1 ) Venture Capital Industry

MAIN FIGURES

" The vast majority of money is being raised by established venture funds with at least one prior operating fund," observed Steven Lazarus, Chairman of the NVCA Research Committee and Managing Partner, ARCH Venture Partners. "In 1999, 78% of the money was raised in follow-on funds. In the first half of 2000, 98% of the money was raised in follow-on funds. This reflects the institutional investor's regard for experienced fund managers especially given today's volatile financial markets."

The list of billion dollar funds increased by seven, including a $1.6 billion close by Accel Fund VIII, L.P. and the largest close by Spectrum Equity Investors IV, L.P. at $1.75 billion. These seven funds in total made up almost half of the fundraising for the second quarter, continuing the trend of larger funds controlling the majority of the capital.

Balanced-stage funds raised $6.7 billion in 23 vehicles while early stage raised $6.3 billion through 37 funds. Later stage funds accounted for only 20% of venture capital fundraising for second quarter 2000 as compared to almost 50% in 1999.

On a regional level, 33 Northern California funds raised an astounding $9.9 billion, a five-fold increase over the second quarter 1999. Coming in a close second were the 21 Northeast-based funds with $6.3 billion. These two regions dominated the U.S. venture capital industry, pulling in just under 90% of all capital raised in the second quarter 2000. The Midwest was next with six funds, the Mid-Atlantic with five funds, while both the Southeast and Southwest raised four funds each.

RECENT EVOLUTION

Venture Capital Investments Finally Plateau
Q3 Investments Decline Slightly to $17.6 Billion

-- Full Year 2000 Still on Track to Double 1999 --

Venture-backed investments in the third quarter of 2000 reached $17.6 billion, a slight decrease from the record of $19.8 billion in the second quarter of 2000, according to the PricewaterhouseCoopers Money Tree™ Survey. However, investments were still nearly double the $8.9 billion recorded in the third quarter of 1999.

Tracy T. Lefteroff, Managing Partner of the Venture Capital Practice in the Global Technology Industry Group, announced the findings. According to Lefteroff, "Turmoil in the NASDAQ is still just a ripple in the venture capital market. This summer, we projected investments in 2000 would hit $70 billion, double 1999's level of $35 billion. That projection still holds. The mix of investments is changing, but the appetite for investing hasn't."

Compared to last quarter, the number of companies receiving funding declined 11%, down from 1,434, and the average funding remained relatively flat at $13.74 million as compared to the $13.82 million recorded last quarter. However, for the third quarter of 2000, the number of companies receiving funds increased 28% to 1,283 compared to 1,004 companies a year earlier. At the same time, average funding per company increased 55% to $13.74 million versus $8.87 million a year ago.

"The financial markets have affected valuations, thereby reigning in continued increases in average deal size. It's a reality check, not a reversal," Lefteroff pointed out.

Industry Sectors

Technology-based companies, including Internet-related businesses, accounted for $16.9 billion, or more than 96% of all investments in third quarter 2000. Although the raw dollars invested decreased, the percentage of total investments going into Technology-related companies increased slightly over last quarter.

Internet-related companies, which cut across all standard industry classifications, fell slightly to $10.0 billion; down from the record of $11.9 billion invested in Q2 2000. The number of Internet companies receiving funding was also down from 779 last quarter to 746 this quarter. Average funding for Internet-related companies fell to $13.5 million, a 12% decrease over last quarter.

Among Internet companies, Tools/Applications companies, including firms providing website security and traffic management solutions, captured the largest share of the dollars with $2.88 billion, remaining virtually unchanged from last quarter. Access/Infrastructure companies, which includes Internet service providers, were next, capturing $2.43 billion. This category was the only one that experienced an increase from the prior quarter, rising 24 percent. The other four categories of Internet companies, Services, Content Sites, Business-to-Consumer e-Commerce Sites, and Business-to-Business e-Commerce Sites, all experienced decreases from last quarter, both raw dollars invested and the percentage of total Internet-related investments. These categories captured $2.23 billion, $695 million, $799 million, and $992 million respectively in the third quarter of 2000.

Lefteroff observed, "These shifts in investment categories are evidence of the underlying strength of VC. Dollars are not just sitting on the sidelines. They are being put in play into areas with the greatest opportunities. And, with more than a dozen VC firms closing new funds in excess of $1 billion each, there is plenty of money to put to work."

