updated 10/31/2013 2:17:17 PM ET 2013-10-31T18:17:17

If you don't see any activity for, say, the last five years, be wary. You could be looking at a firm that's dying a predetermined slow death.

Picture this: The group that invested $2 million in your startup notifies you that it's shutting down. You may think you're off the hook in terms of providing a return on their investment, but in fact, the opposite is true. After all is said and done, the defunct firm's investors still expect to
see a return on their investment.

Sadly, this scenario happens more often than you might think. The most recent Silicon Valley Venture Capitalist Confidence Index, a quarterly report by University of San Francisco professor Mark Cannice, notes that more than 400 venture capital firms are now either inactive or have quietly gone out of business. Another source, FLAG Capital, claims that last year fewer than 100 VC firms were active (meaning the firms made at least four investments or deployed $4 million in a year). By FLAG's count, that's down from 441 firms in 2000. Ouch.

Venture firms go dormant or disappear for the same reasons regular companies do: mainly poor planning, bad investments or both. Unfortunately for the entrepreneurs involved, the obligation to deliver a return on the investment rarely goes away.

So how do you know if you're dealing with a "zombie firm" as a prospective investor in your startup? Start by researching how recently the firm raised a round of new funds and/or recruited new partners. If you don't see any activity for, say, the last five years, be wary. You could be looking at a firm that's dying a predetermined slow death.

More commonly, once-healthy VCs turn into zombies because they can't raise new capital due to poor performance. Without new investors, firms can't grow; instead, they contract, until what's left are a few harried partners to monitor and nurture the portfolio.

In some situations, VCs are in such bad shape that they're forced to punt management to another firm. In fact, there are firms that specialize in absorbing distressed venture capital investments and turning them into cash. In my book, this is the worst-case scenario for the entrepreneurs involved. When the original VC firm is replaced, there's a good chance that a startup's growth will become second priority to some form of liquidity action--the sooner, the better.

As an entrepreneur, it's good business to monitor the health of a VC--or any potential investor--for signs of the zombie apocalypse. After all, no one wants his or her company's entire future determined by a consultant's fee for liquidating the business, a dwindling firm or a distracted retiring partner.

Copyright © 2013, Inc.


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