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A publication of the NJ Technology Council
and the Education Foundation

November 2002 Vol. 6 Issue 10

Just as you think you have the venture capital industry all figured out they go and modify the rules of the game. Companies are quickly realizing venture capitalists aren’t seeking new investments, but rather worrying about their existing portfolio companies. When venture capital firms do invest they require good business disciplines like revenues, customer traction, profits, and experienced and proven management teams. Venture capitalists who made their reputations by funding smart people with “ideas in a garage” are now exclusively investing in companies possessing these characteristics.

Before the Internet and technology craze of 1999 and 2000, the venture capital world was built on a conservative strategy of investing in organizations with a clear business plan. The company had to prove a market existed for their product or service and, many times, these companies were required to generate revenue and possibly positive earnings before an investment was considered. During the Internet craze however, all the common valuation techniques and investment analyses seemed to disappear as people and venture capital firms invested in startup companies with no revenue, no earnings, and no clear strategy going forward. Not only did they invest in these companies, they were competing with other venture capital firms forcing company valuations to spike. Everyday the market discounted profitable companies while unprofitable, cash strapped startup companies’ market capitalizations skyrocketed upward. In 1999 and 2000, venture capitalists invested approximately $55 billion and $102 billion, respectively, compared to only $20 billion in 1998. As the technology momentum kept building, the venture capitalists were rewarded with returns of over 150 percent, according to Thomson Financial Venture Economics and the National Venture Capital Association, as many investment companies went from writing a business plan to an initial public offering within months.

Then came 2001 and venture capitalists’ fortunes were severely reversed. So far removed from the good old days of 1999 and 2000, the venture capital firms actually lost an average of 27.8 percent in 2001, according to Thomson Financial Venture Economics and the National Venture Capital Association. In contrast, the average venture capital fund gained 28.6 percent in 2000. The losses venture capitalists suffered in 2001 marked the first calendar year loss since statistics began being kept in 1980. The market downturn has forced many venture capital firms to refocus on their core portfolio rather than seeking new investments. Venture capitalists are even being forced to return excess funds to investors. Gone are the days when a company is funded with a business plan written on a napkin. It was a long year as many entrepreneurs received the same response from venture capitalists – “no new investments.” The venture capital firms concentrated on their existing portfolio companies, aggressively trying to keep many financially healthy and operational by advising on management issues, strategy, and marketing plans.

When a portfolio company required additional capital it was typically at a much lower company valuation or what has become known in the industry as a downround. Venture capitalists have begun writing deal requirements that allow them to buy shares at the lower prices if, at a subsequent funding, the company is valued lower. This is designed to guard the original investors against possible dilution in later rounds. Some people may say valuations have returned to normalcy again as values placed on management teams, ideas, and the like have decreased dramatically. Some early stage venture capitalists we have spoken to say they have not seen any companies with pre-money valuations in excess of $5 million in 18 months. Start-up companies’ valuations are no longer extremely high just because their idea involves the Internet.

Many venture capital firms are focusing their time and effort on their existing portfolio companies. However, the venture capitalists’ pocketbooks are opening ever so slightly as companies are receiving funding. In the first quarter of 2002, over $6 billion was invested throughout the United States including $400 million invested in the New York Metro region, according to PriceWaterhouseCoopers’ MoneyTree survey. Before investing in a company, many venture capitalists require potential investee companies to prove their product or service has market potential by generating sales or showing signs of potential customer acceptance. Recently, venture capitalists have been funding companies in stages only after companies have met strict milestones for sales, profits, management hires, etc. These restrictions have limited the funds venture capitalists have invested recently, and forced company management to think twice before accepting these funds.

According to Thomson Financial Venture Economics and the National Venture Capital Association, in the second quarter of 2002, venture capital firms returned $2.7 billion to their limited partners primarily resulting from a lack of investment opportunities. This further shows that venture capitalists have become more cautious and would rather return investors’ money than risk investing in marginal companies. It is not unusual to speak with venture capitalists who have not made a new investment in 18 to 24 months.

What will the future hold for the venture capital industry? That is the next big question. We’re sure the next new wave of technological innovation is just around the corner. We can’t wait to see how it transforms these typically sound financial individuals into gamblers again.

Michael Sohmer is a consultant to management at Amper, Politziner & Mattia.	Alan N. Wink is both a consultant to management and co-director of the firm’s Technology Group.