One of the things I continue to struggle with as a VC is the unfortunate fact that I am in the business of saying "no" all the time.

Saying "no" in the context of how you invest your time is one thing – fellow VC blogger Brad Feld did a good blog post on this topic in the context of time management a few weeks ago as did Y-Combinator's Paul Graham.  But I really struggle with saying "no" to entrepreneurs.  Entrepreneurs pour their hearts, souls and dreams into their start-up ventures and to summarily dismiss them remains the hardest thing about the job.  One of my entrepreneur buddies asks me whenever I see him:  "So – did you crush any entrepreneurs' dreams today?"  Very funny.  Ha ha.

One of the reasons for this dynamic is that VCs are in the business of trying to see everything (i.e., learn about and meet with all the best deals out there) but do nearly nothing (i.e., invest in only one or two companies a year).  My blog post on this topic a year ago was a bit tongue in cheek (VCs and Deal Flow), but only a bit.

My dilemma becomes more acute when I try to explain why I am saying "no".  In particular, how do you say no when the reason for turning down the investment opportunity is the team?  It's easier to say no when you have concerns about the market, the business model or the price.  The entrepreneurial team is great, you would enjoy working with them, you think they are money-makers, but there's something in the general model that prevents you from pulling the trigger.  Those are the easy ones.

The hard ones are when you are saying no because of the team.  Successful start-ups typically follow Thomas Edison's genius formula:  10% inspiration (in start-up land, the vision or idea), 90% perspiration (in start-up land, the execution).  Whether you like the idea or not is irrelevant if you don't believe the team has the wherewithal to execute it successfully.  Sure, a team can evolve over time and new leaders can be brought in, but very few VCs invest behind teams they don't believe in.

One curmudgeonly VC I know used to say to entrepreneurs:  "I don't think is an opportunity that suits you." At Flybridge Capital, we try our best to be direct and honest in providing feedback to entrepreneurs to help them with their ventures and perhaps we should have the courage to give it to people between the eyes.  I'm just not sure this blunt feedback would pass the decency and respectfulness test.  After all, who am I to project such an unfair judgment based on a 45-60 minute meeting?  VCs need to "Blink" and make snap judgements after those 45-60 minutes in order to filter and prioritize how they spend their time, but why be mean about it?  So in the end, I often settle for a polite "it's just not a fit for us".  Is that the right approach?  Let me know what you think.  What's the meanest turn down you've ever received from a VC?

VCs have an unfair advantage when it comes to financings.  They simply have more experience doing deals.

A typical start-up company will do 2-4 venture capital financings before a successful exit (or, conversely, an ignomious ending).  A typical serial entreprenur may lead 2-3 companies in their career before calling it quits (or checking themselves in to an insane asylum).  Thus, the universe of financings that even the most experienced entrepreneurs get directly exposed to is typically 5-10 financings over a 15-20 year career.  In contrast, the typical venture capitalist, either individually or across their partnership, will do 5-10 financings in any given year.  Year in, year out,

Thus, VCs and entrepreneurs are not operating on an equal playing field when it comes to negotiating financings and interpreting the impact of the terms involved.

One area that has always struck me where this assymetrical relationship comes into sharp focus is when there's a discussion around the price of the deal.  Entrepreneurs often mistakenly focus solely on the pre-money valuation while VCs look at multiple knobs in the negotiation to drive to a set of terms that, in total, they find acceptable.  And if they don't focus on the pre-money, they focus on their ownership position after the financing, irrespecive of the amount of capital that was raised.

In my partnership, we've come up with a new term (I think it's new – I don't see it written or talked about much) called the "promote" to help communicate with entrepreneurs the real value behind a particular deal so get them to step back from concentrating only on the pre-money valuation or post-money ownership.

What is the promote?  First, let me take a step back and define a few terms.  In the world of VC-backed financings, there are multiple terms that impact the ultimate price of the deal.  The first, and most focused on, is something called the pre-money valuation. That is, what is the company worth prior to the money being invested? This pre-money valuation is own known in shorthand as “the pre” and you will hear entrepreneurs and VCs discussing other company finances using this term (“You were able to raise money at a $9 pre?  I had to struggle to get to $6 pre and I have a prototype and real customers!  Life isn’t fair.”)