In the standard industry categories, companies in the Software Industry, including ASPs and e-commerce software firms, captured 24% of all investments, decreasing 13% over last quarter to $4.16 billion. The Telecommunications category, including broadband and wireless service providers, ranked second with $3.45 billion for the quarter. And the Networking and Equipment category ranked third with $2.48 billion, doubling over last quarter, and experiencing the single largest increase of any category, fueled by optical networking services and equipment. Closely related, the Telecommunications category saw a drop in dollars invested, but, taken together, the Networking and Telecommunications industries experienced a net increase over Q2 to $5.9 billion.

All together, the top three categories accounted for over half of all investments in the third quarter, evidence of the continued strength of "traditional" technology. Also of note, the Life Sciences area, which includes investments in the Biotechnology, Pharmaceuticals, Medical Devices, and Healthcare Services categories, experienced a marked increased for the first time in several quarters, increasing half a billion dollars, or 38%.

Geographical Markets

Of the five regions capturing over $1 billion each, Silicon Valley and New York Metro both remained virtually unchanged from last quarter, while New England, the Southeast, and Texas all experienced declines in investing. Overall, most major markets were flat or declined slightly, as compared to Q2.

In all, eight regions attracted more than $800 million each in the third quarter. Those regions were:

According to Lefteroff, "It's important to keep the quarter-to-quarter decline in perspective. All major markets still had increases of 50% or more over Q3 1999, some at double last year's level. That's not exactly bleak."

 Stage of Company Development

Formative stage companies, those in the startup and early stages of development, garnered the most funding: $8.13 billion, or 46% of total dollars. And, they represented 52% of all companies. On average, each company received $12.14 million, up 3% from $11.74 million last quarter.

Companies in the expansion stage of development were close behind with $6.53 billion, or 37% of total dollars. But, they represented 32% of all companies. On average, each company got $15.88 million, down 17% from $18.56 million in the second quarter of 2000.

Tracy Lefteroff noted, "Formative stage companies are the harbinger of future investments. They continue to represent around half of all companies getting funding. This indicates that venture capitalists are investing the future while continuing to support their existing portfolio companies".

(source : PriceWaterhouseCoopers)

FOCUS ON SILICON VALLEY

For six straight quarters, Bay Area venture capital investment tallies set record after record: The figures ballooning from a mere $1.72 billion in 211 companies in the first quarter of 1999 to $6.99 billion in 412 companies in the second quarter of this year.

But the trend just came to a halt. In the third quarter, VC investments dipped to only $6.95 billion in 379 local companies -- down by $41 million and 33 companies from the second quarter, according to the latest Money Tree report compiled by the Mercury News and PricewaterhouseCoopers LLP.

Still, that's a drop of less than 1 percent in dollars and 8 percent in companies. And it remains more than twice the money invested in the third quarter of 1999 -- and seven times the amount invested in the third quarter three years ago.

To Kirk Walden, national director of venture capital research at PricewaterhouseCoopers, the decline is "statistically insignificant.''

But those who have watched venture investment climb so high so rapidly might wonder why VCs haven't fallen over the edge of the cliff. After all, many venture-backed dot-coms are withering away. Business-to-business Internet enterprises are fighting to survive, and the volatile stock market has made initial public offerings difficult for portfolio companies.

Why aren't VCs rending their garments in the middle of Sand Hill Road? In short, because most of them don't have to -- not yet anyway. And that's because of the nature of venture investing, which can delay, buffer and diffuse the pain caused by lackluster or even failing companies.

It's not that VCs are wholly unaffected by the troubles their companies are facing. But for the time being the discomfort is more like a bad case of indigestion than a major heart attack for most investors. So VCs are changing their diets.

They have slashed their investment in e-commerce almost in half in the third quarter compared with the second, and they're reinvesting in their existing e-commerce companies. Only one local deal in the third quarter was a first-round investment in an e-commerce company.

Business services companies also took a hit, raising $973 million in July, August and September, compared with $1.48 billion in April, May and June, according to the Money Tree.

Conversely, Bay Area networking and equipment companies raised $1.23 billion -- more than twice the $604 million of the second quarter. Software remained the perennial favorite, raising $1.88 billion.

They're also spending less energy seeking out new start-ups to back. Onset Ventures general partner Darlene Mann, expects the new-company investment pace to slow more rather than pick up.

``I think also that more money was going into existing investments. This is certainly true for us,'' said Noel Fenton, a general partner at Trinity Ventures.

He expects the trend to continue as companies that hoped to complete an initial public offering in the summer or fall are forced by market conditions to raise more money in the private market instead. ``We're having to feed our children a bit longer,'' he said.

