Caution in a risky business: VC investment drops 12% amid IPO chill and fiscal cliff

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America’s storied risk-takers are feeling the heat: Venture capital (VC) investment fell 11.6% in the US last quarter as firms found it harder to raise money to finance early-stage businesses and tougher to cash out once those startups had grown. That pause echoes across much of the globe, where American money often still drives venture investment. “How the US goes is mostly how the world goes,” says Emily Mendell of the National Venture Capital Association (NVCA).

A total of $6.5 billion financed 890 deals in the third quarter, down from $7.3 billion and 992 deals in the same period last year and headed for a two-year low, according to data released today by the NVCA and PricewaterhouseCoopers. Declines came across investment stages and sectors, although internet and IT investment were a bright spot. Mobile-payment company Square drew the quarter’s largest investment, $200 million. In contrast, life sciences, including biotech, once comprised a third of all VC investments but have now slipped to a 26% share, as an uncertain and unpredictable drug approval process continues to scare off investors—although many hope an FDA reform bill signed in July will turn things around.

A handful of reasons are driving the slide in VC funding. Cooling IPO markets—further chilled by Facebook’s spotty debut earlier this year—are giving VCs fewer opportunities to recoup their cash and return it to investors. Acquisitions, which had provided a “bread-and-butter” avenue to exit a deal, have also started to slow, as the big companies that would normally buy up startups instead sit on their cash, awaiting the results of the US election, economic recovery, and looming fiscal cliff.

Unable to exit investments and return cash to investors, newer VCs have a tough time building the kind of track record they need to raise more capital. And the institutional investors that have financed so many funds are now cautious about the same big-picture economic threats. Much of the cash that is available is flocking to established giants like NEA, Bessemer Venture Partners and Andreessen Horowitz, or to smaller First Round Capital. Many other firms are spending more than they raise, drawing down a rainy-day “overhang” of capital, Mendell says. As that runs out, investment can be expected to slow even further. A few firms are even looking to raise money abroad, where Brazil is seen as a rare hotspot, not only for new ventures, but for new venture funds.

Still, the VC industry is known for its cycles, and today’s pause may even help to weed out flabby companies, forcing more qualified startups to compete for limited funds. “VCs want to be careful not to fund too many ‘me-too’ companies,” Mendell says. “We didn’t need 15 PetStore.coms, and we actually funded 15 back in the bubble.” It doesn’t look like there’s much chance right now of that happening again.