But the pre-money isn’t the only term that defines price, the amount of capital raised and the post-money plays a part as well.  The post-money is the pre-money plus the invested capital.  That is, if a company raises $4 million at a pre-money valuation of $6 million, then the post-money is $10 million.  The investors who provided the $4 million own 40% of the company and the management team owns 60%.

Another term that impacts the price is the size of the option pool.  Most VCs invest in companies that need to hire additional management team members and sales and marketing and technical talent to build the business.  These new hires typically receive stock options, and the issuance of those stock options dilute the other investors.  In anticipation of those hiring needs, many VCs will require that an option pool with unallocated stock options be created prior to the money coming in, thereby forming a stock option budget for new hires that will not require further dilution after the investment.  In our $4 million invested in a $6 million pre-money valuation example above (known in VC-speak shorthand as “4 on 6”), if the VCs insist on an unallocated stock option pool of 20%, then the investors still own 40%, there is a 20% unallocated stock option pool at the discretion of the board, and a 40% stake is owned by the management team.  In other words, the existing management team/founders have given up 20% points of their ownership in order to go towards future hires.

This relationship between option pool size and price isn’t always understood by entrepreneurs, but is well-understood by VCs.  I learned it the hard way in the first term sheet that I put forward to an entrepreneur.  I was competing with another firm.  We put forward a “6 on 7” deal with a 20% option pool.  In other words, we would invest (alongside another VC) $6 million at a $7 million pre-money valuation to own 46% of the company.  The founders would own 34% and we would set aside a stock option pool of 20% for future hires.  One of my competitors put forward a “6 on 9” deal, in other words $6 million invested at a $9 million pre-money valuation to own 40% of the company.  But my competitor inserted a larger option pool than I did – 30% – so the founders would only receive 30% of the company as compared to my deal that gave them 34%.  The entrepreneur chose the competing deal.  When I asked why he looked me in the eye and said, “Jeff – their price was better.  My company is worth more than $7 million”. 

At the time, I wasn’t facile enough with the nuances myself to argue against his faulty logic.  That's why we instituted a policy at Flybridge to talk about the “promote” for the founding team more than the “pre”.  The “promote”, as we have called it, is the founding team’s ownership percentage multiplied by the post-money valuation.  It represents the $ value in the ownership that the founding team is carrying forward after the financing is done.

In my example of the “6 on 7” deal with the 20% option pool, the founding team owns 34% of a company with a $13 million post-money valuation.  In other words, they have a $4.4 million “promote” in exchange for their founding contributions.  Note that in the “6 on 9” deal, the founding team had a nearly identical promote:  30% of a $15 million post-money valuation, or $4.5 million.  In other words, my offer wasn’t different than the competing offer, it just had a smaller pre and a smaller option pool.

Entrepreneurs negotiating with VCs should spend time making sure they understand all of the aspects of the deal, but particularly the elements of price – the pre-money, the post-money, the option pool – and do the simple math to calculate the "promote".  There are many other elements of the deal that affect price (participation, dividends) and control (board composition, protective provisions), but make sure you think hard about the value you're carrying forward, not just the price tag you think the VC is giving your company in the "pre".

Follow me on Twitter at www.twitter.com/bussgang.

With the 4th of July approaching, the unofficial summer is about to begin.  In almost every board meeting with portfolio companies and other entrepreneurs who are raising money, I'm hearing the same refrain:  "The VCs are about to shut down for the summer".  Phone calls and emails won't get returned, partners meetings won't be held, and you might as well put your head down and build your company as best you can and then show up after Labor Day rather than wasting time knocking on VC doors.

I admit this is only my 7th summer as a VC, so I'm still new to this thing, but I just don't get it.  I still work during the summer.  My partners work all summer.  My co-investors and their firms seem to be working all summer.  And even when I'm on vacation at the end of August, if there's a board meeting, a financing, or a crisis, I'm available to my CEOs.  So are all the other VCs I know in the industry.  When I switched from being an entrepreneur to becoming a VC, I remember my friend and mentor Ted Dintersmith telling me:  "Jeff, take as much time off as you can in before you start off, because when you're a VC, you're never really 'off'.  There's always some crisis in the portfolio, a transaction that needs to get done, a personnel issue that needs attention."

it got me wondering what the data showed on this topic.  If the urban legend was true that VCs took the summer off, you would expect Q3 deals to be meaningfully lower than other quarters in the year.  So I looked at the NVCA funding data by quarter (www.nvca.org).  The quarterly chart was revealing – I saw no discernable quarterly pattern.  In fact, in each of the four years betwen 2005-2008, an eerily precise 25% of deals were closed in Q3 (25.0%, 24.6%, 25.1% and 25.0%, respectively)!

