Venture Capitalists Shut Wallets

Venture Capitalists Invest in Internet, Energy in Slow Year

By TOMIO GERON
April 19, 2008

Facing an uncertain economic environment, venture capitalists showed restraint with their wallets in the first quarter.
These investors sank $6.8 billion into U.S. companies across 603 deals in the period, according to data from Ernst & Young and VentureSource, a division of Dow Jones & Co., publisher of The Wall Street Journal. The deal total is the lowest since the first quarter of 2005, while the investment level is down 8% from the $7.4 billion recorded in the year-ago quarter and 9% in the fourth quarter of 2007.
The health care sector showed particular weakness in the first quarter. Venture capital firms invested $1.74 billion in 142 health care companies, a drop of 43% and 19%, respectively, from the year-ago quarter.
Since several health care firms have recently raised large funds, the drop-off may be temporary. For now, though, instead of the customary six weeks of diligence, some firms are scrutinizing deals in the sector for two or three months, said Brian G. Atwood, managing director of Versant Ventures. "We're seeing timelines extend out pretty significantly," he said.
On the flip side, companies in the area that VentureSource classifies as information services, which includes many companies dealing on the Internet--continued to receive strong interest from investors. Investment funding jumped to $1.59 billion in the first quarter of 2008, more than doubling the $776 million reported in the year-ago quarter. And the number of deals here rose 38% to 170 from 105 a year earlier.
Another hot area for venture capitalists continues to be energy, where 22 companies raised $368 million, up 5% from $351 million reported in the first quarter of last year's record-breaking period for the category.
Some of the largest deals in the quarter were the result of a tightening IPO market. Companies such as Web analytics and marketing firm Coremetrics Inc. had expected to make a public offering but instead raised a $60 million eighth round of funding. Other large deals came about because start-ups explicitly decided to raise larger rounds just in case they need to survive through difficult economic times, such as widget company Slide Inc., which raised $50 million.
Many venture investors say they aren't overly concerned by short-term economic factors, instead looking for the next big company that will emerge as a mainstream hit in two to four years.
"Investors continue to be bullish about secular trends as opposed to cyclical trends," said William Price, who left his position as a general partner at Hummer Winblad Venture Partners last month to become chief executive WidgetBox Inc., a start-up that provides tools and online distribution for Web application developers. "They're brushing off near-term volatility and focusing on the very long term."
Still, investors are telling their portfolio companies to conserve cash and are looking especially closely at potential new companies to make sure they have clear and strong revenue channels.
"You want to make sure your portfolio companies have two years' of capital, so what may have been a year or 18-month bar before is extended out, given that none of us have a crystal ball for when the market might turn," said Dennis Miller, general partner at Spark Capital. "And capital efficiency may move up the hierarchy of questions and concerns you have with new companies. An inability to monetize for some time is also going to cast a shadow over companies that might have gotten funded more quickly in the past."
The slowing economy will likely push down valuations on start-ups, as public offerings by start-ups and acquisitions by larger corporations slows, said Don Wood, managing partner at Draper Fisher Jurvetson.
A report earlier this month from VentureSource showed that 80 U.S. start-ups either merged or were acquired at a total deal value of $7.78 billion in the first quarter, a big drop from 110 deals valued at $15.69 billion in the fourth quarter and 105 deals at $10.2 billion in the first quarter of 2007.
Despite the broader economic downturn, venture investors still see specific sectors in which they expect to realize big returns in years to come. Draper Fisher Jurvetson, for one, has had strong deal flow with clean technology, "Web 2.0" and mobile companies, Wood said. The firm also has investment teams in Asia, Europe and South America, in addition to the U.S., and that diversification helps offset any particular geographic declines, Wood said.
The continuing interest in Web start-ups is based on their potentially quick international roll-outs and the anticipation of continuing growth of new Internet users, especially in countries like Brazil, China, India and Russia, WidgetBox's Price said. And the broad trend of media moving online, including the Internet broadcasting of full-length movies and television shows by major studios, is an indication of strong growth potential, Price said.
Despite these positive trends, there is still an abundance of venture capital in the market, which leads to funding of some companies that will probably not succeed in the long term and a need for caution when investing, Miller said.
In addition to digital media, Price also sees strong bullish impulses from investors in start-ups in the enterprise software-as-a-service and open-source sectors. Miller, meanwhile, whose firm focuses on technology and media, has been actively investing in mobile, infrastructure such as optics and Internet television, and a variety of digital media companies.