After several long, difficult years, venture capital is back. In the first quarter of 2006, investors injected some $5.6 billion into fledgling companies. That’s 12 percent higher than the level of investment in last year’s first quarter, according to PricewaterhouseCoopers and the National Venture Capital Association. This gain follows small but steady increases for the full years 2004 and 2005, following a six-year low in 2003 that was triggered by the bursting of the late 1990s tech-stock bubble.
Yet despite the nascent recovery, these are anything but heady days for start-up companies and those who finance them. Even as they pick up the pace of investment to prebubble levels, venture capital firms are dealing with a far more challenging environment today than in the mid-1990s. Start with a tepid market for initial public offerings, the venue of choice for off-loading venture investments: Through June 5, venture-capital-backed companies accounted for just 16 percent of the year’s 76 IPOs, according to Thomson Financial. That’s down from 25 percent in 1997 and even higher levels during the bubble years of 1998 and 1999. This year’s venture-backed offerings have raised an average of $54 million each, down from $92 million in 2005’s fourth quarter.
Industry professionals had hoped that Google’s high-profile, $1.9 billion IPO in August 2004 would whet the public’s appetite for more venture-backed offerings. But the search company’s coattails failed to materialize. The share price of this year’s biggest venture-backed debut, Internet telephony concern Vonage Holdings Corp., has declined nearly 50 percent since it raised $531 million on May 24. Investors have been cool toward new offerings for several reasons, not least that companies have had difficulty complying with the governance and accounting strictures of the Sarbanes-Oxley Act. Experts see no imminent signs of improvement.
“That’s a big anxiety in the venture capital community,” says Bill Reichert, one of three managing directors who run Garage Technology Ventures, a Palo Alto, California–based firm.
Without a healthy IPO market, venture capitalists are turning to corporate buyers. “For the past five years M&A has been the only way to get exits,” says Keith Benjamin, who specializes in software and digital-media investments at San Francisco’s Levensohn Venture Partners.
Venture investors are also holding on to portfolio companies longer than they have in the past. NVCA research head John Taylor, borrowing from the Eagles song, calls this the “Hotel California” effect — start-ups enter portfolios freely, but seemingly never leave. The incubation period has grown from three to four years in the prebubble period to five, six or seven years today, investors say. Rather than growing larger, as they had in the past, later rounds of financing are more modest, as venture capital firms see diminished prospects for big exit valuations.
“There are companies in our portfolio with decent revenues that could’ve gone public in a different world,” laments Garage’s Reichert.
Though inflows to venture funds are rebounding — reaching $14 billion during the six months ended March 30, up 19 percent over the year-earlier period — some firms find it hard to put the cash to work. Polaris Venture Partners closed its latest fund in March at $1 billion, despite having commitments for more than $2 billion. “We exercised restraint in not taking all that money,” says Polaris co-founder Jonathan Flint.
With venture firms having to nurture older portfolio companies, less money is available for the youngest, riskiest start-ups. Companies less than 18 months old accounted for a mere 3.3 percent of venture investments in the first quarter, according to PricewaterhouseCoopers and the NVCA. Just 219 companies received first-time financing, down 18 percent from the prior quarter. The upshot: Although the venture spigot has reopened, start-ups aren’t necessarily quenching their thirsts.
