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VCs more selective, but San Diego continues positive trend

Venture capital trends look positive, particularly in San Diego, but the sector won't see an echo of the bubble days going forward, experts say.

"We're never going to see it the way it was," said Bill Molloie, PricewaterhouseCoopers partner and leader of the firm's San Diego pharma/life sciences practice. "And I'm not sure that's necessarily a bad thing."

Molloie and other venture veterans use the word "efficient" to describe this new world of venture capital. Limited partners, or LPs -- the institutions and individuals who provide funds with capital -- are more close-fisted these days after losing money in the downturn.

In turn, venture capitalists are more selective about how they choose to deploy their funds: Companies should be further along in development and able to make a little capital go a long way.

In a recent survey of its members, the National Venture Capital Association found that venture capitalists still consider the strength of the management team as the most important factor, followed by market sector. Also, venture capitalists now favor venture-backed talent and value vision and fundraising abilities in a chief executive more than they did nine years ago.

The results "reflect shifting priorities in an environment where both raising funds and the path to liquidity have become more challenging for VC-backed companies," wrote NVCA marketing director Jeanne Metzger on the advocacy group's blog.

Indeed, most agree that venture investors have to be committed for the long haul: Most early stage deals take anywhere from eight to 10 years to reach an exit these days, a panel of venture capitalists agreed at a San Diego Venture Group event in June.

For those in the industry, it's just the reality of the situation. The solid companies with disruptive technology and a stellar management team will still get funded, they say. Investors need to cherry-pick the "innovation nuggets," said Bryan Roberts, a partner at Venrock.

"I think you're going to have a greater sorting of wheat from chaff," he told the SDVG crowd. "But it will remain a picking game … you don't want to invest in the basket."

This is especially the case since returns have been comparatively poor, the SDVG panel said. Roberts, Austin Ventures' Mike Dodd and Battery Ventures' David Dreesen all agreed that there is still too much money in venture capital and most sectors are "overfunded" -- although some say that it's really a matter of perspective. As a result -- to use Roberts' terminology -- some chaff is getting funded along with the wheat, depressing returns in the long run.

The clean-tech sector is a case in point, Dreesen said. Targeted stimulus funds and tax credits have diverted a recession in clean tech, and the sector has attracted $30 billion in venture funding for more than 900 companies since 2005 -- but with very few exits or even failures to show for it.

"There hasn't really been a shakeout yet," Dreesen said, dryly remarking that an investor at least wants his money back and typically wants to see a return of five times the cash invested on an individual deal.

He acknowledges that the sector drivers are all very real: His firm is selectively funding companies for that reason.

"But if you look at the sector as a whole, I have a hard time saying that math is going to work," Dreesen said.

Earlier this month, solar energy company Solyndra canceled plans for a highly anticipated initial public offering that would have raised up to $300 million. The company said it would sell $175 million in notes instead.

"Given the ongoing uncertainties in the public capital markets, we elected to pursue alternative funding from our existing investor base," said Solyndra CEO Chris Gronet in a statement.

Still, the venture capital numbers seem to be improving. Nationally, venture capitalists invested more than $4.7 billion in 681 deals in the 2010 first quarter, according to the MoneyTree report released quarterly by PricewaterhouseCoopers and the NVCA.

The figures are lower than the $5.2 billion invested in 832 deals in the fourth quarter of 2009, but represent an improvement from a year ago. In the first quarter of 2009, the amount invested dove to $3.4 billion in 635 deals from $5.8 billion in 913 deals the quarter before, and $7.7 billion in 1,020 deals in the first quarter of 2008.

In San Diego, dollars invested surged to $222 million in 29 deals in the first quarter. This figure was down slightly from $305 million in 31 deals in the fourth quarter but a vast improvement from the $92 million invested in 16 deals in the first quarter of 2009.

"We often hold up San Diego as an ecosystem that is working," said Emily Mendell, NVCA vice president of strategic affairs and public outreach, pointing to the local community of entrepreneurs, trade support groups and universities.

PricewaterhouseCoopers' Molloie warns that quarterly totals can be skewed by large deals and other factors. For him, the percentage of dollars going to fund startup, early-stage and early-sequence deals is more an indicator of growth than the number of investment dollars per quarter.

Those numbers are trending positive, too: The percentage of dollars and deals going to startup and early-stage companies as well as the percentage of dollars and deals going to companies for the first, second or third time have been steadily edging up over the last few quarters.

San Diego's data is even stronger: Forty-two percent of dollars and 41 percent of deals went to startup or early-stage companies in the first quarter, compared to 32 percent and 44 percent nationwide, respectively. The average deal size was $7.9 million, compared to the national average of $4.8 million.

Fifty-four percent of dollars and 55 percent of deals were in the first three funding sequences, compared to 52 percent and 60 percent, respectively, nationwide. The average deal size was $7.5 million, compared to the national average of $5.9 million.

Venture capitalists are also keeping an eye on financial reform. The overarching issue for the industry is taxation treatment of carried interest, or a percentage of profits that the venture industry sees as its return on investment rather than compensation for services.

Carried interest, or carry, is currently taxed at the long-term capital gains tax rate of 15 percent. However, both the House and Senate versions of the evolving financial reform bill call for blended tax treatment of carried interest, with a large portion being treated as ordinary income and the remainder being treated as capital gains.

The venture industry argues that treating carried interest as income removes the incentive to invest in high-risk startup companies.

Still, Molloie says the industry is resilient.

"Whenever economic policy changes, it has an impact on people's behavior. … Do I think it will shut down investment forever? No," Molloie said. "It'll just take some time to figure out how the investment process becomes efficient again."

The Associated Press contributed to this report.

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