Sunday, Jan. 11, 2009 | Like so many things in the world of finance, the way in which small start-up companies in San Diego and elsewhere get their seed money might be forever changed by the crash of 2008.
The explosive growth of San Diego’s high tech and biotech sectors over the past two decades was largely dependent on the venture capital financing model, a model that industry experts say has broken down over the past year.
Venture funds, which had their heyday in the 1990s, had already fallen somewhat out of favor in recent years, mainly due to a steady decline in the number of venture-backed companies that were hitting it big in the stock market. But until last year’s market meltdown there was enough investor interest to keep things rolling.
And unlike during previous downturns, some in and around the business are questioning the extent to which venture funds will come back.
“I don’t think you will see a return to the way it was,” said Duane Roth, chief executive officer of Connect, a trade organization for San Diego’s high tech and life sciences industries. “I think it will change radically.”
How things will change, exactly, remains somewhat of a mystery — and a worry — to Roth and others in the innovation economy. For whether it is a university scientist who may have discovered the next breakthrough drug or a computer genius with a potentially revolutionary string of programming code, inspiration needs money to become reality.
Historically, venture capital funds have filled that need. In a venture fund, wealthy individuals or institutional investors like pension funds agree to invest large sums of money regularly for a period of years, with the payoff coming when the company goes public or is acquired.
This model worked famously in the 1990s when initial public offerings were almost daily occurrences. But these days they are barely yearly occurrences. In 2007, there were 76 IPOs of venture-backed companies nationwide, and three in San Diego, according to Dow Jones VentureSource. Last year the number was seven, with just one San Diego company — CardioNet — going public.
From the third quarter 2007 to third quarter 2008, total investment dollars in venture funds dropped by 33 percent, according to Dow Jones. The data for the fourth quarter won’t be out for a couple weeks, but industry insiders say funding fell off a cliff at the end of the year.
An even more ominous statistic for the industry is the median number of years it takes a venture backed company to reach the IPO stage. In 1999 and 2000 it was two years. Last year it was just more than eight years.
So as each quarter passes, the astronomical investment returns of the 1990s are becoming a more and more distant memory. Today, the 10-year average return for a venture fund is 33.9 percent, said Adam Wade, a communications manager for Dow Jones. But if the timeframe is shortened to seven years, the return is 0.2 percent.
“There is a crisis with the venture capital business model,” Wade said. “It will be very hard for them to make the sell that venture funds are a good place to put your money.”
Both Wade and Roth say the data point to significant change in how startups get funded. “We in San Diego, and across the country, need to come up with new ideas on how to fund innovation. Maybe it’s government. Maybe we invest face-to-face with the inventor,” said Roth, meaning that people might try to get more bang for their buck by investing directly in start-up companies rather than through venture funds.
Not everyone shares the views of Wade and Roth. While there is widespread consensus that the current environment for venture funds is as hostile as it’s ever been, some argue that venture funds will come back into favor once the current crisis passes.
One is Elliot Parks, managing director of Hamilton BioVentures, a Solana Beach-based venture fund that specializes in biotech start-ups. Parks said that while the big bubble in venture funds burst during the 2000-2002 market crash, hedge funds suffered the most this time around. This is because hedge funds, unlike venture funds, use borrowed money to build up assets, a big negative in the current environment.
“I think the bloom is off the rose for hedge funds,” Parks said. “So, when things calm down money will not be pouring money back into hedge funds, and venture could benefit from that.”
However, even Parks hedged a bit, calling his outlook “either one man’s opinion or one man’s hope.”
Joseph Panetta said he is bullish on venture capital in San Diego, arguing that where there is high-quality innovation, there are people willing to invest money in it. Also helping matters in the biotech world, he said, is that large pharmaceutical companies like Pfizer and Merck have established venture capital funds because their drug pipelines have been depleted in recent years.
“The evolutionary change is the emergence of big pharma in the venture capital world in a way that is creating a lot more of an attraction to investing in biotech than there was 7 or 8 years ago,” said Panetta, who is chief executive officer of BIOCOM, the biotech trade organization.
Others say the success of venture capital firms will depend on the industry they specialize in. Arama Kukutai, the managing director of San Diego-based Finistere Ventures, said a lot of prominent players have given up on raising capital for the time being. But funds in hot sectors like clean tech may do well even in this environment, he said.
“San Diego has as good a shot as anyone at surviving this,” Kukutai said, referring to the region’s smart workforce and overall desirability. “But we can’t be complacent.”