The route to financing for start-ups is changing dramatically, largely due to changes that are taking place within the venture capitalist (VC) community.

Possibly the most important of these changes relates to the "exit strategies" employed by VCs to eventually "cash out" - and profit from - the early stage investments they make in start-up companies.

The concept of the exit strategy is quite simple. Venture capitalists, by their very nature, are not long-term investors. Some entrepreneurs regard them as a "necessary evil", accepting that VCs exist solely to make as much money as possible - in as short a time as possible - by buying a stake in a start-up company, helping to company to grow quickly, and then cashing out.

In the late 1990s, the preferred method of "cashing out" was the initial public offering (IPO) whereby institutional and retail investors would be offered shares in a start-up company through flotation on the stock market. And as institutional and retail investors bought in, VCs would cash out.

VCs enjoyed huge profits off the back of the technology and dotcom IPO boom through 1999 and early 2000, only to suffer dreadfully when the bottom fell out of the IPO market. Then, venture capitalists found it very hard to sell their stakes in struggling new media companies.

According to statistics from the New York-based National Venture Capital Association (NVCA), 1999 was really the watershed year for VC-backed IPOs. In 1998, only 20 per cent of US IPOs were backed by venture capitalists. By 1999, that number had risen to 50 per cent.

Within the last 18 months, the number of IPOs overall has declined significantly as has the percentage of IPOs that venture-backed companies participated in. By the first quarter of 2001, NVCA statistics showed that venture-backed deals accounted for only 34 per cent of all IPOs.

"The continued sluggishness in the IPO market is a major concern of the venture community," says Mark Heesen, president of the NVCA. "However, venture capitalists remain convinced that good companies with great potential and excellent management teams can, and will, go public. Those venture-backed companies that have gone public in this difficult period are seasoned enterprises which are cognizant of business cycles and can operate in good times and bad."

But IPOs are not the only way for VCs to exit. "There are two key methods for venture capitalists to realise a return on their investments: acquisitions (M&A) and IPOs," adds Mr Heesen. "For venture-backed companies in the first quarter, the $7.0bn in acquisitions exceeded both the amount raised through the IPO ($930m) and the IPO valuations ($4.5bn) of those companies."

A report released jointly in August 2001 by the Venture Economics and the National Venture Capital Association reveals that venture-backed mergers and acquisitions activity increased for the second straight period last quarter, as 76 deals were completed for $2.02bn.

None of these statistics come as a surprise to Duncan Lamb, senior corporate finance manager at Oxford-based Grant Thornton e*tech. He says that within the past year there have been significant changes in how venture capital firms look at exit strategies.

Mr Lamb says the first thing that has changed is the time horizon for the implementation and execution of an exit strategy. "VCs that are having the greatest degree of success are those that are prepared to have a longer time horizon," he says. "Having an IPO within 12 to 18 months of the VC investment is not a practical proposition anymore."

He notes, however, that a number of VCs are looking at a variety of inventive solutions to the challenge of IPO-wary investors, including those that use a merger or acquisition as a route to take a company public.

In the UK, the mechanism is to find a cash-rich, publicly-listed "shell" company (one that has, perhaps, just sold a lot of assets, has money, but is looking for a new business sector in which to operate) on the London Stock Exchange's AIM market. Andd then do a "reverse takeover" of the VC-backed private company into the AIM shell company.

This allows the VC-backed company to gain access to the cash within the AIM-listed company, provides it with a way of offering existing and future investors liquidity, and gives the VCs themselves a chance to "cash out" by selling their shares in what is now a publicly-listed company.

"This did happen in the past, but not as often," Mr Lamb says. "It now looks like a very good route to market."

He adds that one other consequence of VCs needing to hold onto their investments longer is that they are feeling the need to take a more active role in advising the management teams of the companies in which they have invested.

"VCs are taking far more interest because their investment is in there for a longer time they want to make sure that if their covenants are breached, they know why," says Mr Lamb. "They are also turning up more often to board meetings - which they had been more casual about. And there's also the simple fact that lots of investment managers have much more time on their hands."

Perhaps coincidentally, this higher level of VC participation in invested companies comes at a time when management buyouts of VC-invested companies are on the increase.

Mr Lamb says VCs are now willing to hear buy-out offers at much lower prices than they would have previously. It gets the VCs out of the company's hair, and it gives the VCs an exit strategy that might not otherwise be available to them. The fact that valuations have dropped substantially over the last 18 months has also helped make management buyouts more feasible.