Venture capitalists have seen their preferred exit strategy for their portfolio companies – going public via an initial public offering – suffer through one of the grimmest periods in recent memory. What’s more, there’s little sign of a turnaround for the remainder of 2009.

It still hasn’t been enough to turn skeptical VCs towards reverse mergers, however.
With the IPO market at a near-standstill, and the merger and acquisition industry equally depressed, “logic would tell you they’d be more open minded. But it hasn’t happened,” said Jim Chapman, managing partner for the Palo Alto, Calif., office of law firm Nixon Peabody LLP.

Venture-capital-backed exits ended an already bleak 2008 with the worst quarter in years. There were no venture-backed IPOs in the last quarter of 2008, and just six IPO exits for the entire year. That’s the lowest level seen in more than 30 years. There’d been an average of 74 such IPOs per year from 2004 through 2007.

Likewise, there was a modest 37 merger and acquisition exits of venture-capital-backed companies last quarter, and 260 M&A exits for all 2008, according to January data from the National Venture Capital Association. An average of 357 M&A deals was seen annually from 2004 through 2007.

With the barren IPO market depriving venture capitalists of their traditional way to cash out of older investments, venture capital investments in new companies have taken a tumble.

Venture capital investments declined 8.4% in 2008 to 28.3 billion, from $30.9 billion for the prior year. It’s the first decline since 2003, according to a report sponsored by PricewaterhouseCoopers and the NVCA.

Venture-capital funding in the fourth quarter fell 33% from a year ago to $5.4 billion.

The trend is expected to continue through the next year. “New investments and fundraising will slow considerably in 2009 until the exit markets re-open, and the pipeline is cleared,” said Mark Heesen, NVCA president.

Those depressing trends would appear to help the cause of reverse merger backers, which saw a more modest decrease of about 17% in total deals last year. But so far, the venture capital market has largely remained allergic to the practice, except for a few biotech-related deals.

“The common perception is that [VCs] are risk takers. But, in truth, they’re not. They tend to follow each other,” said Chapman, whose office has a large venture capital practice.

A few clients that Chapman works with are considering using the reverse merger route as an exit strategy, but it’s a rarity for the industry right now, he said.

It will likely take a sizeable venture capital firm, like Menlo Park-based Kleiner Perkins Caufield & Byers, to push for more reverse mergers for its portfolio before others would follow suit, said Chapman.

The VC industry’s three core objections about reverse mergers have long been that they’re shady, that it’s better to wait for the payday of an IPO, and that it’s too hard to liquidate their investment, according to David Feldman, managing partner of New York-based Feldman Weinstein & Smith LLP. “Venture capitalists are the last holdouts of IPO alternatives,” he said.

On top of that, many VCs are still skittish about the smaller market capitalizations that usually come attached to a company that goes public via a reverse merger, along with the post-merger stock performance of private companies that go public by reverse merger, Chapman said.

Biotech trade journal Start-Up Magazine late last year completed a review of nearly 30 biotech reverse mergers – the most likely source of future venture-capital-backed exits – since 2005. It found that six months after a reverse merger, when a VC’s lock-up provision would normally end, the typical deal had seen a nearly 19% decline in stock price.

From the beginning of 2005 through September 2008, and admittedly bad ending period for reviewing any stock’s long-term performance, those reverse merger deals saw declines of nearly 40%, the report said.

Venture capitalists are still asking to see the positive track record of other deals, Chapman said.

Skeptics point to a more basic reason that many venture capitalists shy away from reverse merger deals: By waiting for the IPO market to turn around, they can continue collecting management fees that run about 2% a year. That brings in close to $720 million annually for the industry, according to Forbes.

Reverse mergers could become more prevalent in 2009, especially among life sciences firms, according to Kyle Lefkoff, a general partner of Boulder Ventures, a Boulder, Colo.-based venture firm that started up in 1995.

Expect more strategic buyers to acquire life science startups this year. Reverse mergers will be a popular choice for many as an exit strategy, Lefkoff told private equity trade journal PEHub last month.

“There’s no IPO market, but big pharma is flush with cash and many corporations are interested in buying early-stage life science companies,” Lefkoff said.

One such company that’s gone the reverse merger rout is ARCA Biopharma Inc., a Bloomfield, Colo.-based biopharmaceutical company that Boulder Ventures had invested in.

The company went public late last month through a merger with San Carlos, Calif.-based Nuvelo Inc., a cash-flush public company whose business had stalled after its clot-busting drug failed in a late-stage 2006 clinical trial.

The deal was first announced in September. Nuvelo implemented a 20-to-1 stock split, and issued about 4.9 million new shares of common stock to shareholders of ARCA.

Existing stockholders of the private company retained about 67% stake in the company following the merger. Boulder Ventures, InterWest Partners, Atlas Venture and other investors had reportedly invested close to $60 million in ARCA, which is developing drugs to treat heart diseases.

Nuvelo had $65 million in cash on hand at the time the merger was announced. ARCA said that cash would be enough to fund operations through 2009.

Early-stage, public biotech companies like Nuvelo are stronger candidates for a reverse merger than typical shell companies in large part because they often are sitting on large piles of cash after their product development efforts have failed in trials, or been unable to gain regulatory approvals.

That was the case with Replidine, Inc., a Louisville, Ky., maker of anti-infective products whose drugs failed in clinical trials over the summer. Rather than liquidate or continue testing, the company looked for a merger partner.

Replidine chief executive Kenneth Collins told analysts on a quarterly conference call in November that there were 120 companies that showed interest I nbuying the company, which had $40 million in cash at the time.

Cardiovascular Systems, Inc., a St. Paul, Minn.-based medical device company, ended up pulling its own IPO plans, and instead opted to acquire an 83% stake in Replidyne, in a deal announced shortly after that analyst call. Cardiovascular Systems had raised some $45 million in venture capital in the past two years with investors including Eastern Capital Investment Group, Maverick Capital, and Mitsui & Co. Venture Partners.

Not all biotech deals have gone that smoothly, as was seen last month in the failed reverse merger of Cambridge, Mass.-based therapeutics company Archemix Corp., and publicly traded NitroMed, Inc.

NitroMed accepted a richer offer from hedge fund Deerfield Management rather than go through a merger with Archemix, which received a $1.5 million termination fee for its efforts.

Archemix has raised close to $135 million in venture capital funding from firms like Atlas Venture, in Waltham, Mass., and Palo Alto, Calif.-based Prospect Venture Partners.

If a big, tech-focused venture capital firm is going to become involved in reverse mergers, market watchers point to a firm like Menlo Park, Calif.-based Redpoint Ventures.

After a four-year absence, Redpoint got back into the private placement arena last summer, as part of a $6 million investment in Answers Corp., the Israeli-based parent company of website Answers.com. There’s speculation that more deals could be on the way from Redpoint, which counts some $2 billion under management.

Mark Mueller can be reached at mark@dealflowmedia.com.