Venture Capital: A Cautious ApproachVenture Capital: A Cautious Approach

Venture-capital investment during the third quarter sank to its lowest level in four years and fell more than 25% from the second quarter, according to a benchmark industry survey.

Investors put just $4.5 billion into 647 companies during the quarter, down 26% from the second quarter, when venture capitalists invested $6 billion in 838 startups, according to the MoneyTree survey released last week by PricewaterhouseCoopers, Venture Economics, and the National Venture Capital Association. The last time venture investment during a single quarter came in below $5 billion was in the first quarter of 1998, when it was $4.2 billion.

But more prudent investments may yield technology startups better able to survive a harsh economy and deliver products that customers want.

"We're moving back to a place that will allow us to build better companies," says Allan Ferguson, managing director at 3i Group, a venture-capital company that invests in companies' late rounds of funding. "We have more bright people around the table, the good entrepreneurs are back in the marketplace, and the ones looking for a quick buck have gone elsewhere."

That's hopeful thinking. The most attractive investments include companies developing wireless-networking technology, computer security, and data storage, Ferguson says. "For technology to continue to grow, security has to be improved, so we're looking at that aggressively." Storage companies are more risky to fund, he says. "It's difficult for VCs to make money there, because there's always been a faster, cheaper product coming behind the company you just backed."

Software companies continue to garner the largest amounts of cash, according to the MoneyTree survey. They accounted for 22% of total venture funding during the third quarter, or $993 million, though funding dropped 10% from the second quarter.

"Software is once again leading VC back to its roots," says Tracy Lefteroff, global managing partner of the venture-capital practice at PricewaterhouseCoop-ers. Software companies are a safer bet for investors than companies in other sectors, he says, since they can be started with a small investment and provide measurable milestones to determine whether a company is worth further funding.

Telecommunications and networking companies continue to struggle. Telecom, the second-largest category of funding, declined 32% sequentially to $555 million invested in 67 companies. Investment in network-equipment companies fell 34%, to $341 million, across 39 deals. "Nobody is buying anything" in those categories, Lefteroff says.

The slower pace reflects a changing VC strategy. Jean-Francois Astier, a venture capitalist with AB Novestra, a Swedish investment company, cut the number of companies he's backing in half, sticking with businesses that fill needs in specific sectors. For example, Novestra backs broadband vendor Speedera Networks, which Astier says has a seasoned management team that changed its strategy and cut costs to compete. Now, he says, the company's revenue is growing, and it's profitable in a tough sector.

"We've cleaned up our portfolio and shed the businesses that didn't have the right strategy," Astier says. "In general, VCs are having to spend most of their energy on making sure the companies they have can survive."