Think Your Start-up Is Venture Worthy? Think Again.

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Pepperdine has a new study out that attempts to shed some light on the clubby, shadowy world of private finance. Researchers polled experts in lending, mezzanine capital, private equity, venture capital and private businesses themselves. Not a big shock, but things don’t look pretty, especially in the venture capital world.

A lot of the stats weren’t surprising. According to VCs, there’s been a 65% decrease in up-rounds (where a company gets a bigger valuation) in the last six months and more than 60% of those polled expect a longer wait for an exit. Similarly, the bulk of the companies getting funding are still California-based.

There does seem to be some shifts on where the money is going. After Northern California and Southern California the biggest area of investment geographically was in international companies. And investors said they intend to invest more in cleantech than software going forward. This is a big reversal, as software has long been the dominant category for venture deals, but it’s unknown whether software has lost favor, or whether it’s just become so pervasive that it doesn’t really hold together as a category anymore.

But it’s when you look between the survey of VCs and the survey of private businesses that things start to get ugly. The businesses, it seems, vastly over-estimate their ability to raise funds. 41% of them feel that they qualify for venture capital funding. Meanwhile, the VCs surveyed indicated that their firms are only doing a few deals every six months and go through one hundred business plans to close one deal. Clearly, the rate of acceptance isn’t anything like 41%, says researcher John K. Paglia, Pepperdiine’s Denney Academic Chair and Associate Professor of Finance.

A few more stats make that picture look worse. Researchers divided the portfolio companies into six stages and startups are still operating a loss in each of the first four. Those categories represent roughly 84% of all portfolio companies. That means the vast majority of privately held companies are still very dependent on venture money to stay in business. And investors aren’t necessarily keen on their prospects. Respondents deemed between 12%-16% of companies generating revenues to be essentially “worthless” and deemed 20%-26% of their pre-revenue investments to be “worthless.” Ouch.

Add to this that 72.7% of VCs said they had a decreased appetite for risk and that more than half of those polled expect their firms to do between zero and three deals in the next year and you start to get the feeling things are going to get a lot worse for private companies, in aggregate, before they get better.

Of course life isn’t that much better for the VCs: Sixty percent of them say their own prospects for raising new funds have declined over the last six months and 41% said they aren’t planning on even attempting it in 2010.

Long term, shake-outs are good for the industry, Paglia notes. Once valuations finish falling, worthless companies are closed or sold at a loss and venture firms that can’t raise another fund hang it up, venture capital will be a much healthier industry on the rise. The big question is just how long that reset takes.

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