US overview

The venture capital industry in the US continues to invest at a pace similar to that experienced in 1997 and 1998, between $15 billion and $20 billion a year. In the view of many experienced fund managers, this is a good level of investment given the available deal flow, the effort needed for thorough due diligence on potential investments and the anticipated liquidity in future capital markets.

At the beginning of 2003, much of this investment was additional funding for existing portfolio companies. As we approached the end of 2003, there was the beginning of a shift to new investment in start-up companies that are expected to be the initial public offering candidates in 2007 to 2010. What this means is that work has begun on the next generation of great companies. The investment scene was helped by less stratospheric valuations. This was coupled with much lower costs to launch an enterprise. Everything from rent to talent was cheaper. A saner pace of investment allowed more careful negotiation of main company elements. The concept of capital efficiency became the watchword as venture capital investors carefully balanced the anticipated cash needs of companies to reach maturity with the likely valuation for that grown-up company in uncertain future capital markets. Less became more as even larger venture funds contemplated small, trial investments in new companies.

Interestingly, during most of 2003, the valuations of expansion stage companies were comparable to, or better than, some of the garage start-up valuations. The short-term effect was to draw more money to companies with slightly more maturity, better pricing, and less risk. As 2003 drew to a close, there was some mitigation of that effect and the industry's attention was turning toward the next crop of early start-ups.

The one-year industry returns to investors continue to be negative, driven in part by valuations in the public markets, which, although improved in some sectors from late 2002 levels, remained below prevailing valuation levels at the time of original investment. As 2003 nears its end, there are some signs of improvement in the public equity markets, which bodes well for portfolio companies nearing maturity. Overall though, the pace of initial public offerings is far below the pace seen in 1999 and 2000 and far short of what is necessary to sustain the industry going forward. Although the number of acquisitions (M&A exits) remains not too far below the record-setting pace of a few years ago, a much smaller number of these realize strong valuations.

Fundraising, the process of obtaining capital commitments by investors for funds being formed, continues at a mere trickle compared with the torrid pace of 2000. This is not surprising. Record amounts of money were raised in 1999 and 2000 and much of this capital - an estimated $70 billion - has not yet been invested. With investment on a $15 billion to $20 billion pace, demand for fundraising is limited.

Projections for venture capital industry metrics in 2003 are:

• fundraising of less than $10 billion compared with $37 billion in 2001, $107 billion in 2000, and $12 billion in 1996;
• investment of under $19 billion compared with $41 billion in 2001, $106 billion in 2000, and $12 billion in 1996; and
• total estimated dry power (funds committed but not yet deployed) around $70 billion as of year-end.

In addition to the elements identified above, the US venture capital industry was constrained by continued low levels of information technology (IT) spending by corporations. Historically, 70% (now around 60%) of venture investment goes to IT start-ups. These investee companies are still having difficulty getting revenue and profit traction because their customers are not buying.

National Venture Capital Association and its research partner Thomson Venture Economics define venture capital as growth-oriented private equity investment in a company from its start-up to exit. The goal is to build successful public or acquired companies. Under the broader category of private equity, venture capital makes up one portion - historically about one-fourth. The other portion of private equity is the buyout/mezzanine fund group.

The data and analysis in this article pertain only to the venture capital portion of private equity unless otherwise identified.

NVCA forms new research coalition

In December 2001, the well-regarded and widely cited PricewaterhouseCoopers MoneyTree™ survey joined forces with our existing research consortium of Thomson Venture Economics and National Venture Capital Association. All data in this article related to investment in companies comes from this new three-party coalition. The resulting data stream is known to the chagrin of newspaper editors and chart makers as the PricewaterhouseCoopers/ Thomson Venture Economics/National Venture Capital Association MoneyTree™ Survey. Creating this new coalition has resulted in US venture capital activity being measured by a single official designated industry survey. The results are distributed by these three organizations, local venture capital groups, and essentially all big newspapers and broadcast outlets.

All investment in this article has been restated from recent years to include merging the legacy data from PricewaterhouseCoopers and to reflect the updated criteria for classifying a MoneyTree transaction. These updated criteria, most recently revised in December 2001, are spelled out at www.pwcmoneytree.com under the Definitions tab.

