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By Michael Hildreth
Nicole Buisson
There
is no doubt that 2002 presented many challenges to investors and
entrepreneurs alike. Corporate scandal, geopolitical uncertainty
and faltering economic conditions worked in concert last year to
keep VC investment down and exit markets nearly shut tight. It might
be tempting view this as the worst of times; put in historical perspective,
however, the picture looks brighter. Downturns in economies, capital
markets and even venture capital have happened before, and each
time the market has recovered. The venture capital industry by nature
is cyclical; in the last 30 years there have been two other major
downturns – each time the lull has ended as new ideas emerged
to spur innovation.
This survey of U.S. venture capital investment in 2002 attempts
to put the last year in perspective by providing an analysis of
investment activity, a look at the year’s top investors and
a snapshot of the year’s biggest deals. Finally, the two previous
downturns are profiled to show that great companies come out of
difficult times.
INVESTMENT OVERVIEW
The $19.4 billion invested in 2,056 deals across the United States
last year represented a level of investment slightly higher than
that seen in 1998, making 2002 the fourth largest investment year
in history. Yearly investment declined $15 billion from 2001 to
2002 – a much smaller decline than the $59 billion drop from
2000 to 2001. Quarterly investment seemed to stabilize in the last
two quarters of 2002, with Q3 ’02 seeing $4.2 billion invested
and Q4 ’02 garnering $4.0 billion.
Geography - Continued Dominance of the West Coast Market
All areas of the U.S. saw declines in venture capital investment.
The West Coast continued to dominate investment in 2002 with 44%
of total investment occurring in the Bay Area and Southern California.
New England also continued to account for a large portion of investment
with 14% of the total.
Software and communications dominate, but healthcare is
the bright spot.
All industry groups were affected by investment decline in deal
and dollar terms in 2002; however, some showed greater resilience
than others. Information technology continued to account for the
majority of investment in 2002, led by software and communications
segments. Software investment remained steady at 23% of total investment
dollars in 2002, while communications dropped 3% to 22% of the total.
Healthcare
proved to be the bright spot of the year seeing a 9% increase as
a percentage of total investment dollars in 2002 - receiving $5.2
B in 488 deals. This was led largely by the biopharmaceutical (+5%)
and medical device (+3%) segments. Even more interesting are the
healthcare increases in seed and first round investment - in 2002
31% of early stage dollars were invested in healthcare. This represents
an increase of 14% over 2001. In a time of little early stage investment
it is these deals that will form the pipeline of tomorrow’s
successful companies.
Focus on later stage, lower valuations and increased insider
rounds
2002 was characterized by a continued focus on portfolio management,
leading to increased investment in later round deals. Eighty per
cent of last year’s investment dollars was directed at second
and later rounds. With potential exits further in the horizon investors
continued to provide their viable portfolio companies with the funds
needed to weather the current environment. Indeed, median round
size, which was $6.5 million in 2002, has not fallen as fast as
other measures, suggesting that VCs are willing to support the right
companies. In 2002, the median time between rounds stretched from
16 months to nearly 20 while the number of rounds declined, highlighting
venture capitalists’ heightened focus on capital efficiencies
for portfolio companies.
With longer times to exit, and private market valuations closely
tracking activity in the public markets, pre-money valuations have
been pushed down. 2002 saw a decline of 35% in pre-money valuations
down to $10.9 billion - similar to mid-90s levels. Due to an environment
characterized by higher risk, many venture capitalists are being
increasingly selective in their investments. Many seasoned investors
are taking advantage of the low valuations, seeing them as a valuable
opportunity to get better deals for less cash invested. For entrepreneurs
the impact of low valuations doesn’t paint such a rosy picture
– issues of dilution of company ownership are currently hotly
debated.
Insider rounds in later stage financings across all industry groups
have increased over the last three years. The increase of insider
only rounds (rounds with only incumbent investors) highlights the
current focus on portfolio companies and impact of lower valuations.
There are several potential explanations for this – with the
current level of valuations, investors may want to keep new investors
out in order to maintain the best possible valuation. A second potential
explanation is that new investors simply don’t want to be
included due to the current risk-averse nature of the industry.
In either case, VC syndication was strong in 2002 as investors banded
together more frequently to support companies in the longer term
and manage risk.
VC
Fundraising
Through 2002 fundraising showed massive declines with just $11.4
B raised - a decline of 74% over 2001. This year was the first in
the last decade when the industry has seen a net outflow of money
to investors. Large reserves of uninvested fund dollars held by
VCs rendered it unnecessary for many to raise further dollars. There
is estimated to be around $75 billion of uninvested capital available
and a dramatic reduction in the number of companies looking for
financing. On the positive, a slight up-tick in fundraising in the
fourth quarter of 2002 was seen with $3.5 billion raised.
