If you wanted to buy a Mercedes-Benz in Silicon Valley last year, you needed patience. The average waiting time was six months. As the Nasdaq slipstreamed through 5,000, tens of thousands of high-tech employees in the Valley became multimillionaires, at least on paper, thanks to their share options. They were hugely prevalent in Santa Clara county, near San Jose, where almost a third of households owned options. Fuelled by expectations that the good times would continue, house prices soared and sales of European luxury vehicles reached new heights.

Nowadays, if you want a Mercedes you can have instant gratification. The Nasdaq crash of 60 per cent from its peak of March 2000 has meant that many people who believed themselves rich are now holding options that are worthless. Take Yahoo!: between 80 and 85 per cent of Yahoo! employees' options are under water.

Not surprisingly, discretionary consumption has slumped: Mercedes dealerships report they are receiving cancellations at the rate of 35 to 40 a week. House prices in the $10m (£7m) plus range are falling fast.

The market collapse, combined with its volatility, is having a profound effect throughout the regional economy in general and the venture capital industry in particular. Initial public offerings, which provided the traditional route for new companies to realise capital for their founders and early investors, have ground to a halt.

Even the most gold-plated technology companies have struggled to come to market. In March, Loudcloud was virtually the only technology company to achieve an IPO in the US. It should have been a storming success. The group, which provides services to help customers build and operate online enterprises, was the brainchild of Marc Andreesen, the co-founder of Netscape. Many of its senior operational managers are also from browser companies. Its VC backers include Benchmark Capital, the group that took a stake in eBay for $6.5m (£4.5m), which at the peak was worth more than $5bn (£3.5bn). And Loudcloud's investment bankers were Goldman Sachs and Morgan Stanley, Wall Street's best-known blue chips. They aimed to achieve a market capitalisation of $1.3bn (£919m).

In the event, Loudcloud had to slash its issue price from between $10 (£7) and $12 (£8.40) a share to just $6 (£4.20), and increase the original investors' dilution. Within a week its shares were down 15 per cent.

The market for IPOs is, in one word, dead, laments Bradley Feld, self-designated shogun at Softbank Venture Capital in Colorado.

Not buying

The other mechanism for VCs to materialise a paper gain, a trade sale, is also blocked. Potential buyers, traumatised by the collapse of their own stock and anxious to conserve cash in an economic slowdown, are simply not buying. Even mighty Cisco Systems, supplier of much of the hardware that supports the internet and a serial purchaser, has halted its acquisition spree. A sign of the times: West Coast investment bankers, who normally fix such deals, are not only taking calls from journalists, they are now initiating such conversations.

The implications for the VC industry are ominous. The sector has always been subject to booms and busts and currently it is going through a bust. But this time, the slowdown could have a profound impact on the structure of the industry itself. Many VCs believe it is only a matter of time before their industry, too, begins to consolidate.

The sector is certainly bloated. In 1991, the US venture capital industry invested just $2bn (£1.4bn) in start-up companies. Last year, in spite of the slowdown in the second half, it invested a record $68.8bn (£48.6bn), according to a Pricewaterhouse-Coopers/Money Tree survey.

More than 1,000 VC companies were set up in the past five years, attracted by the astonishingly high returns to be had. The market reached such an extreme that VCs such as Benchmark and VantagePoint Venture Partners considered floating their own shares. The market capitalisation of CMGI, a Massachusetts-based internet investment boutique, reached $47.8bn (£33.7bn), thanks to its stakes in AltaVista, the search portal, and infrastructure groups such as NaviSite. Other VCs worried that CMGI would use its paper to buy them out.

"From August 1995 to March 2000 - the history books will show that five-year period was an aberration," says Brad Koenig, a managing director and head of West Coast investment banking at Goldman Sachs.

Now the sector is struggling. Late-stage investors are increasingly reluctant to put money in because of the lack of an exit. That means VCs are having to invest their own money into the companies they think will be winners. The others are being rapidly culled. The VCs, too, must conserve cash. And unless the window for IPOs opens up in the fourth quarter, many of the smaller firms will run out of money.

The impact of the IPO drought on the Valley's entrepreneurs has also been brutal. In December last year some 60 chief executives from Silicon Valley start-ups assembled at Spanish Bay, a swanky resort near the Pebble Beach golf course on California's coast. They came to hear about their prospects from VantagePoint Venture Partners, their biggest investor and one of the West Coast's most consistently successful VC groups. Alan Salzman, the managing partner, says it was the shortest and least popular speech he has ever made. "There's only one thing to say," he told the executives. "There is no money to be had [from the capital markets]."

Carl Schlachte was in the room. "It was like being dunked in cold water," says the chief executive of Bops, a Mountain View-based supplier of intellectual property for communication chips. "The entire audience was sobered in an instant."

"We are being encouraged to conserve cash," explains Mr Schlachte. "At the beginning of the year we had enough for nine months of operations going at full steam. Now we have cut the budgets so we have another six months." The company intended to go public this autumn but will have to wait until at least next year.

Not all is gloom. In spite of the downturn some specialist funds continue to ride high. In February Vinod Khosla, a partner at one of the Valley's top VC groups, Kleiner Perkins Caufield & Byers, appeared on the cover of Forbes magazine and Red Herring, one of the industry's leading publications, with the headline "Is this the world's best VC?". His investments in the narrow field of optical networking have paid off handsomely. "It's good to be lucky in this business," he admits.

It's a lottery4 But Mr Khosla's luck is the exception. "These sectors rotate. In the early 1990s it was biotech, then specialist retailing; next were the dotcoms; now it is optical networking," says VantagePoint's Mr Salzman. "In any given year, the best fund will be a narrow one. Someone will always win the lottery. But such performance is unsustainable over the long term. You never appear on the magazine cover once, always twice. Once on the way up and once on the way down."

In the new environment most VCs are reverting to more conservative return targets of 25 per cent, compared with 100 per cent or more over the past few years. They are asking investors to be patient so they can be judged over the 10-year life cycle of their funds. And they are emphasising classic portfolio management techniques to diversify their risk, dividing their investments among companies in different industries, at different stages of development and with different risk profiles.

But there is no doubt that VCs are becoming more risk-averse, preferring companies with powerful business fundamentals, a large potential market and a huge potential pay-off. No doubt they are also looking for a strong management team that can control costs. Fancy European luxury cars are clearly not to be encouraged in the new, post-crash, environment.

paul.abrahams@ftnetwork.com