New challenges in 2003

Once valuations started falling in the first quarter of 2000, three challenges arose for the industry. First, a number of so-called dot.com companies failed as both private and public companies. Many of the early failures employed new business models which turned out not to be viable. The industry has shifted away from this form of investment.

Second, lowered initial public offering and acquisition (merger and acquisition) exit expectations rendered some previously promising companies poor investment opportunities - especially those companies needing to be carried through an indefinite dry spell in IT sales. Many of these companies simply could not get additional financing and failed.

Third, initial public offering and acquisition markets became dormant. In the first half of 2003, there were only three venture-backed initial public offerings. This meant that venture capital investors would have to provide larger and later rounds of funding for companies at a point in their growth cycles which otherwise meant going through an initial public offering or being acquired. On top of this, initial public offering markets are now viewed as more demanding on company pre-IPO revenue and profits. This lengthens the amount of time a company must be carried before a successful exit.

In 2003, despite glimmers of hope, there was no relief from the spending drought for commercial information technology products and capital goods in general. This meant that more companies had no one to sell products to just as their investors were expecting the companies to gain traction.

Venture capital firms in the US

The dominant basic structure for venture capital activity continues be a private limited partnership (or equivalent), which is generally an unregulated investment company. The capital structure for most venture capital firms is government independent. The role of the venture capital firm is to bring together a network of investors (limited partners) and entrepreneurs (portfolio companies). The firm's investment in the portfolio company is equity, long-term, hands-on (often the venture capital firm partner will become a board member of the portfolio company), patient and supportive. The venture capital firm, and subsequently the investors, realizes a return on investment when the portfolio company's stock increases in value allowing the venture capital fund to exit through an initial public offering (flotation) or acquisition (merger and acquisition).

During 2002, we saw the first decline in capital under management since 1991. Given continued low levels of fundraising, we would expect a further decline in 2003. Similarly, the industry's headcount declined for the first time since 1991. Although both metrics declined only slightly, we would expect much more decline in the coming several quarters as the industry adjusts to its new sizing (table 1).

Venture industry metrics

Venture Economics and NVCA report regularly on five metrics of the venture capital cycle: commitments to funds (fundraising), investment into companies, initial public offering exits, merger and acquisition exits (trade sales), and industry aggregate internal rates of return. Although investors commit to venture capital funds on the front end, the actual transfer of funds to the venture capital funds (take downs or capital calls) takes place as investment opportunities are identified. Because most corporate venture capital groups do not raise money from outsiders per se, formation and funding of these groups are not included in fundraising statistics. Their investment activity alongside more traditional venture capital firms is included in MoneyTree investment totals.

Classic parlance categorizes initial public offerings as one of the two types of exits. Initial public offerings are generally referred to as exit events as are acquisitions (M&A). But in the economic environment, the initial public offering is regarded more as a financing event than an exit, with the venture fund often holding its interest in the portfolio company long after the initial public offerings lockup period has expired (table 2).

As venture capital activity levels have declined over the past few quarters, institutional investors remain committed to the venture capital asset class with continuing expectations of a 500-basis point premium over the public markets. At this time, there is little demand for fundraising. We are seeing renewed interest in fundraising activity by some of the larger funds considering raising a new fund in late 2004 and in 2005.

With record amounts of capital raised in the previous two years, and as many as four years of dry power, several large venture firms decided to reduce the size of existing closed funds, which in effect returned capital to the limited partners. Although attributed by some industry observers to LP concerns over management fees, those funds returning money expressed concern about the upside potential for investments available over the next few quarters. Most of the fund reductions took place in the first half of 2002 with some additional reductions in 2003 (table 3).

Often misunderstood by those not familiar with venture capital in the US is the fact that venture firms are private and generally independent of government involvement. The two main areas of federal government support are in the SBIC programme and in basic research. A small number of venture capital firms configure their funds as a designated small business investment company (SBIC). This programme, organized and managed by the US Small Business Administration, an agency of the federal government, provides certain guarantees and matching funds for small business investment. The venture industry recognizes the importance of several basic research programmes sponsored by several arms of the federal government including the Advanced Technology Program (ATP) of the National Institute of Standards and Technology (NIST), the SBIR programme, and the National Institutes of Health (NIH). In fact, many seed and early-stage investors have relationships with these programmes as well as research programmes of leading universities.

