After a three-year downturn, the pace of venture capital investment in technology startups has begun to accelerate. Barring a significant global economic relapse, capital invested in new information technology ventures promises to increase, virtually every quarter, over the next several years. Sound business plans, developed by capable and committed professionals, will enjoy a significantly higher likelihood of funding in 2003, and that outlook should continue to improve in 2004.
The venture capital community has been cleaning house since late in 2001. The job is almost complete and VCs once more are focusing much of their attention on new opportunities. Venture investors have revisited their portfolios and have made sober bets as to which companies are likely to prevail. The others have been written down or written off. They will not receive further capital infusions and will be absorbed by other companies or simply close their doors. This "spring cleaning" has been costly. Although statistics are not yet available, it is likely that the number of failed venture-backed companies in the first three years of our new century will far exceed any similar stretch of time in the past.
More dollars were invested by venture capital partnerships in the year 1999 alone than in the entire decade of the 1980s. Until about mid-2002, our industry was wrestling with a portfolio bloated by the extraordinary amount of capital deployed in the latter half of the 1990s. In retrospect, many of those companies should not have received any capital whatsoever. Too many were led by unseasoned executives. Most of them probably raised too much money for their own good. And virtually every one of those companies slammed headlong into a precipitous, fierce and protracted economic recession.
Those recent excesses were fueled by circumstances that have made repetitive appearances throughout the history of economic cycles. The global economy was extremely strong, financial markets were robust and inflation was tame. One good thing simply led to another, until the situation literally became too good to be true — and hence unsustainable.
Other aspects of those days are a bit more difficult to comprehend. One would think, for example, that prominent companies could manage their balance sheets. It is unimaginable that billions of dollars were spent to acquire unneeded communications bandwidth spectrum, or that the global communications establishment would overprovision itself by as much as five years. The entire business community was carried away by a tsunami of overenthusiastic optimism, and nowhere more so than in the technology sector.
When the IPO market disappeared, the major avenue for private company "liquidity" vanished. Sagging sales and severe stock price attrition of public companies shut down the acquisition path as well. Thus, every new investment added volume to a venture capital portfolio already swollen to flood stage. Inevitably, new investment activity ground to a trickle.
Fortunately, this is now changing. As investors, venture capitalists thrive on change. When significant change is accompanied by economic travail, as is the case today, the pressure on incumbent corporations becomes almost unbearable. They must protect their franchises and the products they have already developed, and investment in the future invariably suffers. By contrast, startups have nothing but a future. Consider just a few recent changes wrought by technology. Last month, sales of digital cameras surpassed those of conventional point-and-shoot models. Mobile telephones have suddenly become Internet platforms and cameras. A customer can now "talk" to a computer in natural language and obtain airline flight information. And we can obtain airline-boarding passes by sliding our driver's licenses under a scanner. Established companies hate change. Startups love it.
Recent harsh experience will lead to better business plans, more modest financings and valuations more closely related to rational public market metrics. The "recreational entrepreneur "has been replaced by serious, experienced people. They understand that building a company is a process, not an event, one that will probably take five or six years to reach a first stage of maturity. Rents are now low, talent is readily available, salaries have declined and vendors are anxious to serve. This combination of positive conditions bodes well for the success of venture-backed startups. I believe that 2003 and 2004 will ultimately be viewed as excellent vintage years for venture capital.
The likelihood of at least a mild resurgence in the IPO market is yet another promising omen. Should this occur, late-stage, or mezzanine, investors, who have been absent for the past three years, will probably resurface. As it stands now, early-stage VCs have to plan on carrying their companies almost all the way to the break-even point. If mezzanine investors do reappear, this burden will be alleviated and venture capitalists will be able to invest in more startups.
Being superstitious, I prefer not to spotlight any U.S. Venture Partners companies. But change is our bread and butter, and it has consistently driven USVP's investment strategy. For example, budget-conscious enterprises are no longer willing to live with the prospect of multimillion dollar software installations. Therein lie opportunities for new entrants that can provide the software tools companies need, in a new, more economical business model.
In the semiconductor arena, the ASIC market is in flux. The cost of masks and EDA tools for deep-submicron technologies are making many custom devices uneconomical to manufacture. The opportunities for alternative silicon solutions, EDA tools and infrastructure improvements are abundant.
While the venture capital community is likely to shrink somewhat, there is still plenty of capital available. I do not believe that industry fundamentals will change. As more companies are funded, confidence will increase and the trend will accelerate. The venture community has returned to its rational roots and, with a bit of luck, will soon again become the midwife of successive generations of new industry icons.
Irwin Federman is general partner of U.S. Venture Partners (Menlo Park, Calif.).
