E-BUSINESS SPECIAL REPORT
The Long Road Back for Venture Capital

Venture capitalists are experiencing déjà vu. After funding of startups skyrocketed between 1999 and the first half of 2001, it has receded to levels not seen since before the dot-com bubble. What lies ahead for VCs on the long road back from recession?

Of all the various types of investments, venture capital is the riskiest, yet also can offer the highest returns. But the rules changed during the Internet bubble. The cost of capital plummeted, and the level of risk fell accordingly, making it almost a no-brainer to choose to fund a startup.

Since the bubble burst, though, the cost of capital has risen again. As a result, venture capitalists have slammed shut their wallets, especially for new investments in early-stage startups. Private companies in the United States raised just US$20.3 billion in venture capital in 2002, down from $37.7 billion in 2001, according to figures from VentureWire. But both of these years are a far cry from 2000, when the VC market broke the $100 billion funding barrier, according to an NVCA study.

What Next?

So, you may be thinking, what happens now?

Some in the VC industry say they do not miss the profligate spending of the dot-com years.

"I think you have to ignore the big boom," Jeanne Metzger, vice president of business development and public affairs at the National Venture Capital Association (NVCA), told the E-Commerce Times. "Everyone in the industry feels that there was too much money invested, and there were too many companies that were started. Now, we're back to where we should be."

IPO Market Hurdle

Of course, not all venture capitalists are thrilled by the prospect of remaining tight-fisted in the long run. But challenges abound for VCs who want to loosen the purse-strings.

One daunting roadblock is the lackluster IPO market, said Scott Sandell, general partner at New Enterprise Associates, which inked more deals in 2002 (76) and 2001 (84) than any other VC firm. The lack of IPOs is problematic because when a startup goes public, its VC backers often sell their shares at a profit. That capital then becomes available for reinvestment in other companies.

This process of shedding the old and investing in the new has short-circuited in the past couple of years, as startups wait for the market to improve and venture capitalists find themselves locked in with their existing investments.

Indeed, everything is connected in the world of venture capital. Once the IPO market improves, Sandell told the E-Commerce Times, the merger and acquisition market also should start to accelerate as larger companies look to add startups' offerings to their own lineups of products and services. This is good news for VCs, since they can divest existing portfolio companies through M&A deals as well as IPOs. Indeed, an upturn in the IPO market could represent the first upswing in the road back toward VC liquidity.

IT Spending Must Rise

Spending on technology by corporate America also needs to increase before the venture capital pipeline can expand again, Sandell said. "Newly formed startups are going after the newer priorities that IT managers have, and those that successfully identify those needs are actually able to grow revenues in this environment," he noted. "That's going to be the one thing that venture capitalists will be unable to ignore."

Some of those new needs are in the fields of hosted applications, security, and storage of everything from databases to audio and video.

Good Deals Abound

Though the hurdles will be tough to overcome, many in the venture capital arena think the tech market finally has hit bottom and is beginning a long, slow climb upward.

One promising aspect of the current situation, Metzger said, is that venture capitalists now can apply low valuations to companies in which they are considering investing. This means that they can demand a greater equity stake than they could in the past -- often in exchange for a smaller investment.

"What I'm hearing is that what used to be a $10 million financing is now a $3 million to $5 million deal," she noted. "Salaries, rents, marketing costs, everything in terms of building a company from a cost-structure standpoint has come down."

Angels Landing

Both Metzger and Sandell said they think the number of first-time financing rounds will increase in 2003. Metzger noted that she had just returned from a VC/entrepreneur roundtable in Denver, Colorado, where venture capitalists said 80 percent of their triage and refinancing of existing companies is behind them, leaving them with more time to consider new deals.

In other words, although the venture capital industry faces a long and rocky road back toward higher investment levels, there are some positive signs on the horizon. Indeed, if the IPO market picks up and Metzger's and Sandell's brightest predictions come true, startups may have more reasons to smile in 2003 than they have had in years.