Some may argue that the quarterly data is misleading because Q3 covers September and many of these deals get closed after Labor Day.  But this argument seems specious given that all the hard work on both sides happens 30-60 days before a deal is closed, when the VC does their due diligence and term sheets are negotiated.  Rather than rejecting this counter argument prima facie, I decided to dig deeper.  So I looked at our own data at Flybridge Capital Partners and did a more micro seasonality analysis.

We have closed 42 new deals since we started the firm 7+ years ago.  Guess which month was our largest in terms of number and capital?  August, with 9 new deals closed!  December was second and July was third.  So much for taking the summer off.  Looking at the follow-on investments and new deals in aggregate (nearly 120 transactions), our data shows that December was the most active month and August second.  So much for that theory.

I'd be curious to hear what other VCs and entrepreneurs experience on this dimension, but I have to say that the data suggests the urban legend is false.  VCs simply do not take the summer off and aspiring entrepreneurs can get plenty of deals done, all else being equal.

We announced today a mentoring program for New York-based start-ups alongside a number of other VCs and Lowenstein Sandler.  More information can be found at:  www.firstgrowthvn.com. 

I was excited to be a part of starting this effort to provide more support and resources for fledging young start-ups in NYC and contribute to the start-up ecosystem.  I have been impressed with the quality of entrepreneurs and companies in NYC for a number of years now and have dedicated a day or two a month to get to know some of the players and leaders in the community.  When Ed Zimmerman of Lowenstein Sandler threw out this idea a number of months ago, it immediately resonated with me.  In many ways, it's taking a formula that has worked so well at MIT and Harvard – teaming former entrepreneurs, VCs and financial and legal advisors with young entrepreneurs – and applying it to NYC.

Anyway, very excited to be a part of it and it will be fun to see where it leads and to have a forum to collaborate with others to help contribute to the start-up ecosystem in NYC.  A nice article about the effort can be found at Xcomomy.

Anyone interested in joining the program can find information at the program's website at www.firstgrowthvn.com.

June is innovation month in New England and it has started off with a bang.  A few weeks ago, Business Week named Boston the 3rd most inventive city in the world.  This week, The Deal declared that Route 128 is well-positioned to continue its leadership in innovation, despite the economic crisis, due to its diverse economy and robust enterpreneurial environment.  All month, there are numerous high-quality events going on, including an Unconference run by Mass TLC,  MIT Deshpande Center's IdeaStream and MITX 2009 Awards night.  Much thanks to Scott Kirsner for catalyzing this energy around innovation month (to learn more, see:  www.neinnovation.com)!

With all this attention being put on innovation in New England, I thought I would throw out a top ten list.  If there were ever to be created an Innovator Hall of Fame, these 10 would get my vote for the first inductees.  With apologies to Edwin Land, Ken Olsen, and others, this is not a historical view.  These are currently active players in the innovation scene.  I solicited input via Twitter and Facebook on this and got great (and fairly consistent) responses.  In no particular order:

1) Bob Langer.  With over 600 patents in his name, MIT Professor Langer is second only to Thomas Edison as the most inventive American in history.  Bob's work during his decades at MIT has resulted in the creation of 25 companies.  My partner, Michael Greeley, refers to Bob as a "National treasure" and New England is very fortunate to have him.  Harvard Business School did a wonderful case on the Langer lab.

2) Ray Kurzweil.  Ray is a controversial figure as a futurist but is an accomplished inventor and entrepreneur.  His latest book, "The Singularity", claims we will have multiple microchips and machines blended into our body over time to prolong life (which, given our investment in a Langer founded emerging leader in implantable biosensors and drug delivery, MicroChips, this may not be so far fetched!).  Newsweek had a wonderful profile of him last week, describing him as "a legend in the world of computer geeks".

