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 “Down in the Dumps” (venture capital), Business New Haven, December 10, 2001

  Business New Haven is a regional business-to-business publication targeted toward and circulated to business owners and top managers at companies throughout south central Connecticut.

For decades, venture capitalists have nurtured the growth of high technology and entrepreneurial enterprises, laying the groundwork for significant job creation and future economic growth. After a nine-month free fall during which regional venture-capital investment fell more than 40 percent, the latest figures from surveys of the industry are no rosier than the malaise associated with the spring and summer of 2001.

National venture capital investment fell more than 23 percent in the third quarter to $6.5 billion from the $8.4 billion invested in the second quarter, according to the latest figures from the PricewaterhouseCoopers MoneyTree Survey undertaken in partnership with VentureOne. The $6.5 billion pumped into young companies during the period was also 23 percent less than that invested in the previous three months and less than a third of the amount invested during the same quarter in 2000.

According to the figures, venture capital investment has fallen in each quarter since the first three months of 2001, with declines in technology sectors leading the way. Moreover, only one year ago, $22 billion was invested in all industries during the quarter ended September 30, 2000 - and even that was down from a record total of nearly $26.5 billion for the first three months of 2000.

Confirming venture capital investment's slow decline, the latest third-quarter survey by the research firm Venture Economics (VE) and the National Venture Capital Association (NVCA) reports that during the third quarter of this year, venture capitalists invested $7.7 billion in 873 companies, while 46 venture capital funds raised $6.2 billion. That $7.7 billion invested represents a 31-percent decline from the previous quarter and a whopping 73-percent decline from the year-ago period, when venture capital investments peaked at an all-time high. However, Q3 2001 investment levels are comparable to Q1 1999 investment levels when $7.2 billion was invested - an amount considered extremely healthy at that time.

New England continues to retain its rank among the top three regions for attracting investment. The top three regions for venture capital investment in 2000 as well as 2001 - Silicon Valley, New England and the New York metro area - represent more than half of the dollars invested nationwide as well as half of the deals reported during the year.

While the year 2000 was a record-breaker for investment in Connecticut venture-backed companies, reaching nearly $1.2 billion - a 50-percent increase over the amount venture capitalists invested in 1999 - year to date investment according to the NVCA and VE comes in at a paltry $443 million. NVCA reports Q3 figures for Connecticut at $68.9 million raised, with 16 deals completed.

Connecticut companies snagged just $49 million in seven deals, according to the MoneyTree survey, just behind upstart New Hampshire and tech powerhouse Massachusetts, which garnered the lion's share at $610 million while New Hampshire grabbed $54 million.

Bucking the regional investment trend, investments by industry in Connecticut for the third quarter of 2001 were led by industrial, biopharmaceutical, communications and networking enterprises. Regionally, software investments retain the top slot, with communications and networking in second place and business services a distant third. Nationally, communications and networking ranks No. 1, with software and business services not far behind. Hardest-hit industries include telecommunications and software, while the most resilient industries include biopharmaceuticals and bioinformatics, especially those related to the defense or security-related industries.

All stages of development have been affected by the downturn, but venture capitalists say early-stage companies without proof of concept or significant revenue traction and no major referencable customers have been impacted most. Still, there is nearly unanimous agreement that raising capital at the current time - no matter what stage of development a company is in - has become considerably more difficult with investment levels now at their lowest levels since 1998.

Not only are VCs more cautious about funding new technology start-ups, but they are investing at lower valuations and in smaller increments across the board. In fact, valuations are down 50 to 70 percent from 1999 levels, and typical VC rounds are now $2 million to $10 million (not $20 million to $50 million as during the '90s boom). Yet, local VCs believe that a company with a highly attractive technology and management team in a potentially hot market will get some money - but probably not much more than it needs to achieve lift-off.

“Seed rounds and early-stage rounds that have often been funded in the past by high net-worth individuals, [but] this whole sector is very skittish right now,” says Frank Morse, managing director of Southport-based Carter Morse & Co., a regional investment banking firm that specializes in providing corporate finance services to owners of entrepreneurial companies.

“The reality is reflected in the numbers,” says Morse. “Transactions are slow to get done. Many traditional private equity firms are inwardly focused on their existing portfolio. And up until now, they have been fighting the valuation battle. Now companies are going to have to deal with lower, more realistic valuations if they are to get funding.”

A specialist in debt and equity financing and financial-advisory services for mergers, acquisitions and divestitures, Morse says he remains generally encouraged about the future: “I don't know what's going to happen over the next six to 12 months. But entrepreneurism isn't dead. We need new technologies. That hasn't gone away with the capital markets.”

Morse believes the supply-and-demand curve will meet with the capital markets over the next year and we'll see a more normal flow of private equity closings. “The equity markets seem to be coming back, especially in certain sectors - biotech for one,” he says. “There's a lot of interest in early-stage companies in that sector, so now it's a matter of becoming more selective.”

Despite tough economic conditions, Connecticut venture capitalists continue to show resolve on behalf of young companies in the state and express cautious optimism. Most are spending the majority of their time and capital resources on existing portfolio companies, as demonstrated by the fact that more than 80 percent of total venture investment in the third quarter flowed to follow-on investments.

