Venture Funding Rises from the Ashes
September 1, 2003

By James Klein, Larta VOX Editor

Two years of declines in venture funding turned around in the second quarter of 2003, according to the PricewaterhouseCoopers/Thomson Venture Economics/National Venture Capital Association MoneyTree Survey. Investments were up nationwide, but Southern California faired especially well, receiving more than double the amount garnered in the first quarter of 2003.

Investments totaled $4.3 billion nationwide in the second quarter of 2003, up from $4 billion in the first quarter, the first increase since 2001. A total of 669 entrepreneurial companies received funding in the second quarter, compared to 647 companies in the first quarter of this year.

Venture Capitalists have been cautious since getting burned in the technology crash of 2001, when investment rates plummeted. Many VC firms shifted their focus to the management of their (often troubled) existing portfolio, and when they were investing, they did so in revenue generating companies and in later-stage deals.

VCs Less Cautious?

Though the second quarter increases were modest overall, a close look at the data could indicate the venture industry may be easing its cautious approach. In 2002, VCS were more interested in later-state deals with companies that had already proven themselves in the market. The 2003 second-quarter figures revealed more first-time and early-stage deals. Investments in early stage companies increased 43%, from $668 million in the first quarter to $956 million in the second quarter of the year, the first significant increase in early-stage investments since the fourth quarter of 1999. 200 early stage companies received investments in the second quarter, compared to 155 in the first quarter of 2003, a 29% increase. Overall, early stage companies accounted for 22% of venture capital dollars, up from 17% in the first quarter.

In addition, the number of companies receiving venture capital for the first time increased in the second quarter after falling to an eight-year low in the first quarter. 153 companies received first-time investments, compared to 138 in the first three months of the year. First-time investments increased 12% from the previous quarter to $775 million, indicating venture capitalists' increasing interest in riskier earlier-state investments.

Don't Believe the Hype

Though the second-quarter data is encouraging, especially with regard to early-stage and first-time investments, and some are heralding a dramatic change of attitude amongst VCS, others believe the industry will likely continue its go-slow, back-to-basics approach as it waits for a more significant national economic recovery.

Although there was an increase in early stage investing in the second quarter, VCS continued the trend toward investing in more established companies. Investments in expansion stage companies declined slightly to $2.3 billion, or 54% of total investments. This was partially offset by an increase in investing in later stage companies to $958 million, or 22% of total investments.

Joel Balbien, Managing Member of Smart Technology Ventures, believes the second quarter figures do not indicate a major change in attitude among VC firms. "I would not call the national second quarter results a dramatic turnaround, but certainly venture capital investment activity is on the rise along with other leading indicators of economic recovery like the stock market," said Balbien. "[Investors] are hoping that the upturn in the Nasdaq, and private equity investment is followed by real economic growth in the IT, and telecommunications industries."

Brad Jones, Founding Partner of Redpoint Ventures, believes the second quarter data constitutes a "gradual increase" rather than a dramatic turnaround in the venture market, but does perceive a change in attitude among investors. "There is certainly a more optimistic outlook right now both within the venture capital community and I think within technology markets generally."

Jones feels quarterly investing in the $4 billion range, though dramatically higher than a decade ago, may be sustainable. "Ten years ago the annual investing was somewhere on the order of $3 billion a year, so $16 billion for a year is quite an increase from that, but it is ten years later and the economy is bigger and markets are bigger, and 16 billion is certainly down from the levels of 1999 and 2000, so it's possible that it's sustainable, but it's probably a little too soon to see."

Todd A. Springer, Managing Director of Trident Capital, is also cautiously sanguine. He believes the second quarter numbers are probably not indicative of a dramatic turnaround, but they "…can be seen as an indication that venture investing has bottomed, and is likely to increase steadily in the coming quarters." Springer also says the new data "…does indicate that many VCS are winding down "triage" activity with existing portfolio companies, and are now focusing on new investment opportunities."

"Is this quarter a harbinger of a dramatic turnaround in venture capital investing? It's not likely," said Mark Heesen, president of the National Venture Capital Association, in a recent statement in Forbes. "The venture industry invests based on anticipated future market conditions, so before we declare a trend reversal we must first see a sustained opening of the IPO market and consecutive quarterly increases in corporate capital expenditures."

The Perils of Caution

Though caution and conservatism rule the VC industry today, some players may be hurt by an overly cautious approach as a surplus of uncommitted assets could make a fund's investors impatient, and even result in the return of capital. "With $70 - $80 billion in committed but uninvested reserves, and an overhang of physical and human infrastructure to invest those funds at unsustainable rates, there is likely to be considerable consolidation and downsizing in the number of active venture capital funds," said Balbien.

Todd Springer of Trident Capital points out that a VC's job is not to wait for the market to improve but to anticipate the improvement and capitalize on it. "The tech decline is still fresh in the minds of VC investors, and everyone wants to avoid the mistakes of the past," said Springer. "That said, VCS are not generally paid to time the market, but to invest in solid business models and capable management teams in both good markets and bad. Good VCS have demonstrated the ability to generate superior returns in all kinds of markets. Many VCS are beginning to recognize that if they wait until the economy is roaring again, it may be too late to invest at attractive valuations."

