We’ve all seen it.  Since last fall there has been an amazing lack of IPOs in the marketplace.  Credit has dried up on the corporate side.  And the M&A world has largely come to a complete halt.  Of the few acquisitions that have closed in the past months, a surprising number were what one might call “survival mergers”, where two marginal companies combine in order to save half of the overhead and at least have a chance at a future.

At the same time, venture capitalists have dramatically slowed investing.  They have battened down the hatches on just about every one of their portfolio companies – slashing burn rates, laying off staff, and slow-rolling product development.  In many cases, investors have asked the VCs to delay capital calls and in extreme cases, investors have divested themselves of their VC portfolio and missed future capital calls (with corresponding contractual economic penalties).

Many funds formed in the late 90’s or early 00’s were unable to cash out enough investments before the crash, and so they are deeply underwater by almost every possible measure.  In fact, if they have had enough early losers and do not have enough winners making it through this downturn, it is very likely that some VCs will generate negative returns for their investors when they wind down their funds in the coming 1-3 years.

What this means is that we will see a lot of VCs fold in the coming months and years.  It is anybody’s guess, but my back of the envelope analysis projects that at least 25% of venture funds will be about of business before the end of 2010.  I am sure that we could all agree that some of these funds had no business being investors in the first place.  Maybe they had money burning a hole in their pocket.  Perhaps they were successful on Wall Street and decided to play more directly in Private Equity.  Or maybe they were smart, well-connected people who thought “how hard can this VC thing be?”  And then there were funds that just did not attract the right talent to manage the investments.  Or lastly, maybe they just made some well-intentioned poor investments.  Regardless, they will be toast.  OOB – Out Of Business.

So if the ranks of VCs shrink by 25+%, what does this mean to the entrepreneur?  Fewer investors means less competition for deals and thus lower valuations.  Sure, there is always some competition for the very best opportunities, but the bulk of businesses will see fewer firms interested and a longer cycle of fund raising. 

Now add on top of that the risk aversion that has become apparent in the marketplace these past 6-8 months.  The investors behind the VCs are scared.  Virtually every asset class was decimated near the end of 2008, and pension funds, wealthy individuals, trust funds, and endowments are justifiably running scared.  That message will filter to the VCs, where even though they are seen as a risky asset class to begin with, it is unlikely that the core investors will not be asking for at least a little more conservatism in the investments.

Now back to you, the entrepreneur.  Now not only are you seeing lower valuations, you will likely see more conservative investing.  There will be more diligence, and more expectations of proof-of-concept from businesses before VCs will invest.  This combined with the general shift to later stage, larger investments by most funds means that the skill of bootstrapping will be more useful than ever.

Readers of my blog will recall that while I support VC investing as an important and valuable part of our capitalistic system, I also strongly encourage entrepreneurs to bootstrap whenever possible.  Even if you plan to take money later on, the longer you bootstrap to prove your business, the higher your valuation and the more of your company you will own in the end.

So save your pennies, mooch for free office space and bandwidth, and stick with cheap takeout Chinese food – bootstrap now more than ever.  The coming years will likely not be kind to early stage entrepreneurs.