Exits
- Few opportunities and longer horizons
In 2002 both M&A and IPO exits remained scarce. Although yielding
comparatively little, M&As were the primary venture-backed liquidity
option, accounting for over 90% of exits. In 2002 twice the number
of M&As as in 1995 occurred but they yielded the same cash ($10
billion).
Through
2002 the IPO window remained nearly shut. The public markets showed
little activity with just 19 venture backed IPOs raising $1.6 billion
in the U.S.. On a positive note, the median amount raised for these
IPOs was high at $78 million. Companies going to IPO are much more
mature than at the height of the boom – 3.9 years as compared
with 2.7 years. This represents a move back towards the historical
model where the investment cycle for IPOs was typically 4-5 years
– time enough for companies to establish themselves, develop
a customer base and show a profit prior to the IPO.
Top Deals - Money was still out there for
the right companies
Despite the fact we are in a downturn venture capital is out there
for the right companies. The increased competition for VC dollars
today given the current environment only ensures that the companies
receiving funding are of a higher quality. Venture capitalists report
the number of entrepreneurs looking for venture capital has fallen,
however the quality of business plans has improved. The table below
summarizes the most well-funded venture capital investments of 2002
by select segment.
 Top
Investors – Seasoned investors continue to invest
The top ten investors in the United States invested in 30 to 65
deals in 2002. New Enterprise Associates led the group overall with
65 investments split predominantly between information technology
and healthcare of which 13 were seed or first round deals –
making NEA also the number two early stage investor. NEA’s
investment followed industry trends with healthcare investment split
between biopharmaceuticals and medical devices, while information
technology investment was split between software and communications.
Intel followed in second with 55 investments, primarily in the software
segment of the information technology group. U.S. Venture Partners
was in third place with 43 investments overall, but led the pack
in early stage investing with 14 seed or first round deals in 2002.
The majority of U.S. Venture Partners’ investments were also
in information technology; however, split across the communications,
semiconductor and software segments.
2003 OUTLOOK
‘Everything that can be invented has been invented has
been invented.’ -- Charles H. Duell, the U.S. Commissioner
of Patents, 1899.
It
is difficult to know when the current situation will stabilize or
if it indeed is in the process of doing so. What is important to
remember, however, is that just because the economy is in a downturn
doesn’t mean innovation has stopped. Some of the most successful
technology companies were funded and became public during downturns
- Companies such as Cisco, Apple, Ciena and Genentech. It is difficult
to know which technologies will pull the economy out of the current
slump – perhaps today’s gems lie in the life science
sector, which is currently receiving an increased percentage of
seed and first round financing.
The
U.S. market has a great deal of infrastructure talent and resources
left over from the dot com boom years that will make it easier for
the industry going forward. Currently most of the components necessary
for building a company can be acquired inexpensively, such as talented
people, professional advice and real estate.  There
is still no shortage of entrepreneurial spirit waiting in the wings
to turn these building blocks into new companies. And as seen in
the survey of venture capital in 2002, there are VCs who are willing
to invest significant sums into promising companies. In essence,
this is a classic time for great companies to start.
About
the Author:
Michael Hildreth, Partner and Emerging Growth Companies Co-Leader
in the Pacific North West, is a graduate of Stanford University.Mike
has extensive experience in serving technology, communication and
life science clients, from start-ups to multinational organizations,
as well as local venture capital funds, including:
AllBusiness.com, Bay City Capital, Entopia, ChemGenex, Corcept Therapeutics,
Caspian Networks, Centillium Communications, Cirrus Logic, Incyte
Genomics, Force 10 Networks, Garage Technology Ventures,Gemfire,
Icarian, NeoMagic, New Meadow Ventures, Omneon Video Networks, Portera
Systems, Responsys.com, Gilead Sciences, Inhale Therapeutic Systems,
Protein Design Labs, Transmeta, Vantage Point Venture Partners,
WorldRes.comIn late 1999, the Palo Alto Venture Capital Advisory
Group was created under Mike's leadership. This unit is dedicated
to serving the needs of the local venture capital community, and
this activity is now operational in 14 entrepreneurial hotbed markets
around the world.
Mike is a guest lecturer in the Venture Capital program at the Haas
School of Business of UC Berkeley and a past director of the Northern
California Cystic Fibrosis Foundation and the Churchill Club.
For add'l info please contact Jonathan Speed
Ernst & Young
1451 California Ave.
Palo Alto, CA 94304
650-849-3756
jonathan.speed@ey.com
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