There's good news and bad news in the latest results of the Silicon Valley Venture Capitalists' Confidence Index and survey.

Before I get into the details, I'd like to describe the history of the index, and explain why it is a good indicator of venture activity. I have been tracking Silicon Valley venture capitalists' confidence in a quarterly survey since the first quarter of 2004. In each survey I ask venture capitalists -- usually between 25 and 30 respondents -- to estimate their confidence on a five-point scale in the Bay Area high-growth entrepreneurial environment over the next six to 18 months and provide ‘on the record' commentary to support their ratings.

Other organizations provide excellent information on the flows of capital to VC portfolio funds and VC investments in their portfolio firms, information that confirms the relative strength of the venture market in recent months and quarters. I began tracking VC confidence because I reasoned that it may provide a leading indicator for the overall health of the new venture environment. Venture capitalists' insights are particularly relevant and informed because they operate on the cusp of the private and public equity markets -- exercising close oversight of their portfolio firms and negotiating potential IPOs and acquisitions -- and so have excellent and perhaps early perspectives into new venture opportunities and the public market reception to them. Over the first three years of the Index, confidence ebbed and flowed but remained relatively stable. In Q4 2007, however, VC confidence fell dramatically to a new low despite a very robust level venture investments in 2007. Why? A number of the VC respondents expressed concern over the potential fallout of the credit crisis on the exit market for their portfolio firms. Their intuition proved spot on as the National Venture Capital Association reported that in Q1 2008 IPOs for venture-backed firms slowed down to their lowest level since Q2 2003 and M&As fell to one of their lowest levels in 10 years.

What is VC confidence for Q1 2008? The index shows another steep drop, once again falling to a record low.

Respondents indicated that declining confidence was linked directly to the growing scarcity of exit opportunities for venture-backed firms. Focusing on declining opportunities for liquidity events, Eric Buatois of Sofinnova Ventures communicated that "we continue to see good deal flow with innovative entrepreneurs, but the shutdown of the IPO window will make investors a bit more cautious." Dan Lankford of Wavepoint Ventures concurred, saying that while he sees a bright long-term future, economic turmoil in the present has created a "challenging exit environment."

Declining confidence may impact the valuations that entrepreneurs receive when negotiating the terms of venture investment. To this point, Dag Syrrist of Vision Capital made this calculation:

"There is significant capital in funds raised over the last several years that needs to be deployed. However, valuations are likely to be reduced, but the investments will be made nonetheless. However, if economic pessimism continues through Q3, it will result in fewer investments made, similar to 2002-03."

 

 

Extending this logic, Daniel Ciporin of Canaan Partners offered that "valuations in entrepreneurial activity and venture funding are a lagging indicator to the overall market environment, but we are about to see that lag catch up to us."

However, not all of the responding venture investors expressed declining sentiment. Bill Reichert of Garage Technology Ventures noted the strength of today's venture-backed tech firms:

"This recession is very different than the last one. First, it's not inherently a tech recession, which the last one was, and second, startup companies are structured very differently than they were in 2001; they are much leaner and scrappier, and they are more international and out of the box."

 

 

Investors in early stage companies such as Ron Conway of Baseline Ventures appeared to have a generally higher level of confidence.

Again, while overall confidence declined in Q1, some commentary gave us reason to expect an eventual uptick. For example, Venky Ganesan of Globespan Capital Partners, whose comments you will see here first, shared with me the following observation:

"To paraphrase Dickens, it's the best of times, it's the worst of times. If you are a passionate, talented individual with a great innovative idea, this is the best time to start a company. It is in recessionary times that the best companies are born, a la Cisco, Oracle, etc. If you were, however, bathing in the sea of credit liquidity, which a lot of our financial institutions were, the tide has gone out and we are going to find out who is swimming naked and who is wearing a swimsuit."

 

 

So, what do you predict will happen in Q2? I encourage Industry Standard readers to reflect on the expert insight of the venture capitalists I directly quoted in my Industry Standard essays and quarterly reports, and offer their own analysis below.

Related news, commentary, and predictions:

• Prediction: The USF VC Confidence Index will rise to 3.70 or greater in Q1 2008
• Mark Cannice: Venture Capitalists' Confidence Wanes
• Mark Cannice: The impact of Bear Stearns' collapse on entrepreneurs
• Mark Cannice: China VC confidence index sees mild drop
• Opinion: 10 'Net services that will succeed (and 10 that will probably fail)

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