Technology entrepreneurs and venture capitalists are no longer objects of envy. Start-ups are mostly desperate for cash – and so many are failing to raise it, that companies are folding in alarming numbers. Venture capitalists (VCs) are seeing their portfolios disintegrate and triple digit returns are little more than a dream. They are drawing up tougher and tougher term sheets – and that is if they are investing at all.
"We're uncertain about how the value of small companies will develop. Recognising this, we're quite cautious [toward new investments]," admitted Andrew Holmes, managing director of early-stage venture capital firm Quester, during a recent venture capital conference. Such an admission hardly fits with the visionary, risk-taking image that VCs like to cultivate. Nonetheless, the sentiment is echoed by venture capital partners across the UK, and evinced by the paucity of deals throughout 2001.
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Admittedly, says Gerry Montanus of Atlas Venture, this attitude runs counter to the trusted industry adage that, "the key to successful venture capital is investing in the downturn and exiting in an optimum economic environment". But with the entire technology sector mired in one of its most prolonged and overwhelming recessions, VCs have been noticeably hesitant in committing the funds entrusted to them.
Many VCs are still reeling from the speed with which the recession engulfed the technology sector: "For the first time in my career, we saw a situation where the whole industry was paralysed. Balance sheets disintegrated overnight, there was a complete standstill among buyers, and there have been hardly any IPOs in the last year," says Montanus.
Signs that the economic environment was starting to improve at the end of summer 2001 were quickly extinguished by the terrorist attacks that crippled business. And, the long-predicted boom in merger and acquisition activity – a possible quick exit route for VCs – never materialised. The value of M&A deals actually halved in the fourth quarter of 2001 compared to the previous year.
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Growing user scepticism and media weariness toward 'the next hot thing' have added to the general feeling of disillusionment. The impact on investment levels has been severe. In the fourth quarter of 2001, European technology investments fell to €842 million, compared to a whopping €3.2 billion in the same period in 2000.
VCs rightly argue that such comparisons are unfair. The bloated investment levels of 1999 and 2000, they say, were not sustainable. "It was a very unusual and bizarre state of the market," says Michael Elias of Kennet Capital. "You knew that if you made an investment in say optical technology, then a couple of years down the line you'd be able to get a big exit."
Publicly, VCs insist that they are relieved to return to a normalised environment, that it is time 'to get back to business'. But the 74% fall in investment levels suggests they are certainly not back to business yet, and that the industry is experiencing more than a 're-adjustment'.
Tending the flock
One factor holding back new investment activity is that VCs have been distracted by tending to the problems of existing portfolio companies – deciding which companies to dump and which to give follow-on funding to. "Every portfolio has its problem children and refinancings," says Michael Jackson of early-stage technology investor, Elderstreet, "but most companies are now fixed or don't exist anymore."
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In the process, valuations have been decimated. 3i, the London-listed behemoth, saw the value of its portfolio shrink by £1 billion (€1.6bn) between April and September 2001, with 70% of write-offs related to technology companies. Many companies have had to live with downrounds: "The discounts between rounds one and two [of fund raising] are enormous," says Stuart Watson, head of Ernst & Young's venture capital advisory. The valuations are "up to 80 or 90%" lower, he says.
But, say VCs, even in today's environment of 'new realism', there are few bargains to be had: "The market is becoming polarised: good companies are maintaining their valuations relatively well; those companies that aren't worthwhile, are finding it very, very difficult to raise cash," says Jackson of Elderstreet.
Sifting through their portfolios has made VCs highly conscious – and anxious – about the huge sums invested at the peak of valuations. Not only are they nervous about overpaying, they are also looking for other ways to limit risk. That has led to a resurgence in syndication. Before committing funds to companies, investors are insisting that other VCs come on board. And with every investor rediscovering the art of thorough due diligence, finalising an investment takes many months. The "£10m in 10 days scenario" – when a VC would meet a company on the Wednesday and invest the following Friday – has simply disappeared, says Watson.
