Venture capital firms -- faced with poor returns from a dismal IPO market and a shrinking pool of mergers and acquisitions -- are resetting their expectations for an economic environment in which companies raise less money and cash out at smaller prices. The new reality is causing many in the venture business to reevaluate how they invest, with many VCs trumpeting the concept of "capital efficiency."

That means startup companies are forced to get by with less.

The more conservative mantra contrasts with the wild dot-com boom days when money-losing companies could raise tens of millions of dollars in venture capital and then go public a few years later with a $1 billion valuation. Those days are gone, though the aftereffects are still plaguing the venture business.

At the turn of the decade, venture capital firms raised massive amounts of capital -- more than $100 billion in 2000 alone.

Today, Seattle area venture capitalists say they are more inclined to invest smaller amounts of money and the billion dollar funds of the past may soon be archaeological relics.

While there's still the hope of a merger or IPO bringing riches, many VCs understand that a smaller payout on a $5 million or $10 million investment is much more realistic.

"The multiples are lower today" explained Bill McAleer, a partner at Voyager Capital in Seattle. "The average acquisition prices are such that you have to have a pretty efficient model deploying capital into these companies."

Lucinda Stewart, a partner at OVP Venture Partners, agreed. She's adjusted her investing techniques over the past year, now spending time analyzing whether the startups can reach break even quickly on fewer dollars.

Lucinda Stewart

"I used to think about just the big exit, the big home run scenario and do everything I possibly could to get there," said Stewart. "I am not reducing my swing-for-the-fences opportunity -- because then I wouldn't have a job and that's what I have to do. But, at the same time, I think you have to be able to stop at second base ... while you are on your way to the home run."

At this point, however, venture capital firms are just struggling to get their portfolio companies up to bat. During the first half of the year, only five venture-backed companies completed IPOs.

In Washington state, Clearwire was the last technology company to go public. And that IPO happened more than two years ago.

The IPO drought is bad news for the venture industry, with National Venture Capital Association president Mark Heesen saying earlier this summer that "it will be some time before we can even be in a position to return to healthy IPO activity levels."

The mergers and acquisitions market is faring better for venture-backed companies, but the number of deals and total disclosed dollars are going down compared to past years, according to research from Thomson Reuters and the NVCA.

"Everyone is way more cautious, and people are trying to find companies that can get to break even a lot faster," said Stewart. "No one wants to go out and raise money right now.... Exits aren't just there anymore, so the only way to control your own destiny is to get to break even."

Making matters worse, it is taking longer on average for venture capitalists to see returns. According to a study by SVB Analytics, it took venture-backed software companies 91 months to generate a return in 2008. That compares to 26 months a decade ago.

All of those factors are creating an ugly environment for venture capitalists. And that's driving some speculation that the venture capital model is simply broken.

The shakeout may already be under way. Sources say that Frazier Technology Ventures -- a Seattle venture capital firm with $150 million under management -- has postponed its plans to raise a new venture fund. Len Jordan, a partner at Frazier, declined to comment on the company's fundraising efforts.

But perhaps the biggest change will come on the upper end of the spectrum, those venture funds that raised $500 million or more. Industry watchers say the venture model has changed so much in the past few years that those funds no longer can profitably invest the money in the information technology sector, an industry where it has become much cheaper to start new companies.

Bill McAleer

"You can't put gobs of money into companies and then expect to get reasonable returns unless you are the last guy in and happen to have the right preferences," said McAleer, whose firm raised an $110 million fund in 2006 and still has about half of the capital to deploy. "This whole notion of ... putting a lot of capital in before you actually understand if customers are going to buy your product is where the model is broken because you just can't make returns with large capital deployments."

Bigger, in this case, isn't necessarily better.

Stewart, for one, anticipates a shakeout among those big funds with partners at some of those firms reincarnating themselves at smaller, more focused funds.

That's part of the reason why several Seattle area venture firms -- including Madrona, OVP and Voyager -- are spending time looking for early-stage deals where the capital requirements are lower and they can grab a larger share of the company. Madrona's recent success with companies such as Seadragon and Farecast -- both of which were sold to Microsoft -- are good examples of companies getting by on less capital.

And some industry watchers, including Silicon Valley Bank's Geir Hansen, don't think the model is broken so much as it is "evolving."

Stewart is trying to adapt. She's no longer spending time on companies that require $30 million or $40 million to execute the business. Instead, she's looking for deals that may require half that amount before an exit.

"I think we are going to come out OK, but the old way of thinking of just increase the top line and just raise new rounds on great sales milestones, those days in my mind are over," she said. "When I see pitches like that, I am like 'Ok, that's interesting, but when do you get profitable?"

[Flickr photo via AMagill]