3) Bill Sahlman.  Bill has been a professor of entrepreneurship at Harvard Business School for nearly 25 years.  When he began, he was one of two or three professors teaching this topic.  Today, the entrepreneurship department, which he chaired for many years, is the second largest department in the school with over 30 faculty members.  Bill has inspired and seeded countless entrepreneurs (including me!) and has taught his sold out Enterpreneurial Finance class (created in 1985) to over 5,000 students, including probably 20-30% of the VCs in the country.  He once told me he has been a private investor in over 100 start-ups and 70 VC funds – many of whom were former students (HBS profs aren't allowed to invest in current students)!

4) Helen Greiner.  The founder and former CEO and chairwoman of iRobot, Helen has been the godmother of the robotics industry in Massachusetts.  Today, there are dozens of robotics start-ups that can trace their roots to iRobot, which pioneered both military and mainstream consumer applications for robots.  iRobot's Roomba vacuum is so mainstream, it was the subject of this hilarious Jon Stewart piece.  Helen  is starting another robotics company (currently in stealth mode) and serves as chair of the national Robotic Technology Consortium.

5) Yet Ming Chiang.  MIT Professor Chiang is the technical founder of A123, the battery start-up that is shaking up how power is generated in the automobile, utility and tools industries.  A123 has become the poster child for the power of innovation in clean technology, both in Massachusetts and nationally.  Yet isn't resting on his innovation laurels.  He recently founded another company, Entra (currently in stealth mode), with fellow MIT Professor Michael Cima.

6) Eric Lander.  Eric is the director and co-founder of the Broad Institute, the leading genomics research institute in the world.  With the help of the Broad family, other philanthropists, and your tax money via the NIH, he now presides over a research institution with a $240 million annual budget that is using cutting-edge genomics research to revolutionize medical knowledge and practice.  One of the leaders of the Human Genome Project, Eric was named one of "America's Best Leaders" by US News & World Report and recently asked by President Obama to co-chair the President's Council of Advisors on Science and Technology.

7) Paul Sagan.  As CEO of Akamai, Paul has been there from the beginning in leading this pioneering start-up in Internet content delivery from inception (alongside now chairman George Conrades) to its current status as the $1 billion king of the Internet content delivery industry.  Paul's work in navigating the company through the IPO during the boom times of the 1990s and bubble crash has allowed it to emerge stronger than ever.  As a former media executive (Paul won three Emmy Awards as a broadcast journalist) teamed with brilliant MIT technical founders, Paul is proof positive that teaming up business minds with technical minds can create a revolutionary company.

8) Paul Levy.  He may not be a company founder, but Beth Israel hospital CEO Paul Levy is an incredibly innovative and entrepreneurial leader.  He is the only hospital CEO in the country who regularly blogs (see:  Running A Hospital) and uses Twitter (www.twitter.com/Paulflevy) to communicate with his employees and patients.  During the economic crisis, he was out in front in communicating with his eight thousand employees the impact on the hospital's budget and took a very public pay cut, alongside his senior team, to save jobs.  Paul may not be a technology entrepreneur, but as a leader who is using technology in an innovative way, he stands head and shoulders above his peers.

9) Governor Deval Patrick.  Deval has arguably done more to foster and support New England's innovation economy than any political leader in New England history.  He has demonstrated exemplary leadership both in words and deeds — passing legislation in clean energy and life sciences and travelling around the country as an effective Salesman in Chief.  As a former business executive, he gets the power of innovation and technology and values it as a key asset in the Commonwealth.

10) Ned Johnson III.  The very private and low key founder of Fidelity, one of the most important financial services firms ever created.  Johnson democratized mutual funds and the stock market, pioneered online brokerage and sophisticated call centers, and has created tens of thousands of jobs in Massachusetts, New Hampshire and Rhode Island.  Celebrating his 79th birthday at the end of this month and still firmly in charge, he is well deserving of a Hall of Fame inductee.

These 10 are awe-inspiring innovators and it is simply a gift to have them as members of our community.  Honorable mentions include: Josh Boger (Vertex), Michael Cima (MIT, MicroCHIPs, T2, Certus, Entra), Desh Deshpande (Cascade, Sycamore, Deshpande Center at MIT), Dean Kamen (Segway, Deka), Alan Khazei (City Year), Larry Lucchino (Red Sox), Mike Stonebraker (MIT, Illustra, Vertica, Streambase, Goby), Jeff Taylor (Monster).

