US Introduction

No one has repealed the business cycle. The dramatic growth in the US venture capital industry from 1993 through 2000 reversed in 2001. The industry peaked in the third quarter of 2000 and activity has slowed in each quarter since then. Even at these reduced activity levels, 2001 is the third best year in the history of the industry in both total dollars raised and total dollars invested in companies. Financial performance of the industry, measured as internal rate of return net to the limited partners, is retreating from triple digit returns a year ago to the industry's long term IRR of 20% to 25%.

Projections for key venture capital industry metrics in 2001 are:

• fundraising of around $40 billion (third best year ever) vs. $105 billion in 2000 and $12 billion in 1996;
• investment of just under $40 billion (also third best year ever) vs. $107 billion in 2000 and $12 billion in 1996; and
• total overhang of money raised but not yet invested is around $42 billion as of yearend.

The US venture capital industry in 2001 was characterized by:

• dormant IPO and acquisition (M&A) markets;
• an attention and funding shift toward existing portfolio companies (81% of investment dollars in third quarter 2001 were follow-on);
• falling valuations from a peak in 1Q 2000;
• as these valuations fall and as industry IRR returns to traditional levels, there have been several negative IRR quarters and there is reason to expect some negative quarters in the near future;
• slowdown in IT spending by corporations which delayed the generation and/or growth of revenues by portfolio companies (IT companies historically receive 70% of venture investment. In 3Q2001, IT companies received 79.6%); and
• successful fundraising of large funds by the largest and most experienced firms which said that these funds would be invested over the more traditional two to three years.

The National Venture Capital Association (NVCA) and its research partner Thomson Venture Economics define venture capital as growth-oriented private equity investment. It is long-term, institution-led, patient, hands-on, professional, value-added money. The goal is to build successful public or acquired companies. Most of the analysis and the statistics in this article pertain only to the venture capital portion of private equity unless otherwise identified.

NEW CHALLENGES IN 2001

As valuations fell starting in the first quarter of 2000, three challenges arose for the industry in 2000 continuing into 2001. First, a number of dot.com companies failed as both private and public companies. The industry shifted away from this form of investment. Second, lowered IPO and acquisition (M&A) exit expectations rendered some previously promising companies a bad investment – especially those companies which would have been carried through an indefinite dry spell in IT sales. Many of these companies simply could not get additional financing and failed. Third, IPO and acquisition markets became dormant. This meant that venture capital investors would have to provide funding for companies which otherwise could have gone public or been acquired. On top of this, IPO markets are widely viewed as more demanding on company revenue and profit track records prior to IPOs. This lengthens the amount of time a company must be carried prior a successful exit.

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 unregulated and 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, very 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, realize a return on investment when the portfolio company's stock increases in value allowing the venture capital fund to exit through an IPO (flotation) or acquisition (M&A).

As venture capital activity levels have declined over the past few quarters, institutional investors continue to invest in venture capital. Not all venture firms are having equal success in raising additional money. Venture firm experience is becoming a greater factor in fundraising success. In the second quarter of 2001, venture firms with 11 years or more experience raised 49% of the money. That is to say that about half of the money was raised by venture firms that had survived the last downturn in 1990-1992. Only 6% of the money was raised by venture firms with one or fewer years of experience.

Often misunderstood by those not familiar with venture capital in the US is the fact that venture firms are private and generally independent of governmental involvement. The two big areas of federal government support are in the SBIC program and in basic research. A small number of venture capital firms configure their funds as a designated Small Business Investment Company (SBIC). This program, 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 programs 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 program, and the National Institutes of Health (NIH). In fact, many seed and early-stage investors have relationships with these programs as well as research programs of leading universities.

Private equity funds are raised specifically as venture capital funds or buy-out/mezzanine funds. Venture capital funds provide growth capital for companies from the seed stage through an acquisition or IPO. Buy-out funds work primarily with established companies, both private and public, to create value through reengineering and reconfiguration. Historically, buy-out funds have raised about four-fifths of the money going to private equity, leaving around one-fifth for venture capital. Starting in 1999, venture capital funds have actually raised more money than buy-out funds. This may have been fueled both by the much higher returns paid by venture funds in recent quarters, and the recognized number of attractive investment opportunities for growth capital.

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 startups. 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 as a kind of farm system for creating companies for their future investment. No one has accurately measured the total investment activity of the angel community 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 may include minority participation by angel investors.

INVESTMENT PATTERNS

Most industry metrics in late 2001 indicate that the industry has returned to activity levels experienced in late 1998 and early 1999. Anyone in the industry at that time will recall that it was a very busy time for the industry. Only in comparison with the frothier portions of 1999 and 2000 does this activity level look small. Information technology continues to receive about 70% of the funding. The portion of money going to life sciences has increased to around 10%, up from 7% in all of 2000.

One key difference is the amount of time and money venture capital professionals are investing in their existing portfolio companies. Venture capital firms estimate that an all-time high 80% of their time is concentrated on existing companies. The statistics below on the share of dollars going to Series B (second) and later rounds shows this shift.

INDUSTRY PERFORMANCE

Spectacular returns seen a year ago and the negative returns seen in recent quarters have clouded the fact that the venture capital industry historically has returned around 20% to its investors. As investor returns appear headed back toward historical levels, venture capital continues to attract significant amounts of institutional and individual capital.

Compare those performance statistics to the same time horizons as they were calculated exactly one year earlier. There is every reason to believe that with further correction anticipated in valuations for some sectors and the inevitable inertia in writing down challenged investments we will continue to see low and negative quarters in the short term. Remember that with most of the money 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 significant performance metrics are based on cash taken from the industry's investors and the cash or stock distributed to the industry's investors. The true IRR for a fund is known only after all portfolio companies have been liquidated and proceeds have distributed to the investors.

ECONOMIC IMPACT OF VENTURE CAPITAL

During 2001, the NVCA released a study by the highly regarded econometrics firm DRI•WEFA, which quantifies the economic impact of venture capital in the US. This is the first study to look at all of the companies funded during the 1970s, 1980s, and 1990 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 7.6 million people in the US;
• venture-backed companies had a combined $1.3 trillion in US revenue;
• one American job existed for every $36,000 invested during this 31-year period. This is remarkable given that most companies receiving funding during this period did not survive the 1990s; and
• venture-backed companies produced $4.73 in US revenue for every dollar invested over this 31-year period.

These figures represent 5.9% of US payroll, 13.1% of US GDP, and 7.9% of US company revenue. This is not a bad track record for an asset class which 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.

WHAT'S AHEAD

Although long-term factors are favorable, the downturn which has affected the US venture capital industry since the third quarter of 2000 shows no signs of abating. 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. The quarterly investment survey done by Thomson Venture Economics and the National Venture Capital Association show that there many business plans that receiving first time funding. However, these are less visible than the efforts concentrated on existing portfolio companies.

Even in the current downturn, institutional investors have continued to provide most of the money in venture capital with some institutional investors increasing their asset allocation target for private equity. The other necessary ingredient, worthy entrepreneurs with fundable ideas, seems to be increasingly available. As larger organizations, once entrepreneurial and possibly venture-backed themselves, mature culturally and in growth potential, qualified managers from these organizations are coming forward with business plans.

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.

National Venture Capital Association
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