Venture capital (VC) is the money and resources made available to small businesses and startup firms that normally would not have access to public or institutional funding. These investments are traditionally long term and high risk, but have become an important function in the formation and expansion of high-technology companies.

In the mid- to late-1990s, rapid technology growth and the misconception that business patterns and practices were being radically and permanently changed by some of those technologies, created an environment where venture capitalists invested in start-up companies without any type of rational judgment. Investors disregarded the need for sound business plans, market analyses, and competitive situations and chased companies that focused on technologies like e-commerce, photonics, and genomics-based biotechnologies. These investors were attracted by the high gains made through VC investments in the early-1990s and the projected financial growth in new technology sectors. They seemed unconcerned with the lack of underlying justifications for the new financial growth predictions.

In 1999 and 2000 (now known as the “bubble years”), for example, start-up Internet-specific companies involved in online commerce attracted more than 40% of all VC funds. And in 2000 alone, more than $100 billion in total VC funding was spent (according to the Money Tree Survey by PricewaterhouseCoopers, Thomson Venture Economics, and the National Venture Capital Assn.) in a marketplace where only two years earlier only $20 billion was invested.

When the Internet bubble burst and the economic recession occurred following the Sept. 11, 2001 terrorist attacks in the U.S., the high level of VC funding saw equally rapid declines. The artificially high levels of investments made during the bubble years are now gone and not likely to be even closely approached any time soon. According to a recent report by the Bioseeker Group in Stockholm, Sweden, “Guide to the European Life Science VC Market,” the consequences of the crash of the VC market in 2001 was decreased optimism from investors—in August 2004 there had been no successful IPOs (initial public offerings) of European biotech companies for the past 20 months, compared to 39 IPOs in 2000 and five in 2001. Bankruptcies have become common, and valuations of late-stage companies are lower than ever before.

Click the image to enlarge The venture capital “bubble years” of 1999 and 2000 have been replaced with a more rational growth rate and business model similar to that in the early-1990s.

According to the Bioseeker report, “to get over this critical funding crisis in the European life science area, major consolidation, M&A and increased b2b-pharma collaborations will be needed.” European life science start-ups are still continuing, but in order to survive the next generation of entrepreneurs will have to run real companies with a clear potential to generate profits in a shorter time frame than in the past—the traditional time frame for life science IPOs has never been more than five to seven years.

In the U.S. high-tech VC market, after experiencing similar investment reductions throughout 2001 and 2002, quarterly VC investments ‘bottomed out’ in 2003 and have seen some regrowth patterns in late-2003 and into the first half of 2004. About $5.6 billion was invested into 761 companies in the second quarter of 2004, according to the Money Tree Survey. This figure compares to $5 billion invested in the first quarter of 2004 and $5.4 billion in the fourth quarter of 2003.

“While investment levels are not exuberant, they’re realistic,” says Tracy Lefteroff, global managing partner of the VC practice at PricewaterhouseCoopers, Washington, D.C. “We see refined optimism in the U.S. market. There is a more balanced mix of investing between earlier and later stage companies. And the IPO window here is open again, though temperate. The pieces are in place for good years ahead.”
“It’s difficult to revisit the level of investments seen in 1999 to 2000,” says Jim Millar, a General Partner with Battelle Ventures, Princeton, N.J. “We’re now back to the levels of 1997 to 1998, which was still five times the levels seen in the early 1990s. We’re also back to looking at good technologies, with strong business plans, good market edges, and proven niche sectors.”

Nanotech bubble

Click the image to enlarge Outside of the still stagnant telecom marketplace, most high-tech industries in the U.S. are seeing increasing VC activity over the past year.

“One might hope that investors have learned from these experiences [the bubble technologies] and will be more cautious in the future,” says J. Malcolm Wilkinson, Managing Director of Technology for Industry, Ltd., Cambridgeshire, UK, at the Commercialization of Micro and Nano Systems (COMS) Conference this past August in Edmonton, Alberta. “However, there are signs that once again investors are engaging in ‘herd’ behavior and chasing the latest technology fad—nanotechnology.”

Despite its hype, however, nanotech is still at the beginning of a mostly promising lifecycle. And for now nanotech is still one of the smaller opportunities for VC investors. The life science sector (biotechnology and medical devices, combined) continues to dominate other industries for investment capital, as it has for the past eight consecutive quarters. Investments in life sciences totaled about $1.4 billion, or 25% of all VC in Q2 2004. Proportionately, life sciences investments remains near their historical highs.