Who did I miss?  What would you argue with?

Amid the hoopla a few weeks ago at the annual NVCA meeting, where the focus was rightly on improving liquidity, it was barely noticed that a new chairman was elected – Polaris co-founder and managing general partner Terry McGuire, one of the leading life sciences investors in the industry.  In normal times, the NVCA chairman is hardly an earth-shaking position (although certainly of higher value than FDR’s Vice President John Garner felt about his office).  But these are hardly normal times and the NVCA chairman is bound to find himself in the middle of many interesting policy debates in the coming year.  I was therefore intrigued by Terry’s election and so talked to him the other day about his new role.

Terry co-founded Polaris in 1996 after seven years as a VC at Burr Egan.  His focus on life sciences emerged over the last 10 years, although he started in the business as a generalist and has had no formal medical training or education.  In addition to his impressive life sciences portfolio (including Sirtris, GlycoFi and Cubist), Terry was the initial investor in one of the most successful VC deals of all time, Akamai, a company that Polaris invested in (alongside Battery) with an $8m Series A in 1998 and then went public in 1999 and commanded a peak market capitalization of over $20 billion shortly after the IPO (the market capitalization is now $3.5 billion, as the company has successfully “grown into its valuation” and become the leading in the content delivery market).

Terry’s ascension to chair of the NVCA comes at an interesting time, to say the least.  In our conversation, he made a few observations in his usual soft-spoken but pointed way that I found particularly interesting:

(1)     Small Ball.  At $20-30 billion per year, the venture capital industry as a whole remains a “drop in the bucket” in terms of capital deployed relative to the over trillion dollars sitting in private equity firms.  Yet the impact is enormous, with 18% of GDP provided by venture-backed companies.  Thus, there is great (positive) leverage in the VC model and, as a result, policy makers should be paying more attention to it and demonstrate an interest in how to accelerate it.

(2)     Wanted:  Grumpy Old Men.  There is a tremendous need for “old guys” to stick around in the VC business rather than fade off into the sunset.  In the private equity world, the industry leaders hang around forever well past their 50s and 60s.  In VC, it’s considered more naturally a young person’s game (perhaps because we’re always dealing with waves of new technology, young founders).  Yet, the VC business takes a long time to figure out.  The industry needs the investors who were around in the pre-bubble era (1980s and first half of the 1990s) to stick around and impart their wisdom on the next generation, who has grown up in the business during unusual times.  It is scary to reflect on how few of the 7,000 professionals active in the industry today were general partners before Netscape’s IPO in 1995.

(3)     Life sciences.  With the incredible advancements in genomics, computational power and miniaturization, we are arguably entering into a golden age of innovation in life sciences (which encompasses healthIT, medical devices, diagnostics, and touches adjacent areas such as materials science and robotics.  Having an NVCA chairman steeped in that world, at a time when the US Government is looking to perform a top-down re-engineering of the health care system, which is projected to make up 20% of GDP in a few years, is good timing indeed.

(4)     Boston.  With 14 teaching hospitals and world-class research and entrepreneurship factories like MIT and Harvard, Boston has arguably emerged as the top life sciences start-up environment.  With related technology advancements in energy technology and strong legislative support from the state of Massachusetts, it is arguably uniquely positioned there as well.  Admittedly it is a distant second to California in software and Internet innovation, but as a proud Boston-based VC, I was pleased to see Terry brimming with confidence in Boston as an entrepreneurial hub.

It will be a year of both challenges and opportunity for the VC industry, but Terry was eager to dig in during the year ahead.

For as long as I can remember, I have been an enthusiastic participant in sports.  To be clear, I'm not a great athlete (in fact, I'm the only one of the five Flybridge General Partners that wasn't a varsity athlete in college), just good enough to participate passionately and aggressively like the prototypical weekend warrior.  During any of my amateur sports efforts — whether competing in mini-triathlons, tackling hard ski runs, or trying to jump the wake while Water-skiing — I've always enjoyed pushing myself and approaching the task fearlessly.

