Venture Investment Is Lowest In 4 Years

November 4, 2002
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GRAND RAPIDS — Venture capital investment in the third quarter was at its lowest level in four years, a nationwide venture capital survey reveals.

Results of an Ernst & Young and VentureOne venture capital survey, released Oct. 25, show that the number of venture capital transactions in the United States dipped to 1996-97 levels in the just passed quarter, with $3.9 billion invested in 464 financing rounds.

The survey did not include companies receiving funding solely from corporate, individual and/or government investors.

“I think we’ve seen a slowing not only in venture investing but all investing over the past two years,” said Dan Galante, area director of Ernst & Young’s Venture Capital and Private Equity.

The volume of venture investment was about half of what it was at this time last year, but the median amount of capital invested in each transaction is higher, at about $6.7 million per deal.

Transaction size is a significant factor, said John Gabbert, vice president of worldwide research at San Francisco-based VentureOne.

“We’re seeing a regression toward the median in deal sizes, so there are no longer exceedingly large financing rounds to beef up the overall amount invested,” he explained.

Gabbert said it reflects that investors are less willing to put large sums of cash on the line with no liquidity in sight.

It also suggests that companies are in sustained growth mode; they’re raising money for continued operations but not for an immediate initial public offering (IPO) or acquisition.

In fact, only one venture company in the survey — HealtheTech Inc. of Golden, Colo., — completed an IPO in the third quarter.

Merger and acquisition transaction volume fell 35 percent in the just passed quarter, the survey revealed.

Companies most likely to complete an acquisition in the quarter were software companies, which accounted for 35 percent of both acquisitions and venture capital transactions in the quarter.

Even in a down quarter, software investment increased 28 percent to $1.2 billion, driven by business applications software companies and connectivity and communications tools companies, which saw transaction volumes increase by 14 percent and 44 percent, respectively.

Bryan Pearce, Ernst & Young’s Venture Capital Advisory Group leader, attributed the growth to government and corporate spending on software for security, data center management and enterprise application integrations.

As Pearce pointed out, software is an area that requires a relatively small amount of investment capital to form a company, get a product to the market and sell it within a reasonably short period of time.

“When you see the time between financing rounds increase from a median of 9.5 months in 2000 to 17 months in 2002, you know executives are finding ways to stretch their budgets,” he added.

That’s either because they don’t want to raise large sums at low valuations, or because they’ve found partnering opportunities and alternative cash sources that can help them maintain operations until the economy picks up, he explained.

There has always been a focus on information technology in the Midwest, whether it’s software, services or infrastructure, Galante said. He expects that will continue.

Michigan had three venture capital investments in the third quarter while plenty of states had none, he said. Illinois had four investments in the quarter and Wisconsin two. The extremes included California, with 180 investments, and Massachusetts with 55.

Health care investing in the third quarter fell by about 50 percent from its second quarter level.

The second quarter of this year marked an all time high for health care investing and there was a lot of excitement about the increase, Galante observed.

He pointed out that the drop in health care investing in the third quarter could have been a function of the timing on the close of deals, some of which may have been initiated before the economy soured.

“The second quarter may have been overstated compared to the economy that we’re in now that’s attracting venture (capital), compared to where it was two years ago,” he said.

Galante thinks the decline in venture investment has a lot to do with the reduced pool of capital available.

“Capital that was made available in the late ’90s and into 2000, there was a lot of hype around the returns and the opportunities in venture investing. Very few of those dollars, mainly around technology, actually materialized to generate true returns.

“Subsequent to that period, less capital has been able to be raised. As a result, overall investing has come down.”

According to the survey, only about one-third of venture capital investment went to the seed and first round category.

Venture capitalists, it appears, were more interested in using their investment dollars on building the companies in their existing portfolios than on investing in brand new companies.

Of the 143 seed and first round deals completed in the third quarter, 38 percent involved software companies.

Between 1998 and 2000, 35 percent to 45 percent of all venture dollars invested in the United States went to first-stage, new companies, Galante noted.

Seed and first round financing has decreased to about 20 percent, and that has held steady in each quarter of 2001 and 2002, he said.

He expects the concentration on existing portfolio companies will continue.

There’s still venture capital available, Galante said, but people are just being more cautious about where they’re putting their capital to work.

“Those companies that do receive first round financing are much better than they have ever been before because the competition to attract those dollars is that much tougher.”

The companies that secure first round financing, he said, are without question “world class,” not only in today’s market, but in comparison to anything seen in the last three or four years.

Both venture capital and private equity investing is down, Galante observed. In the Midwest, private equity investment has been down 50 percent or more over the past couple years.

“From an investing cycle, in venture as well as equity, I would say we’re at a low point, but certainly at a point that is able to be built upon,” he said. “I don’t think we’re going to see further drastic reductions as we’ve seen in the past.

“There’s not going to be a drastic turnaround come 2003, but certainly if credit eases a little bit more — which we think will be the case — that will certainly start spurring the ability to leverage some of the dollars that can go into these companies.”           

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