Wealthy individuals investing their own money are called angel investors. Often these angel investors will join up to form a group. Whether individually or together, these angels invest in start-ups. In some cases, angels and angel groups compete with early- and seed-stage focused venture capital funds for deals. Other venture capital firms consider the angels a farm system for creating companies for future venture investment. No-one has accurately measured the total investment activity of angels but some estimates are that the angels, taken together, are roughly the size of the organized venture capital community. The statistics in this article do not include pure angel investment although many of the financing rounds included in these numbers include minority participation by angel investors.

Investment patterns

Most industry metrics in late 2003 indicate that the industry has returned to activity levels experienced in late 1997 and early 1998. Anyone in the industry at that time will recall that it was a busy time. Only in comparison with the frenzied years in the immediate past does this activity level look small (table 4).

The table showing venture capital investment by quarter starts with the largest investment quarter of all time - first quarter of 2000 with almost $29 billion invested - and shows a quarter-over-quarter decline for every reported quarter since, except the second quarter of 2003. The most recent several quarters have each seen investment of around $4 billion. This is a pace that the industry seems comfortable with. As 2003 draws to a close, there is a shift toward smaller, early-stage deals in the next crop of companies. Thus far, the amounts invested are small so there is little observed that would suggest that upcoming quarters would be significantly larger or smaller (table 5).

The table Venture capital investment by MoneyTree™ (table 6) industry sector 2003 shows that the life sciences command much more than the traditional 10% or so of the total investment. In fact, for the first nine months of 2003, life sciences made up over 26% of the total investment. Much of this is due to the shift in drug discovery and product development in the biotechnology arena from the big pharmaceuticals to the entrepreneurial sector. Some observers of past economic downturns suggest that this is a leading indicator of what we can expect to see in coming quarters from the IT sectors.

Observations from the last down cycle

The last time the US venture capital industry experienced a multiple-quarter downturn was off a peak in 1989 at $3.4 billion dollars. That was followed by two years of declining investment activity (table 7).

After two years of that last down cycle, many industry observers, including some well-respected insiders, wondered aloud whether the industry was at a crossroads that meant an end to the industry as it was known, or a transformation to a new way of doing business.

We know now not only did investment rebound from the $2.3 billion level in 1991 to reach $107 billion in 2000 but also during those declining years a number of big companies received their first ever round of venture financing. These include Intuit, Palm Computing, Starbucks, and McAfee. There have been few times in the brief history of the industry that were simultaneously ideal for buying companies at low valuations and selling them at high valuations. The period from 1989 to 1991 and the portion of the business cycle we are in more closely resemble the former.

Investment by corporate venture capital groups

A significant player in the venture capital investment scene over the past few years has been the corporate venture capital group. Before the late 1990s there were some significant corporate venture capital arms many of which were affiliated with the big drug companies and leading IT companies. Although many of the deals done before the late 1990s by these groups are properly classified as buyout investments, the number of corporations creating venture capital arms expanded in the late 1990s and started waning in 2001.

At its peak in 2000, one in every four venture deals had a corporate venture group investor participating. The groups provided almost one of every six dollars invested during 2000 (table 8).

Industry performance

Spectacular returns seen three years ago and the negative returns seen in recent quarters cloud the fact that the venture capital industry historically has returned around 20% to its investors. With valuations continuing to fall, dormant exit opportunities, and uncertain exit markets in the future, recent returns have been crimped.

All internal rate of return statistics shown below are net to the limited partners after all management fees and carried interest. A portion of the returns is based on unrealized portfolio positions. These calculations use the portfolio valuation data provided by the venture capital funds (table 9).

Compare those performance statistics to the same time horizons as they were calculated at the end of 1999. Given further correction anticipated in valuations for some sectors and the inevitable inertia in writing down challenged investments, we will likely see continued low and negative quarters in the near term. Remember that with most of the money ever raised by the industry currently under management, small changes in valuations will noticeably affect performance. Remember also that interim valuations are useful for reporting activity to investors and for statistical purposes. However, the only truly meaningful performance metrics are based on cash taken from the industry's investors and the cash or stock distributed to the industry's investors. The performance of a fund is not fully known until the investors have been paid and the fund has been liquidated (table 10).