This week, for reasons that will become clear shortly, I was reflecting on why it is that I am so fearless as a competitor, even as I've gotten older.  I came up with two reasons.  First, I'm not afraid of losing or failing and, second, I'm not afraid of getting hurt.  The former is probably because winning has never my ultimate objective, but rather the fun of competing and the enjoyment of achieving some level of mastery. 

And I've probably never been afraid of getting hurt because I've never gotten hurt.  I've been simply very lucky.  That is, until 6 weeks ago when a collision during a Saturday morning pick-up basketball game caused my ACL tendon to rupture.  My luck ran out.

That's why I'm typing this blog from bed, with my left leg strapped into a continuous motion machine, barely able to propel myself on crutches, and in excruciating pain.

During my recuperation period this week, one question I've been contemplating is – when I'm back to full strength, will I return to sports with the same aggression, or will I have lost some of my fearlessness?

Ironically, it is the identical question I struggle with as an investor.  Vinod Khosla once said it takes 7 years and $30 million in losses to train a venture capitalist.  Although I haven't lost $30 million of my LPs' and partners' money in my 7 years as a VC, I have made my share of bad investments.  When I look back on my struggling deals and do my post-mortem with my partnership (something we do during our annual strategy offsite), I point to the mistakes I made and errors I'll try to correct the next time.

But I think I now appreciate that Vinod's point is something broader than being a good VC requires learning from failure.  It also requires the fearlessness to pick yourself up after failure and take high risks again and again.  Not losing confidence in your ability to judge good people, good opportunities and good markets is the key to transforming those early failures into more consistent successes going forward.  Vinod and other legendary VCs still make their own investment mistakes 20 years later, but they remain fearless in willing to plunge forward to back the next big idea and great entrepreneur. 

With this challenging economic environment, VCs are facing more than their share of failure – and there's more to come.  Let's hope for our industry's sake that we VCs all bounce back with the same spring in our step that I intend to have 6 months from now on the basketball court.

It used to be that anyone in the entrepreneurial world had to be keenly cognizant of what was going on in New York City.  If you were funded by VCs in Silicon Valley, Boston, or Bombay, it still paid to have your CEO and sales team have eyes and ears in NYC for two main reasons.  First, that's where the customers were.  CIOs of financial services companies were viewed as gods by many in the start-up community, controlling billions of dollars in IT spending and often willing to experiment with young companies and the next, new thing.  The large media companies, too, were seen as great early customers and hotbeds of innovation (I remember how thrilled we were when we secured Time Warner's ground-breaking Pathfinder division as a customer at Open Market back in 1995, thinking we had landed what would be the 800 lb gorilla of the Internet age).

And, secondly, NYC is where the big capital was – that is, after the company had matured past the VC financing stage.  The rules of the game for the start-up's ultimate goal, accessing the public market through an IPO, were set by the investment bankers and sales desk traders on Wall Street.  CEOs of pre-IPO companies were always shuttling into New York to talk up their companies, tell their story and get feedback to prepare for the public markets.

My how things have changed.  New York City feels increasingly irrelevant to most start-ups as both a source of customers and large amounts of capital.  Instead, Washington DC has in many ways become the New, New York.

This new dynamic was evident when I joined 100 CEOs from Massachusetts in a pilgrimmage to our nation's capital as part of my role as co-chair of the Progressive Business Leaders Network (PBLN).  Frankly, I was worried that our fate would be similar to all the other conferences I've attended since the economic crisis – that attendence would be down 20-30% from the previous year.  Instead, it was up 50%. 

As you would expect, the CEOs were keen to hobnob with the Washington elite and their peers.  But more importantly they were interested in how the new paradigm that the Obama administration is going to affect their businesses.  And like all good entrepreneurs (the bulk of our membership are CEOs of mid-sized and small young companies, not Fortune 1000), they were looking for insights and opportunities.  If you are playing in the $6 trillion energy sector, the $3 trillion health industry or even large parts of the $1 trillion IT industry that touch regulations (e.g., broadband, wireless), then what's going on in Washington DC matters to you.  Senator John Kerry repeated what has now become a common refrain from politicians:  "The next Google will emerge from the energy sector".  And it seems the US Government is determined to facilitate this by pouring billions to stimulate the sector.

