High-tech

Are venture capital companies poised and ready for growth?

By Bipin Parmar

Positive trend of latest data

Europe also shows green shoots

Industry focus - key areas

Positive trend of latest data

Recent data provided at the VentureOne-Ernst & Young conference (which was co-sponsored by The Chilli) confirmed that the venture capital (vc) market is showing signs of stabilising. Figures from the US for 2Q03 indicate both venture money invested and the number of deals carried out showed a positive growth - reversing a negative trend that began the long investment winter in 2Q00.

In 2Q03, vcs invested approximately US$4 billion in 442 deals, compared with $3.5 billion and 424 deals in the previous quarter. This reversal in trend is the good news that many lps (limited partners), gps (general partners), vcs, angels, investment bankers, corporate lawyers, founders, management and entrepreneurs have been waiting for as a signal to come out of hibernation. There is still some rationalisation going on, with very little new fund raising by vcs, and most of them still sitting on the large overhang from the past few years. A mere $2.3 billion was raised during the first half of this year, compared to the bubble era figures of $83 billion in the year 2000. Early indications are that fundraising levels will reach the same level as those reached in 1993, when the total raised was $6.6 billion.

Nobody needs reminding of the near disappearance of the ipo market, which has yet to show any sign of sustainable life. This is reflected in the figure of $1.6 billion raised via ipos in 2002, compared to $19.3 billion raised in the peak of 1999. Merger and acquisition (m & a) activity, which normally represents five times higher liquidity than the ipo market in value terms, is showing some stabilising signs due to some real pre-exit gems left behind during the long winter. When the market picks up, the number of deals via m & a will be three times higher than the traditional number of ipo deals. This is a reflection on some key companies that have built themselves some strong fundamentals, such as revenue targets, past break-even, positive cash flow, not to forget surviving the drought of capital starvation in the last three years. No official figures exist about the number of deals in the pipeline awaiting the right conditions, but judging by the number of queries and activity levels, the floodgates are just bursting to open.

Europe also shows green shoots

Latest figures from VentureOne for equity investment in venture backed companies, shows a flattening of the negative trend, exhibited over the last few quarters, with € 700m invested in 2Q03 versus the same amount in 1Q03, although the figure is well below the peak in 2Q01, when it reached a massive €3.3 billion. This sudden withdrawal of oxygen can explain the great exasperation felt by many entrepreneurs and founders who have been pounding the streets looking for that elusive Chilli S2, S3 and R1 funding round.

The good news is that vc offices are looking markedly busier nowadays, with the number of active deals going through due diligence rising at a rapid rate. The problem is that many entrepreneurs, founders and managers are tired and hungry, and some of them have given up altogether. It will take a few more quarters, and a dose of some more good news, before some of the business plans are dusted off and polished up to see if the market window is still open for newcomers.

The frustration felt by early stage companies is corroborated with the facts. In 2Q00 almost 75% of venture money went into S1, S2, S3 and R1 stage startups from a total amount of €975m, whereas this figure dropped to 26% - a mere €53m from a severely reduced pool of €204m in 2Q03. This massive reduction of the early stage pool, is going to create a lot of long term damage for the whole industry, as the total population of early stage companies in Europe will decline to a level where they will not be able to sustain any later stage deals. This will force some lps to look outside Europe for their next tranche and reinforce a very dangerous view, held by some lps, vcs and bankers, that Europe is not capable of generating world class high-tech companies, blaming it mostly on a lack of management skills, which we all know to be a big red herring. Unless the situation improves dramatically, government intervention will be the only viable way out to fix this market failure.

The average amount of venture money invested per company in Europe is far less than that in US. This may mean that European vcs tend to invest more in lower break-even point companies, such as software, services. Or could it be that European vcs are unnecessarily sweating their portfolio companies when they should be encouraging a more aggressive growth culture. The jury is out, but US companies tend to be more globally focused (aided by a higher level of investment), which require a higher level of expenditure in building infrastructure like regional sales and support offices, aggressive partner, promotion and marketing programmes as well as using the latest r & d tools and capital equipment.

A further sign of concern is that European companies are waiting longer and longer between raising their next round. On average, they are now waiting 23 months, compared to a previous figure of 10 months in 4Q2000. It could be that money was far easier to raise in 2000, but a two year gap between coming up for more air does not indicate a healthy appetite or aggressive survival instincts - inherent in some US venture backed companies. Some vcs claim that it is difficult to encourage their portfolio companies to adopt higher, riskier trajectory curves with higher burn rates, but the answer is more likely that founders and managers have made a habit of surviving on breadcrumbs during the long winter, which may not bode well for their future fitness, as they may not be around to give it a second go.

Industry focus - key areas

In terms of industry focus, the majority of European funds are invested in software companies, accounting for 27%, followed by biopharma at 26%. Less than 9% now goes into communications, with 5% going into medical devices. Semiconductors and electronics command a further 5% each. These figures seem to be slightly at odds, when compared with domains where Europeans have world-class strengths. Europe has great home-grown strengths in consumer, wireless, telecommunications, transportation, medical, biopharma, neutragenomics, government, security and defence industries, but not necessarily in that order. We suspect that a combination of lack of seed stage capital, lack of transparent and coherent government policy, the stigma associated with fear of failure and the inability to spawn out of corporate comfort zones, may have something to do with the non-correlation with the market.

In terms of vc funds available as a percentage of gdp (gross domestic product), the US is now running at a respectable 0.1% of gdp, compared to the bubble era figure of 0.8% of gdp, when vcs invested a massive $93 billion. Europe in comparison, is running at less than half the US rate, at 0.05% of gdp, with approximately €4.7 billion. Clearly, there is a lot more room for growth in Europe. The question is, who will make the best use of this additional opportunity - will it be the European vcs, or will the US, Singapore and Japanese vcs come back for more co-investments with their European partners? Those European vc firms that have built multi-disciplinary management teams, with a strong dose of industry expertise and track record are likely attract the most attention, as we come out of the long, long investment winter.

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© Chilli Publishing Ltd 2003

10OCT2003