The main factor curbing investment activity, however, is "the lack of consensus about where to invest" says Elias. VCs no longer rave about their optical investment or rush herd-like into a single industry. In contrast, they are increasingly guarded – or undecided – about their investment strategy. Elias, who made just two investments in 2001, withholds such information as the company's "only intellectual property". Michael Jackson of Elderstreet is looking to invest in, "Anything that helps alleviate the pain; that's the test we have at the moment. If it does that, then it is not discretionary."
Some VCs are clinging doggedly to their tried-and-tested investment strategies. Atlas Venture, says Montanus, is investing in early-stage companies with product-to-market scheduled in a year or two: "With the buyers' strike, you wouldn't want to invest in later-stage companies with the high burn rate that comes with a large organisation and sales force." Mid-range VCs feel under pressure to react to the downturn by repositioning themselves – either earlier or later, in the funding cycle. Several European VC funds have been so reluctant to invest that they have decided to return the capital raised instead.
Money for what?
There is a lack of consensus about how much risk capital is actually available for fledgling technology companies. Riding high on the euphoria of the Internet years, VCs raised record-breaking funds in 2000. Many VCs admit that they have not made a single investment in six or even 12 months, prompting some experts to suggest that this has created a capital overhang. The European Venture Capital Association pegged this at €13 billion at the beginning of 2001. In the UK, according to a report by PricewaterhouseCoopers and 3i, $16.3 billion (€26.3bn) was raised in 2000 but only $12.2 billion (€18.3bn) had been invested by the end of the year.
A large portion of this money has obviously been earmarked for follow-on investments. VCs typically set aside a defined portion of each fund for such cases € Elderstreet, for example, reserves 40%.
If anything, that percentage is now being revised upwards. "Raising funding at the second and third stage is proving tough," says Ernst & Young's Watson, "so early stage investors need deep pockets to support companies through this."
And the funding cycle for a company has lengthened considerably from the heady days of 1999 when a company could graduate from start-up to flotation in just 12 months. Market research group IDC suggests that trade sales of European technology start-ups won't take off until 2003, and that the IPO window will only begin to open in 2005. "VCs will have to fund companies longer and for a greater amount," concludes Watson.
Casualties
The combination of the portfolio clean-out, falling valuations and a longer life cycle, and will inevitably affect the returns generated by VCs. IDC's prediction that, by 2005, investment write-offs in Europe will surpass $14 billion (€15.7bn), leaves little room for doubt. Rumours abound that several high-profile US funds that were investing during 1999 and 2000 will have difficulty returning investors' capital, let alone any profits. An industry shake-out looms, say experts.
The British risk capital industry, which expanded rapidly during the high-tech boom, has already begun to contract. 3i, the London-listed behemoth, axed 185 jobs in the autumn; others have quietly followed suit. Some are more seriously wounded by the downturn: "A number of firms are near to exhausting their funding capacity," says Montanus, "they need to go for new funds but it's as difficult for VCs to raise money as it is for entrepreneurs."
The 'rank amateurs', as VCs sneeringly refer to the analysts and investment bankers who rushed to set up incubators, are a dying breed. Oxygen shut up shop; Antfactory and Brainspark sold up – to a traditional investment bank and technology company respectively. Those on unfamiliar ground are also pulling out. US hedge fund specialist Bowman Capital withdrew from the VC market and its London and Edinburgh offices in October 2001, just 10 months into its European adventure. It decided to return most of the money drawn down from a $470 million (€527.3m) fund.
Well-funded, highly-regarded and long-established funds in the UK are clearly the favourites to survive. For example Apax, created in 1977, boasts 330 portfolio companies and a newly-raised €4.4 billion fund. "The strong will get stronger and the weak are likely to get weaker," says Keith Arundale, who heads up the VC business in PricewaterhouseCoopers' technology group.
Publicly, VCs remain upbeat. In contrast, an anonymous survey of 770 VCs conducted by Deloitte & Touche reveals a staggeringly bleak outlook: 82% of respondents expect the economy to decline further over the next six months; 81% say that equity fund raising will become even more difficult in the same time period. There seems to be little scope for improvement in the short-term, if VCs are to be believed.