To be clear, I'm not saying that there aren't many VCs in New York doing good work.  In fact, it is encouraging to see the NY-based entrepreneurial community flourish as much as it has, centered mainly around the transformation and digitization of the native advertising and media industries.  But for companies outside of NY, it is simply less relevant, whereas Washington has gone from being irrelevant, to suddenly centrally relevant.

Personally, I don't believe this power shift to Washington DC is entirely a good thing.  In truth, it makes me very nervous that we are entering an era where public opinion and public officials are against what has made this country so great and unique in the world – the aggressive pursuit of open markets, free trade and a strong distate for regulation and government intervention in business affairs.  Governments have never been good at picking winners and losers in the free market (see:  Japan, collapse of).  But, the reality is that this administration's ambitions are breathtaking and transformative.  Business leaders have never had a stronger reason to care more about following what's going on in the halls of Washington.

One of our portfolio company CEOs is amazing at spending all his time running around with clients and chasing new business.  Lately, we find ourselves coaching him to spend more time in Washington DC.  Last night, I was at a dinner with the founder of one of the most promising cleantech companies in the country and he observed that in 2008, he visited China and NYC ten times each.  In 2009, he has already been to Washington DC ten times.  It's a sign of the new reality, like it or not.

The news came out yesterday that VC funding in the US was down in Q1.  Really down.  VC funding into start-ups averaged roughly $20 billion a year for many years since the bubble crashed and recently (2007 and 2008) had creeped up to $30 billion a year.  The Q1'09 figure was $3.0 billion, suggesting we are on a $12 billion runrate.

Although new financings may pick up a bit in the second half of 209, I would predict that VC funding for 2009-2011 doesn't exceed $20 billion per year and probably stays closer to $15 billion per year.

And guess what?  VC downsizing is ok.  In fact, it's a good thing. Frankly, I'm not sure the VC industry should be much above this range.  It's not that there are a lack of great entrepreneurs chasing great ideas.  It's simply the lack of good exit prospects.  We don't have input constraints.  Instead, we have output or exit constraints.

Clearly, the lack of attractive exit prospects is choking the industry right now.   VC fund after VC fund can point to portfolio companies that are growing rapidly, taking market share, even achieving profitability in many cases, but have no place to go.  The IPO market remains completely irrelevant to VCs.  Yes, Rosetta Stone had a successful IPO – the first one since March 2008 to be priced above the range.  And there are a few other interesting filings in the pipeline.  But don't be fooled by bankers bearing gifts and snake oil.  The IPO market may return modestly for some large, profitable companies will not return anytime soon for VC-backed companies.  You know it's a bad young company IPO market when the case studies the bankers cite are Visa and Mead Johnson

I attended a breakfast last week where JP Morgan's vice chairman, David Topper, gave his review of the macroeconomic picture, including the IPO market.  Although he was too polite to say it outright, his data clearly showed will be irrelevant to VCs for the foreseeable future.  He laid out the three criteria that are required for an IPO candidate:

1) IPO size of $200 million (implying a market capitalization north of $700 million). Without this level of float, there isn't enough liquidity in the stock to attrack investors.

2) Profitable, established business (i.e., not "approaching profitable" but proven profitable over many quarters if not years).

3) Minimal leverage.

Of these three, #1 is the real killer for venture-backed start-ups.  When I was an executive at Open Market and did our IPO in 1996, we executed an $80 million IPO – at the time, that was considered mid-sized.  In today's environment, where Google is trading at a 6-8x EBITDA multiple and typical revenue multiples are 2-3x, an IPO candidate would need to be throwing off $100 million in cash flow and/or generating north of $200-300 million in revenue while still growing fast.  These are incredible numbers for venture-backed start-ups less than 10 years old.

There are complaints about reforming Sarbanes Oxley – and I have added my voice to those complaints in the past – but I walked away from this breakfast with a greater appreciation for why one of the NVCA policy leaders recently said to me, "SOX reform is important, but no one is going to focus on that until restructuring the financial system as a whole is done."

I also appreciated why my friend and mentor, HBS Professor of entrepreneurship Bill Sahlman, told me last week that he thought the VC industry needed to shrink in half.  Going from $30 billion per year in outflow to $15 billion per year would mean just that – and it will mean more VC personnel departure and fund shut downs.  And, again, that's ok.  It's worth noting that the last time annual VC funding dipped below $20 billion was in 2003, which saw $19 billion in VC investment.  2003 was one of the best vintage years in the last decade, as many are arguing 2009-2010 will be.