Says Michelle Bowman, president of the Connecticut Venture Capital Group, a Fairfield-based non-profit professional association, “There has been a reduction in the amount of venture capital invested in the state. However, there are pockets that are still doing very fairly well, such as biotech. There has been a lot of turbulence in the marketplace and the VC's have become very cautious in terms of their investments, focusing more on valuations and their own portfolios than investing in new ventures.”

There is also increased concern around the limited exit options for existing portfolio companies, as the re-opening of the IPO market and resurgence of the mergers and acquisitions (M&A) market may be further pushed out into the near future. While the market for initial public offerings of stock remains ice-cold, venture capitalists will need to turn to M&As in increasing numbers to recoup their investments. Most foresee increased activity in the next 12 months. If M&A activity accelerates, venture capitalists will be faced with the prospect of supporting their portfolio companies longer than planned - with unforeseen consequences for their funds.

“Because the time to IPO is much longer than compared to couple of years ago,” says Bowman, “VCs are looking at their portfolios, analyzing company strengths and weaknesses trying to determine how Company A could complement Company B's strategies. Valuations of all deals in the capital markets have been falling, so it's no surprise that the average value in M&A transactions has also taken a nosedive.”

Morse says he now has the largest backlog of potential M&A transactions that he's seen in a long time. Call it serendipity or the result of pent-up demand - he says he's not sure what to attribute it to - but says it's been a slow year and things can only improve next year.

The success of the venture-capital industry depends on exiting at a higher price than you invested, so the decrease in valuations and the average deal value from a year ago is worrisome. But the fact that deals are being done at all, Morse says, is encouraging.

Despite the declining market, venture capitalists are still finding promising new opportunities in a wide range of sectors. One of the most compelling right now is biopharmaceuticals. Other sectors, says Morse, especially emerging software companies are still very robust. “Yet it's very hard to differentiate between them and get the attention needed by investors,” he cautions.

As the Federal Reserve's aggressive interest-rate cuts take hold, economic forecasters say monetary policy right now could not be better. But this sort of economic stimulus doesn't bode well for entrepreneurs who traditionally seek their financing in the world of venture capital. And lately, the news about the declining state of venture capital has gradually begun to put a damper on the garage-hatched dream.

Industry experts predict further evaporation next quarter, as the U.S. economy heads into its first recession in a decade. In fact, the VC industry is preparing itself for an extremely difficult economic environment over the next 12 months, but remains confident that private equity investment will prevail at a time when entrepreneurs need it most.

Bandel Carano , a venture partner with Westport-based Oak Investment Partners, a bi-coastal venture capital firm, believes there is no better time to start a company than now. Among the positives he cites: steep reductions in prices for office space and capital equipment, greater ability to attract top talent,
increased access to professional firms (e.g., law firms, PR firms) and higher-quality deal flow.

Oak has raised ten venture capital partnerships with a total of $4.2 billion in committed capital and closed more than 75 deals last year. (Only Stamford-based GE Capital Equity closed more deals in Connecticut last year - 97.) Says Carano: “We closed seven deals last quarter. In the long term you have to be bullish on technology. This is temporary ebb.”

Historically, a number of America's most successful companies were created during difficult economic times. Companies such as Palm, Intuit and McAfee received their first round of venture financing during mild recessions. Bowman, like Carano remains optimistic, especially for the biotech sector. “In the last year or so, a tremendous amount of money has been invested in companies such as Cellular Genomics, Archillion Pharmaceuticals and several others by some very prestigious VCs. When you look at the support being driven out of Yale there is a lot of very positive things to help these companies and they're still able to get good funding. Though valuations may be more difficult.”

The effect on the public markets caused by the September 11 attacks has been well documented, but its effect on the VC industry is less well-known. “Every person in every industry in this country has been affected by it,” says Dayche, a principal in Hartford-based Conning Capital Partners, a private equity firm with more than $600 million currently under management. “Portfolio companies lost time. For companies that are keeping a close on eye on resources and expenditures, that delay hurt. Absolutely. On the plus side, certain sectors with hot technologies that could be used in security applications, have become very high in demand.”

Although, these are clearly difficult times for all business sectors, the venture industry will persevere, says Dayche. “Local VC gurus recognize this downturn as part of the long-term venture capital cycle, and will tell you it's in these type of markets that they've made their best investments,“ says Dayche. “Entrepreneurs with strong business models, great management teams and a certain amount of traction - who have the tenacity to see their ideas through despite market conditions - will ultimately get some funding.”

Despite the short-term concerns, there is consensus in the industry that venture capital will continue to play a central role in the state's economic growth. The nature of VC investment is long term and the industry will continue to return to its fundamental roots and move away from the unsustainable investment pace of years past.

“Everything is more normalized again,” Dayche says. “Right now, you obviously have to be very selective but you can negotiate the right valuations and the right structure in a deal. For venture funds, everyone says they have funds with a lot of cash in them, and that this is a great time to make new investments.”

Dayche is currently focused on new opportunities in the health-care market and is actively looking for high-growth investments. “The dislocation of the property and casualty market have created some significant investment opportunities,” she adds. “History shows that some of the greatest successes of the next decade will be funded during this down cycle.”