Economic impact of venture capital

It is overly simplistic to view the US venture capital industry based on its meteoric rise to prominence in 1997 and 1998 and its slowdown starting in 2001. It is likewise a mischaracterization of the industry to view it as being simply the volcano-shaped chart showing a peak in 2000 eclipsing all previous and subsequent investment totals. In the several decades of the industry, there have been business cycles every 10 years or so and yet when the results are tallied from each, the impact of venture capital investment on the US economy is staggering.

During 2002, the NVCA released the final version of a study by the highly regarded econometrics firm DRI•WEFA, a Global Insight company, which quantifies the economic impact of venture capital in the US. This is the first study to look at the entire universe of companies funded during the 1970s, 1980s, and 1990s in terms of their total employment and revenues in 2000. Previous attempts to assess venture's economic impact have been based on generalizing from relatively small survey samples.

This study by DRI•WEFA concluded that in the year 2000:

• Venture-backed companies employed 12.5 million people in the US.
• Venture-backed companies had a combined $1.1 trillion in US revenue.
• One American job existed for every $13,775 invested during this three-decade period. This is remarkable given that most companies receiving funding during this period did not survive the 1990s.
• Venture-backed companies produced $6.50 in annual US revenue for every dollar invested over this 30-year period.
• These figures represent 11% of US payroll and 11% of US GDP. This is not a bad record for an asset class that was less than 1% of the investment total for most of the study period. In the past five years, venture capital investment has increased to 2.1% of US investment.

The US National Venture Capital Association has asked DRI•WEFA to update this study using 2003 data. The results will become available in mid-2004.

What's ahead

Although long-term factors are favourable, the downturn that has affected the US venture capital industry since the third quarter of 2000 shows no signs of abating. The entrepreneurial economy has become well ingrained in the American culture but its financiers have become cautious about current and future business environments. Funding has to be found for companies that have exceptional promise but are unable to sell products in the current environment or go public in the near future. Although the number of deals has returned to 1997 and 1998 levels, the PricewaterhouseCoopers/Thomson Venture Economics/National Venture Capital Association MoneyTree Survey shows that business plans still receive first time funding. But these new investments are less visible because of the continued efforts with existing portfolio companies.

Many of the experienced practitioners point out that more is not necessarily better. As the industry settles into a $15 billion to $20 billion annual pace, there is still a question whether enough liquidity will be in the future public markets to support even that level of investment.

Although the next few quarters may prove challenging for the industry, venture capitalists are planning investments in the next generation of successful companies. As we saw in the last downturn with such companies as Intuit, Palm Computing, Starbucks, and McAfee, great companies can be created during any phase of the business cycle.

Author biography

John S Taylor

National Venture Capital Association

John S Taylor is vice-president of research at the National Venture Capital Association (NVCA), which is based in the Washington DC area. He is responsible for developing and overseeing association data and research efforts. The main element of this effort is the creation of a research consortium, which was announced in 1998 involving the NVCA, Venture Economics, and the Ewing Marion Kauffman Foundation. In December 2001, PricewaterhouseCoopers joined the team and the tri-branded MoneyTree' survey became the definitive source for venture capital investment information. This team was created to ensure accurate, impartial, durable, and practical data on the venture capital and private equity industries.

Mr Taylor joined the NVCA in 1996. He is frequently quoted by large newspapers and magazines on the subject of venture capital and private equity and has recently provided live commentary on CNBC, CNNfn, Bloomberg radio and NPR Morning Edition.

Mr Taylor's career began with the company now known as Accenture where he was a senior consultant advising small business clients. He has since held senior product manager and IT positions in both large and small organizations. At a national computer services provider, he helped develop a new generation of minicomputer and microcomputer products for the residential real estate industry.

He has served as a board member of both for-profit businesses and non-profit organizations. In 1998, he was awarded the Maryland Governors Citation for outstanding volunteer service. He recently joined the advisory board of the Center for Private Equity and Entrepreneurship at the Amos Tuck School.

He received an MBA degree from the Amos Tuck School at Dartmouth College, and a BS degree in chemistry from Dickinson College.

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