Maybe I'm simply a rose-colored glasses optimist, but at the end of the day, an industry that quickly adjusts to new realities is a healthy sign.  Until we figure out an alternative exit vehicle (and maybe someday the overall public market health will allow some liquidity to filter down to the VC-backed world, but don't hold your breath), we can't absorb more than $15-20 billion in annual VC investments anyway.  So let's get the industry back to that level and vigorously deploy those dollars in as productive and rewarding a fashion as possible.

The annual wireless industry trade show, CTIA, had some interesting trends this year.  Putting aside the fact that Las Vegas feels like a ghost town, cab lines are uncharacteristically short, and my personal frustration that I find myself agreeing with an arch-conservative economist Arthur Laffer’s editorial in today’s WSJ on how Obama’s estate tax policy creates perverse Vegas incentives (!), here were my top 5 Take-Aways from CTIA:

1. <span The Lights Are Still On.  The wireless industry is clearly a bright spot:  secular trends for the industry’s growth and innovation remain strong.  That said, the show was meaningfully affected by the recession.  On the positive side, 2008 saw 1 trillion text messages (up 3x from previous year) and double-digit growth in revenue and subscribers.  Content and applications are exploding as everyone is trying to follow iPhone’s pioneering moves and (finally) smart phones and the mobile Internet are becoming mainstream in the US.  That said, conference attendance was down 20% as compared to last year by some estimates and show floor had a much, much emptier feel than usual. 
2. <span <span Innovation is happening, but VC investment isn't.  Analyst firm Rutberg & Co reports that overall VC investment in wireless was down 30% in 2008 as compared to both 2006 and 2007, sharper than the 15-20% average VC investment decline in technology.  I predict 2009 will also be a bad year for wireless VC investments.  The conversations I had with VCs all rhymed:
   1.  “There are very few big ideas left in wireless”.
   2. “We already have a number of chips on the table and don't see the need for more".
   3. <span <span <span “The bar is very, very high right now”.
   4. <span <span <span (most damning) “The big guys (carriers, handset players, operating system owners) own too much of the value chain – there’s too little room for entrepreneurs”.
3. <span <span <span Device fragmentation is here to stay.  iPhone’s explosion from nowhere over the last two years is impressive, but the entrenched competitors, Blackberry and Palm, are fighting back.  Blackberry’s open application store was a ho hum launch, but at least they recognize that a thriving, open application store is now table stakes and all the major content players are jumping on board.  One carrier executive told me that every device manufacturer (think Nokia, LG, Samsung) is coming to them looking for help on their content and application store strategy.  That’s not going to make things any easier on the leading application developers!
4. <span <span <span Video is mobile’s Next Big Thing.  Everyone is talking about delivering high-quality video on mobile.  With 22 million consumers in January 2009 accessing the mobile Internet according to Comscore, double last year and likely to double again in 2010, rich content on the phone is clearly the next big thing, and video is a huge driver of that.  GenY consumers are watching news, weather and sports on their phones as if it were the normal function of the device as opposed to a full-blown miracle as compared to only 5 years ago.  (Full disclosure:  I’m an investor in mobile video leader Transpera and so am highly biased here, but I’m also seeing the numbers explode!).
5. <span <span <span Carriers seem to finally get it, but it’s too late.  Carriers are seeing their content revenue (ring tones, ring backs) flatten out and seeing voice minutes saturate, so they are all over applications and advertising.  That said, it’s probably too late.  The industry is ripe for disruption.  The landline businesses are dragging the diversified players down and their entrenched, proprietary strategy will be hard to sustain as the world moves more open and off-deck.  The commoditization of communications infrastructure is a movie we’ve seen over and over again (see Railroads, Bankruptcy of) and it may take 10-15 years, but we will see it again here.  The communications companies are at risk at becoming the next Newspaper industry if they don’t adapt fast.<span <span <span

<span <span <span Anyone else there have other observations?  Comment away or send me an email.  You can also follow me on Twitter at www.twitter.com/bussgang.