Southern California Shines Bright

Southern California companies received $603 million in funding in the second quarter, an increase from $262 million from the first quarter of the year, according to an Ernst & Young/VentureOne survey.

In the Los Angeles area, information technology led all sectors, capturing $85.6 million in the second quarter. One of the IT firms in the Los Angeles area that received venture funding was Troika Networks Inc., a maker of computer networking hardware and software (see "Troika Networks Raises $13 Million" in the August 4, 2003 edition of Larta VOX).

Oxnard-based Catalytic Solutions Inc. topped Southern California's second-quarter funding list in the MoneyTree survey, receiving $32.4 million in capital. Catalytic Solutions has developed technology that improves the performance and reduces the cost of anti-pollution catalytic converters. Santa Monica-based Tennis Channel Inc., a 24-hour, all-tennis cable TV channel that officially began airing in mid-May got $25.4 million from investors, according to the MoneyTree Survey.

Balbien urges caution and is wary of the regional indicators. "There is always more quarter to quarter volatility in the regional data, so I would not put too much emphasis on the sharp swing in Southern California unless it is validated by at least a two quarter trend." Balbien also suggests the impact of improving numbers is not going to be as great in Southern California. "The high technology and VC industries are much more concentrated in Northern California. As a result, the economic impact of the worst recession in high technology in forty years is much more severe up north than for Southern California's more diversified economy."

In addition, Balbien cautions that California's VC industry might be hurt by the state's budget crisis: "California's budget problems could hurt the venture capital industry on the supply side by increasing the cost of operating California based Companies, and by forcing reductions in Research and Development spending by Universities. In addition, a junk bond rating for the state and its utilities may lead to the deterioration of California's transportation and public utility infrastructure, which supports all economic sectors, including high technology. Ultimately, California will be forced to bring state and local government spending back in line with sustainable revenue from taxes and fees, to avoid long-term stagnation in business and employment, as economic growth shifts to other regions of the country."

Brad Jones doesn't think the California budget crisis will have a long-term affect on the California venture capital market. "California's disastrous budget situation if it persisted over a long time would cause investment levels in California to drop, but I don't think the budget situation will have a long-term impact. There's a lot of technology in California, a lot of trained people, and it will continue to be an attractive place to invest."

A Rising Tide Doesn't Lift All Sectors

Software led all sectors nationwide, with $864 million going to 179 companies, while the life sciences saw the greatest increases from the previous quarter. Biotechnology investments increased 14% from the first quarter of 2003 as 66 biotech companies received $639 million in the second quarter of the year. After a disappointing first quarter, investments in Medical Devices rose 54%, the largest increase of any major sector, as 52 companies attracted $437 million in capital. Investments in the Life Sciences, including Biotechnology and Medical Devices, reached $1.1 billion in the quarter ending June 30. The Telecommunications industry came in third on the strength of later stage investing as 70 companies captured $615 million in the second quarter, an increase of 21% over the previous three months. Semiconductor investing was essentially unchanged at $268 million. Networking continued to fall, declining 7% to $427 million.

Industry sectors that received first-time investments generally followed the same pattern as the overall market. Software companies led the field with 31 companies capturing $152 million. 17 Biotechnology companies attracted $56 million. First-time investments in Medical Devices totaled $93 million distributed to 15 companies. 12 Media & Entertainment companies received first investments of $117 million. First-time investing in the Networking and Telecommunications industries continued at historically low levels.

"Software and healthcare technology I think are very strong markets right now," said Brad Jones of Redpoint Ventures. "I think healthcare overall, not just biotechnology, will continue to be a very strong segment. The demographics of the population and the sequencing of the human genome and other technology advancements suggest that there are quite a few new opportunities in the healthcare area, and the number of good opportunities directly affect how much investment you'll see going into those areas. Software I believe is a large area, it always has been a large area and will continue to be. I think there are other areas that are promising as well. Wireless for one. There are always some new areas that come along that we can't anticipate as well so one of the things venture capitalists try to do is understand what is going on in the markets and be ready if some new areas begin to show strength."

Joel Balbien of Smart Technology Ventures also believes healthcare is a significant focus of investors, and that the wireless sector bares watching. "Clearly, the stronger second quarter investment numbers were driven primarily by a surge in investment in healthcare-related companies. Software should also do well moving forward since this sector is less capital intensive, and more capital efficient at achieving first revenue than most other venture capital investment opportunities. What other sectors bear watching? The trend towards ubiquitous wireless communications continues, and the best companies in this space should outperform most other opportunities."

Second quarter increases are cause for hope, but it would be naive to celebrate one quarter's improvement as a radical departure from the pragmatism that has prevailed of late in the venture industry. Fund managers will continue to be cautious as they scour the horizon for worthwhile deals, loosening their purse strings judiciously and with an eye toward sustainable and demonstrative value, exploiting activity in the most promising sectors while minimizing risk through rigorous due diligence.

The 2002 PricewaterhouseCoopers/Venture Economics/National Venture Capital Association MoneyTree Survey is available with Larta's Sand Dollar Report 2003: An Analysis of Venture Investing In Southern California, featuring PwC's MoneyTree Survey, which contains comprehensive new information and data, and interviews with leading venture capitalists in the region. Available with the purchase of Larta's Sand Dollar Report 2003.

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