Yet several factors help venture firms weather the demise of some portfolio companies and a tumultuous market.

For one, most VC groups that invested in e-tailing did not make it the primary focus of their portfolio. And if their other companies in other sectors do well, e-commerce losses would pinch rather than devastate returns.

Even firms that are heavily invested in out-of-favor companies can have high returns -- if they have a few big winners per fund. That's because venture capital is a hits-driven business. One spectacular success can almost completely overshadow damage caused by failed companies in the same portfolio.

Phil Horsley, managing director of Horsley Bridge Partners, said his firm studied 61 venture funds in which the firm invested from 1985 to 1996. The firm found that the funds' value grew from $6 billion to $61 billion -- and more than two-thirds of the $61 billion was generated by just 89 out of 1,312 companies in the study. Those companies returned more than 25 times the money invested in them. These home runs overshadowed the losses and laggards among the rest of the investments.

Kevin Harvey, a general partner at Benchmark Capital in Menlo Park, knows how this math works. His well-known firm has a substantial e-commerce portfolio with companies such as luxury-goods seller Ashford.com Inc., florist 1-800-Flowers.com Inc., virtual drugstore PlanetRx.com Inc. and grocery delivery service Webvan Group Inc. that have suffered in the recent market conditions.

But the firm also backed handheld device maker Handspring Inc., e-marketplace builder Ariba Inc. and successful online auction company eBay Inc., all of which added handsomely to Benchmark's returns.

Investment Diversity

Harvey said the e-commerce problems are pretty much ``irrelevant,'' given the diversity of Benchmark's investments. Indeed, he thinks eBay and Ariba alone could probably compensate for the e-commerce portfolio's decline in value.

``E-commerce as a segment is absolutely struggling,'' Harvey acknowledged. ``We spend a lot of partner time working on our companies to try to figure out what the right moves to make for them are.''

Harvey said the firm would continue to fund those companies as long as it believes in them. That's a judgment call many VCs will face in a tighter market. ``We're their partner, but there's no obligation for venture firms to fund companies,'' observed WaldenVC's Phil Sanderson.

No matter how badly the current investments play out, many VCs will be able to hang on, at least for a few years. In large part, that's because they've raised record amounts of money in the last few years. Those who don't have to return to institutional investors for more cash for a few years can continue investing until they need more money, putting off their day of judgment.

Still, the situation could be more challenging for venture firms that will have to raise funds this year or next. That's especially the case for younger firms with shorter track records -- firms whose entire reputations are riding on the last two or three years.

Drop in individual investors

Additionally, the drop in the stock market has taken its toll on institutional investors, shrinking their overall pool. Less total money means less money for venture capital -- especially for institutions whose venture investments have retained their value well. With much of the rest of the portfolio's value falling, the venture piece can suddenly exceed its allotted share of the pool.

There are only two ways to deal with this problem: by putting fewer dollars in each fund or by investing in fewer funds. ``We will probably not be investing in a lot of new partnerships that we normally would have,'' said Philip Halpern, vice president and chief investment officer for the University of Chicago.

Faced with difficult decisions, institutional investors are likely to stick with the firms they know and trust best -- groups with longer histories that have operated successfully through a down cycle before. And while institutions might keep investing with a veteran firm that has an atypically poor fund, they won't necessarily give that benefit of the doubt to greener groups.

And the fallout from the second half of 2000 will soon be evident, noted Tracy Lefteroff, global managing partner for private equity and venture capital at PricewaterhouseCoopers. ``The fourth quarter will be a telling quarter also because all of these funds have to get audited financial statements,'' he noted. If the value of a portfolio company had fallen during the year, that is where it will show up.

All of which raises the question of a shakeout. Will there be one among venture capitalists, and, if so, how severe will it be?

Many VCs believe a shakeout is likely, but disagree about when it will take hold.

To some, like James Wei of Worldview Technology Ventures, the seeds already are being sown. Smaller, younger firms whose portfolio companies have been shut out of the public market will have trouble continuing to support them. They also will have trouble attracting good investment opportunities for the future, he predicted.

Others, like Onset's Mann, think a true shakeout is two to three years away, when the problems of portfolio companies finally catch up with VCs in the form of lowered returns and difficulty raising new funds.

New Enterprise Associates' Peter Morris basically agrees, but he thinks the word ``shakeout'' isn't quite right. It implies too sudden and violent a scenario. He thinks the thinning of the venture industry will take place over the next two to four years, with firms quietly disappearing if they can't attract more money.

(source : Mercury News)

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