Stop Following the Herd, Cut Your Fund and Other Common-Sense Advice –

When the high-tech bust occurred, the result was an economic perfect storm, and many VCs were left without a compass. Three years later, the storm continues. With venture capital financing in a deep dive-down 50% in 2002-it is apparent that Silicon Valley could still be far from bottom. The media have chronicled lean times among venture capital firms, where the overall numbers of early-stage startups and the amount of capital invested have fallen dramatically compared to the levels of early 2000. Even bigger declines could be ahead.

This is bad news for America. Small businesses drive the economy. Some even grow to become emblematic of the economy. As VC funds contract, the successful startup has become a rarity. There is, however, some good news in the form of at least $85 billion in venture capital sitting on the sidelines.

The critical question for the VC community: What will it take to get this money back into play? We can be sure investors will not return as long as venture capitalists continue the practices of the late 1990s. In those years, a huge glut of capital was in the hands of rookie VCs who lacked either the technical or operational experience that are essential for converting ideas into viable business concerns.

Many failed to understand that venture investing is not about picking companies based on momentum-driven trends and waiting for the returns. It is about building companies that create value for customers. Instead, the industry witnessed a herd-like obsession with one or more of the popular investing themes (telecom deregulation, e-commerce, etc.), a stampede even traditional VC firms got swept up in.

Today, the practices that powered the VC bubble still permeate investing. That’s a dynamic we cannot ignore. It is time to refocus our industry and get back to the basics! Fortunately, despite the industry’s losses, that $85 billion-plus of uncommitted capital gives today’s VC sector huge potential leverage. However to steer clear of further financial shipwrecks, the industry has to fundamentally change the way it does business.

First, venture capital must re-assert itself as a craft. Successful venture capital firms don’t just provide financial capital. They provide intellectual capital, including understanding of technology, the experience and contacts to flesh out a management team, expertise in how to enter a market and the type of customer to target, and the ability to recognize early signals that a company faces problems. About 80% of a VC firm’s work takes place after its money is invested. That is what makes venture capital a service-oriented craft.

At Foundation Capital we are all deeply involved in the operation and management decisions of our portfolio companies. For example, I have recently been engaged with the channel strategy at three of our portfolio companies. Hitting on the right technology and how to sell it is only part of the equation. Perhaps more importantly, having the right team in place at the right time makes the difference between simply having a great technology and building a successful business. Our role as a VC is to provide guidance and insight during these key decision-making processes.

Second, VC firms should take a close look at their funds, and consider releasing limited partners from capital commitments for future investments. That’s right: Firms that usually invite capital should give some back, even at the cost of sacrificing management fees. Many have already done that. A total of 21 firms slashed their funds by more than $5.8 billion in 2002. Over-funded firms will face further troubles, especially in working with early-stage companies. More VCs should explore either giving money back or becoming late-stage investors-or both.

Third, venture capital firms must stop acting like settlers massing on one piece of over-occupied space. They should start like pioneers. Rather than judging ideas on whether they fit the “space de jour,” firms need to recognize that the time to pursue a theme is before it becomes popular.

For example, 802.11 wireless networking (also known as Wi-Fi) is a hot sector these days. VCs are tripping over each other to invest. But they are already late to the party: The time to invest was three or four years ago, well before the technology became a standard. Bill Elmore, a Foundation Capital partner, spotted Atheros, a fabless semiconductor developing technology to support wireless connectivity, long before Wi-Fi was popular.

Investors also need to break from the “big bet” mentality. Radical innovation is more likely to come from seeding small investments across a range of disparate ideas, setting up a strict, milestone-based evaluation process, and advancing only the most promising concepts to the beta phase and beyond. This is a climate of incremental innovation that calls for companies to focus on filling technology gaps.

Although seemingly counterintuitive, there is an excellent opportunity in telecommunications today. This is the time to invest in startups developing solutions that will solve niche problems when carriers return to their normal buying cycles. Instead, the last few years have offered up a slew of investments in data storage, Internet security or wireless networking for low-cost broadband.

As experienced VCs, we provide value by trying to see beyond the current popular trends and nurturing new companies and their upstart technologies into the next stages of development. That takes time, patience, experience and mentorship.

The perfect storm continues to hammer the VC industry. Firms that make it over the wave will be those with a steadfast internal compass-an understanding of venture capital as a craft and an investment strategy aimed at being ahead of the pack.

Mark Saul is a general partner in Foundation Capital (www.foundationcap.com), an early-stage venture firm based in Menlo Park, Calif. He joined Foundation in 1999 after nearly two decades experience as an operating executive at high-tech startups. Saul focuses on investments in communications and Internet infrastructure. He sits on the boards of ONStor, Solar Flare Communications and Hammerhead Systems and is an observer on the board of Vivace Networks. Prior to Foundation, he served as chairman and CEO of Acuity, which he successfully repositioned and sold to a division of Avaya. Before becoming a VC, Saul found success as an angel investor.