial, venture capitalists raised nearly $34 billion in funds in 2007. They haven't raised that much since 2001, when they brought in $38 billion.

Fundraising by Venture Funds

Venture capital spending in 2007 was the highest it's been in five years.

Year Funds Venture Capital ($M)
2002 79 3,936.9
2003 152 10,606.1
2004 208 19,057.6
2005 228 28,282.6
2006 229 31,698.1
2007 235 34,675.9
Source: Thomson Financial & National Venture Capital Association

If a recession hits, however, it's not clear how much that will affect the acquisition strategies of large technology vendors, which tend to formulate long-term plans for purchasing start-ups or other competitors, according to Alex Cullen, VP and research director, of Forrester Research. Cullen has been researching what a recession will mean to corporate IT spending. "The thing is this: A firm like an IBM, Google or Microsoft doesn't base their acquisition budgets on near-term economic forecasts," he says. "They'd drive themselves crazy if they did."

The issue of venture capital hits close to home in the technology field, where investors got so badly burned with the dot-com bubble. But Hessen says investors learned their lessons from the poor business models of Internet companies of the late 1990s and early 2000s. "The last time you had a much more Wild West mentality," Hessen says. "You had entrepreneurs assuming they'd be millionaires."

Sector Analysis

Of all the industries affected by angel investments, software, electronics and IT services remain at the top followed by health.

Sectors Deals
Software, IT Services and Electronics 29%
Health 22%
Biotech 10%
Retail 6%
Industrial/Energy 6%
Other 27%
Source: Center for Venture Research

UNH's Sohl says many venture capitalists have placed more stringent demands on the businesses they invest in to show viable business models and the ability to generate revenue. "In Web 1.0, you didn't even need to do that," he says. "Today, they have to show they have a real company and real customers. They need to show they can make money over time."

CIO Editorial Assistant Jarina D'Auria contributed to this report.

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