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As printed in Venture Capital Journal, December 2001
The 2002 Venture Capital Outlook
By Edwin A. Goodman
Although it is always treacherous to pick bottoms, I feel comfortable
that in the wake of the sluggish economy of 2001 and the horrific events
of this past September, 2002 will prove to be a year of substantial recovery
leading to robust growth in 2003. The larger economy and the venture capital
markets enjoyed exuberant growth from 1992 through the first quarter of
2000_a remarkable eight-year run. The venture community, in particular,
grew at a spectacular and unsustainable pace from the point at which it
discovered the Internet circa 1994.
Historically, the entire venture community_about 700 firms operating
in 48 states_raised from $3.5 billion to $5 billion annually and, in turn,
invested this money in promising young companies offering the prospect
of explosive growth. Commencing in 1995, investors, principally institutions,
committed capital to venture partnerships which, in large measure, supported
companies linked to the growth and changing business models fostered by
Internet technology. This annual allocation of investment capital to venture
partnerships grew to an astonishing 105 billion in the apex year of 2000.
Venture Capital Withering and Dying
Those provocative but woefully misleading words were the featured headline
in a story published in The New York Times on Oct. 21, 2001. To
paraphrase Mark Twain, reports of the death of the industry are greatly
exaggerated. In fact, during the third quarter of 2001, venture capitalists
in the U.S. invested $7.7 billion in 873 companies while 46 venture funds
replenished their coffers by raising $6.2 billion. All the other private-equity
markets in the world would be thrilled if they could point to comparable
ferment.
Nevertheless, the Times piece did reflect the perspective of many
observers who view the record of the last several months from the lofty
peak of the Ides of March 2000. At that point, a number of factors coalesced,
marking the end of a year of easy victories and spectacular returns. During
the first quarter of 2000, the storm cloud of leading economic indicators
darkened, signaling an increasingly troubled economy. Along with the broader
decline in the public markets, which accelerated around April 1, 2000,
thousands of public Internet-enabled companies saw their market capitalizations
shrink. In turn, the initial public-offering market dried up. And the
task of raising capital for aborning venture capital funds and countless
venture-backed operating companies proved daunting, if not impossible.
Throughout the second and third quarters of 2000, the picture grew darker
by all conventional measures, punctuated by the unimaginable evil of Sept.
11. The World Trade Center disaster aggravated and accelerated all the
negative economic trends that had been evident earlier.
A Diverse, Complex Financial Community
The venture capital community is not monolithic, and it is misleading
to treat it as such. The industry consists of hundreds of firms with a
myriad of different investment strategies, and this complexity has become
more pronounced accompanying the astounding growth during the past several
years.
With the exception of a small number of partnerships that, for various
reasons, are planning to close their doors, all these firms are engaged
at some point along the inexorable and repetitive life cycle of venture
capital partnerships. They are spending their time in some combination
of raising capital, investing capital, fostering portfolio companies and
harvesting returns.
Today, the market is substantially bifurcated. On one side of the great
divide are those firms that raised significant funds in 1997 and 1998
and invested heavily in 1999 and early 2000. Within this segment of the
industry, the disciplined and cautious firms were greatly outnumbered
by those captivated by "Bubble Theology," the embracing of momentum
and the prospect of ever-escalating prices in order to harvest successfully.
In some cases, they invested in companies with indefensible business models
and were left with struggling portfolios when the IPO take-out option
evaporated with dizzying speed and private-equity pricing of later financing
rounds also collapsed.
These unhappy firms, in the current market, are unable to raise money
for their quality portfolio companies, let alone for their ugly ducklings,
and they lack sufficient cash to support the portfolios by themselves.
This is resulting in the worst performance numbers for the industry in
many years and will worsen as general partners face up to the harsh reality
of taking additional portfolio markdowns and write-offs over the next
12 to 18 months.
The Bright Side
Fortunately, there is a bright side to this bleak picture due to the
venture life cycle to which I referred briefly. Many firms due to prescience
and/or luck were in a capital-raising mode primarily in 1999 and did not
participate harmfully in the binge investing so commonplace.
Accordingly, they have closed sometimes very large funds in 2000 and
are sitting with large cash reserves in a down market with many entrepreneurs
slashing prices and adding attractive deal features. In short, this is
a market which venture capitalists with cash dream about and rarely encounter.
Experienced institutional investors apparently share this view, for despite
all the poor macroeconomic news, they are continuing to invest in venture
partnerships at a robust pace, an estimated $40 billion in 2001, which
would rank as the third highest year in the industry's history, exceeded
only by exuberant 1999 ($60 billion) and frenzied 2000 ($105 billion).
What About 2002?
I believe that, for the most part, the move away from early-stage risk,
which was palpable in 2001, will increase next year. The liquid VCs are
investing in, and will continue to seek out, promising young companies
that have completed products, customers and sales. And yes, in some cases,
these firms will even have profits! These investments will include series
B and series C round financings and PIPES (private investments in public
equities). With sales momentum; attractive, low, entry-level deal pricing;
the capacity to absorb significant capital infusions; and shorter time
horizons to exit through being acquired or tapping the public market_these
companies offer investors the most appealing risk/reward prospects.
One unhappy ramification of these market dynamics is that even the worthiest
start-ups are going to continue to find it almost impossible to raise
capital from traditional venture funds in 2002.
The Sputnik Syndrome
Even the mostly grisly of clouds have silver linings, and I see three
emerging as a product of the Sept. 11th tragedy. Just as the former Soviet
Union’s success in space in the early 1960s led President Kennedy
to challenge the nation to respond, something comparable is abroad in
the land now. I believe the recent influx of dozens of security-oriented
investment proposals, is a tiny reflection of what is going on nationally.
Over the next several years, government, corporations and other institutions
will devote enormous resources in pursuit of heightened security. Within
the venture world, this will encompass, among others, companies that provide
firewall protection for communications systems; encryption software companies;
enterprises devoted to monitoring and analyzing communications to identify
potential threats; data-mining companies to provide useful and faster
analysis of much potentially valuable information that is available but
has not been usefully sifted, etc., etc.
The second area of opportunity is much more immediate from a New Yorker's
standpoint. It was recently estimated in an overview piece in the Times
that the "Information Technology Rebuild" in downtown Manhattan
will cost approximately $3.8 billion. Based on the prerequisite cleaning
up of the WTC site which will take about a year and the subsequent new
construction that will unfold there, the IT investment should begin to
come on line by the middle of 2003 and will most probably continue for
two to three years thereafter. Of course, the IBMs and EDSs of the world
will play a major role, but there should also be plenty of business for
entrepreneurial IT firms with select applications.
The third silver lining is the macro-economic response of the Federal
Government. Balanced budgets have been set aside along with a long list
of laudable but, in these circumstances, postponable government initiatives
including social security reform, healthcare insurance expansion and education
reform. All efforts are now focused on national security, and tax and
spending plans which will reignite economic growth. The national economic
pump will be primed, and GDP growth will return robustly by the second
half of 2002. This can only help entrepreneurs, venture capitalists and
the country.
Adversity is the breeding ground of opportunity, and now is such a time.
Do you know what companies like Starbucks, Intuit, Palm Computing, RF
Micro Devices, