For the first time since 1978, a full calendar quarter went by with not a single VC-backed company going public.

The struggling financial markets are certainly partly to blame. After all, Wall Street is hurting and this understandably raises the bar when it comes to public offerings. Wall Street wants substance over style – strong financials are now required, not optional.

Wall Street’s more discriminating tastes have not, of course, benefited VC-backed startups, most of which still have more style than substance.

While some believe that the cold market for IPOs is part of the natural boom-bust cycle, others see bigger problems for the VCs whose offices line Sand Hill Road.

Investor and blogger Paul Kedrosky thinks that VCs are facing significant challenges because they have been betting on the wrong horses. He observes:

“There is nothing that the industry is producing that investors want. The stuff they’re investing in is idiosyncratic–it’s fun and appealing to them, but Wall Street doesn’t care.”

“The Valley is operating in its own little world, and the capital markets don’t care about the things that are getting the Valley excited.”

Kedrosky, of course, is pointing out what I and many others have been stating for some time – that many of the startups VCs have invested in, particularly in Web 2.0, make less-than-compelling statements as real businesses.

In many ways, Wall Street’s reluctance to demand public offerings from VC-backed startups has sent a clear message to Sand Hill Road:

Fool me once, shame on you. Fool me twice, shame on me.

Like George W. Bush, Wall Street couldn’t be fooled again. So what are VCs doing?

Many have been shifting their money into sectors that have greater potential to generate the type of returns that will interest Wall Street. “Cleantech” has been one of these sectors.

But most of these investments realistically demand more money and time than many VCs and their limited partners are used to providing.

In the case of cleantech, for instance, it’s worth considering that most VCs have little to no experience in the energy industry and many of the technologies they’ve backed may never become viable on a commercial scale.

Throw in the fact that so many cleantech startups are being funded but that, statistically speaking, only a relatively small number are likely to achieve significant success and it’s clear that VCs will end up facing many of the same problems they are facing now.

All in all, there can be no doubt that the VC business is changing – but not for the reasons some entrepreneurs claim.

Frankly, I think it’s time that VCs consider some inconvenient truths:

  • There is not just a problem of too much VC money chasing too few good startups – there are far too many VC firms. While there will always be startups worthy of VC investment, I’ve often joked that there may be more VC firms than good startups.
  • Perspective is needed within the VC industry. Out-of-touch VCs have invested in far too many startups that realistically don’t have a chance to achieve the kind of success that will lend itself to the type of financial prospects Wall Street is looking for. Perspective, of course, is difficult when one considers that many VCs have little practical knowledge about the markets they invest in.
  • There are far too many “useless” VCs. I previously stated…most VCs are little more than McKinsey types who know everything about building a business in theory but couldn’t run a local pizza joint if you gave them a manual.” In my opinion, the industry needs to cull some of its less-useful members. Street smarts are desperately needed.
  • VCs need to provide more than just capital. Most VC firms sell entrepreneurs on the knowledge, experience and relationships that they can bring to the table yet, in my opinion, few actually deliver these things. It’s time that change.

In the simplest terms, the VC industry needs to start focusing more on quality and less on quantity.

Most of the industry’s problems are borne of the fact that venture capital is a form of financing for which there is a smaller market than the industry has “equipped” itself to serve. VC firms have raised huge funds and are more focused on putting those funds to use than they are actually finding good investments.

In essence, much like Wall Street sought to increase the size of the market for mortgage-backed securities by encouraging lending practices and creating mortgage products that generated more mortgages than a sane market truly supported, Sand Hill Road has sought to increase the size of its market by investing in startups that weren’t worthy VC investments.

At the end of the day, while Wall Street’s current pain will certainly eclipse Sand Hill Road’s current pain, if Sand Hill Road doesn’t change its ways, that may be little consolation, especially to limited partners.