November 17, 2003

By Ketaki Sood, Larta Research Economist

Are we finally witnessing a return to normal investment patterns in the venture capital industry? According to the PricewaterhouseCoopers/Thomson Venture Economics/National Venture Capital Association MoneyTree Survey, venture capital investments have remained stable at a rate of $4 billon per quarter for five consecutive quarters, beginning with the third quarter of 2002. The third quarter of 2003 witnessed venture investments totaling $4.2 billion in 667 companies.

Despite a decline in both number of investments (5%) and amount invested (8%) from the second quarter of 2003, third quarter results were still higher than the first quarter of the year, indicating a healthy pace of venture capital activity.

Randy Lunn, General Partner at Palomar Ventures observes, "We are definitely seeing a return to normal investing patterns. The problems are behind the industry, and significant emerging technologies and market opportunities are becoming clearer. Partner capacity is freeing up to allow more investments and board seats."

But this upturn in venture capital investment must be viewed with some caution, as it is partially a result of the large amounts of uninvited capital available for investing.

"I think we are seeing an upturn but also one influenced by that massive overhang of capital," says Alex Suh, Managing Director of California Technology Ventures. "Venture capitalists have to balance their overhang with timing. If they wait too long, they will show poor IRRs. But, this is not to say that the venture capitalists are being careless. They are being very cautious and at the same time being aware that time is not always on their side."

 Source: PricewaterhouseCoopers/Thomson Venture Economics/National Venture Capital Association MoneyTree Survey

No Major Upswings In the Near Future

While we are seeing an upturn in venture capital activity, it will be some time before any major increases in the venture capital industry take place.

John Glanville, General Partner at Athenaeum Capital, cautions, "What we are seeing is a return to normalcy in terms of private equity investment (venture capital) prior to the ramp up in funding amount starting in 1997. It will be a while before things are back on track due to the serious over-investment during the bubble that is still being worked out."

Glanville adds, "It appears that venture capitalists are crawling out of their fox holes but the amounts being invested, along with onerous terms to entrepreneurs, may limit how far things go in this cycle. I doubt we will see a major swing given the recent lessons and losses in the private equity arena."

Biotechnology Takes the Lead From Software

Biotechnology received the largest amount of venture capital investment ($873 million) in the third quarter of 2003, displacing software as the leading category for the first time in seven years.

Investments in biotechnology increased 88% from a year ago, and 31% from the previous quarter. This is not surprising as the promise of innovative products and commercial applications from advances made within the biotechnology sector is attracting a great deal of interest from investors.

Alex Suh concurs, "We have always liked biotechnology. Software is important, but there comes a saturation point where cost exceeds return. Remember, there are a lot of IT departments that have invested large amounts of dollars in ERP software but are still trying to justify the expense. However, with biotechnology, people continue to grow older, become obese, and have other contributory diseases and ailments that need to be treated. As venture capitalists become more comfortable investing in this field that they normally have not invested in because of a lack of knowledge, the trend will continue to rise."

Randy Lunn is quick to point out, however, that despite trailing biotechnology, software remains a crucial area for venture capital investment. "Software will continue to be important as corporations continue to link up their own disparate networks and then extend them to both suppliers and customers. The movement towards real time applications is accelerating and there are many opportunities for entrepreneurs to provide critical pieces of connectivity and monitoring software," says Lunn.

Venture Capitalists Still Cautious of Early Stage Investments

Fifty-five percent of the money invested in the third quarter of 2003 went towards expansion stage companies indicating that venture capitalist are still skeptical when it comes to investing in early stage companies.

Early stage companies received 20% of total venture capital dollars invested in the third quarter of 2003, down from 22% in the previous quarter. But there are signs of a turnaround, according to Lunn, who points out, "Venture capitalists have recently been of the opinion that the stage of investment did not matter because Series A, B, C and D were all priced the same. Nobody was getting any mark-ups on valuations because milestones were not being met. Revenue growth has been so elusive. This is now changing as the economic recovery begins to take hold. Palomar's portfolio companies showed increasing bookings and revenue in the third quarter, as did many other venture-backed companies. Some companies are beginning to get valuation increases and venture investors will begin to see value in investing early and taking start-up risks."

Venture capital is scarce compared to the peak in investment activity a few years ago. But investors continue to seek out opportunities that display the promise of quick returns. "Venture capitalists are still licking their wounds from the late nineties. This, however, hasn't stopped them from looking for the 'quick hit'. There remains continued interest in wireless, software, and other 'short fuse' technologies (as in, rapid growth from prototype to product to customers to revenues)," says Glanville. His advice to companies seeking venture capital in the current economic environment is, however, tempered.

"Know your business, have alternative sources of capital identified, and do not ramp up your burn rate until you have revenues to support it," advises Alex Suh. "Try to build a business and a plan that does not immediately require venture capital. As an entrepreneur and as a venture capitalist, I have always believed that you need to build companies that generate revenue. One should never build a company that builds infrastructure in anticipation of business that may not come in as planned. (It never does.) Build sales, and then worry about the infrastructure by managing growth."

The venture capital industry is undoubtedly on an upturn, but far from the glory days it has witnessed in the past.

11/17/2003