Many of the potential products expected to come out of current nanotech research work are still many years away from being commercialized. The recent withdrawal of Nanosys, Palo Alto, Calif., from its IPO typified the state of the nanotech industry. “Nanosys had a great technology and a great team, but the products were still too far away,” says Battelle Ventures’ Millar. “Venture capitalists look to make money in the five to 10 year timeframe. The 10 to 20 year timeframe is too long a period of time.”

“Nanotech is no different than any other new technology,” continues Millar. VC investors still want to see a business plan (same as pre-bubble), a list of management profiles, and a business model that describes their potential customers, information about their distribution channels, and in-depth analyses of their competitors.

Where to get the money

Click the image to enlarge The continuing reaction to the capital collapse in 2001 has most VC investments going into later stage developments. Click the image to enlarge All rounds of VC funding in the U.S. marketplace, and especially the first round, are seeing increasing levels of activity over those seen two years ago.

Traditional VC is generally made available to an entrepreneurial company from an organized group of wealthy investors. These individuals invest their shareholders’ money in a company along with providing hands-on assistance in the technology, management, production, and overall organization. Funding for a start-up company can also come from an angel investor—an individual who provides capital to one or more startups. Unlike a business partner, the angel investor is rarely involved in the management of a company and can usually add value to a company through their contacts and expertise.

“Angel investment is a simpler relationship, where the investor is often intrigued by the technology and has a high level of individual confidence in the entrepreneur,” says Millar. There are all sorts of variations on these investment types including SEC accredited investors, adventure capitalists, blind pools, bridge loans, institutional investors, silent partners, and others. A good general description of many of these variations can be reviewed at www.fundingpost.com/glossary/venture-glossary.asp.

Long-term outlook

“There’s a healthy amount of VC money now available that is looking for new investments,” says Battelle’s Millar. There are VC groups available for early, mid- and late-stage funding programs. Battelle Ventures is one of the groups that funds seed and early stage programs requiring $3 million or less in annual revenue by the entrepreneurial firm. Most VC firms are not interested in entrepreneurial firms until there are $3 to $5 million in annual revenues.

Milton Chang, Managing Director of VC firm Incubic, Mountain View, Calif., agrees with Millar about the availability of VC funds. “There’s lots of money out there, probably twice as much invested as there should be,” he says. His firm’s proactive involvement in their investments has become the norm in today’s VC marketplace. Today’s successful VC investor has become well versed in the technologies, legalities, management, and marketing of the companies they invest in. They transfer the successes they achieved to attain their own wealth to the companies they now invest in.

And while many new VC investors appeared during the bubble years, some of those have disappeared. The same consolidation phase seen in high-growth technology firms was also necessary for the VC investors themselves, many of the newly established VC investors were simply too small. According to the Swedish business magazine Veckans Affarer, “more than 100 of the 150 previous VC investors in Sweden have ceased their business or undergone a merger or acquisition during 2000 and 2001.” In Europe, this trend has forced most VC investments to move primarily to later stages.

With VC investments, it is always painful to “pull the strings” of portfolio companies since you have to believe in your portfolio companies and that investing in them is right, says Hugo Birner, general partner at TVM Techno Venture Management, a German-American VC firm with offices in Boston. “Because of this attitude, the VC community is probably not terminating unsuccessful companies fast enough, but as technology industries mature, investors have to become tougher.”

There are many contradictory preferences from today’s VC investors. While new high-tech companies need a long-term focus and novel technologies, the development time has to be fast and profits need to be generated as quickly as possible. And while some companies, especially in the life sciences, need a strong focus and deep knowledge of their product’s target application, it’s still important for the company to diversify.
As a result, there has been decreased enthusiasm among VC investors for some very long-range, narrowly targeted technology areas, like stem cells, gene therapy, and agrobiotechnology. Delivering products in these areas has proven to be more difficult than was earlier predicted and the shorter times to market demanded by new VC investors is less likely to be seen in these areas. It’s more likely that these technology areas will be supported in the future by the large, independently funded biopharmaceutical companies, than by small startups.

—Tim Studt

Battelle Ventures, 609-921-1456, www.battelleventures.com
Bioseeker Group, 46-8673-1700, www.bioseeker.com
Incubic, 650-960-2383, www.incubic.com
National Venture Capital Assn., 703-524-2549, www.nvca.org
PricewaterhouseCoopers, 646-471-4000, www.pwcmoneytree.com
Technology for Industry, 44-1353-865400, www.tfi-ltd.co.uk
TVM-Techno Venture Management, 617-345-9320, www.tvmvc.com