Where Investors Fear to Tread

by Wendy Hall, Larta Staff Writer

November 11, 2002

A MoneyTree report released from PricewaterhouseCoopers this week found that venture capital deal flow for Q3 of 2002 decreased 26% from the previous quarter, reaching the lowest level in over four years. The long-awaited investment turnaround is likely to continue until profitable IPOs and acquisitions, as well as solid revenue models, becomes a foreseeable reality.

The Findings

The overall investment figures that came out of the report reflected a steep downward trend--total investments were at $4.5 billion for entrepreneurial companies, compared to $6 billion in Q2 and $6.4 billion in Q1. Meanwhile the number of companies also dropped--from 838 in Q2 to 647. In Southern California, two industries received significantly increased levels of funding during the quarter: semiconductors and telecom. However, the majority of funds invested in those industries was in follow-on rounds, with only $61 million (14%) of the total dollars invested across all industries representing Series A investments. According to co-author Randy Churchill, Director of Business Development with PricewaterhouseCoopers' Technology Practice, the pattern in these two sectors-indicates how VCs may be nurturing existing portfolio companies in these industries, yet they're not aggressively funding new opportunities.

"The factors that have contributed to the decreased levels of funding (i.e., decreased capital expenditures and lack of liquidity) are not specific to one industry," says co-author Randy Churchill, Director of Business Development with PricewaterhouseCoopers' Technology Practice. "As a result of all of this, we're likely for a while to see good companies that possess strong IP struggle to secure funding. Companies that are fortunate enough to obtain funding will need to be very cash conscious as follow-on funding will be scarce and the terms arduous."

The kinds of companies that have been able to successfully attract financing are more so later or expansion stage businesses, while startup funding is more and more difficult to come by. Expansion stage companies received 56% of all capital invested, and 55% of the number of deals in the third quarter. Longer investment cycles and valuations being at all time lows, as well as a concern that startups will be unable to gain sales traction, have caused the bulk of VC capital to gravitate towards more developed businesses.

"The business models of the companies that are getting funding have also had a huge shift because of what's going on, they're more developed, further along," says John Taylor, another co-author and VP of Research at NVC Association, which collaborated with PwC on the report. As far as sector impact, the investment decline was noticed across all the industries, leaving no sector unaffected. Although all major industries experienced declines, some drops were more severe. Biosciences, a sector which analysts have been following closely due to the sector's investment surge of the past two years, declined 52% to $468 million, while medical devices fell 28% to $448 million. Yet Taylor says that the VC interest in biotech, as well as software which took only a only 10% investment dip from the prior quarter, is fairly sustainable.

"It's being driven by a big realization among the major pharmaceutical companies that the entrepreneurial sector is a very good place for product development," Taylor says. "I think we'll see a continued interest in the biotech sector by the venture capital industry simply because of the success of the entrepreneurial sector in developing new products."

Turnaround time still way off

Although the data in the report found investment flow to be at one of the slowest periods in nearly half a decade, the news was hardly surprising, if not anticipated. The venture capital market has been steadily dropping, and money had already been flowing towards later stage deals more and more, and making the startup environment particularly treacherous. Despite the widespread eagerness for a turnaround, economic realities have positioned the investment climate in a cautious standstill. What the industry is planning for and what the industry is hoping for have to be separated, says Taylor. And the ever-elusive tech turnaround could largely depend on the successes of IPOs from the few companies that are being funded in the current climate.

"There's one other factor that's out there that I think is largely running the show in the minds of the venture capitalists, which is what the exit markets will look like five or seven years from now when these companies that they're investing in for the first time are ready to go public," Taylor says. "There's a concern as to what kind of valuations even the best of these companies will be able to get on the public market. And it's a function less of whether the successful companies can be built, and more what is the kind of overall thing going on in the public markets. There will be the question of whether anybody will be interested in buying technology-based companies."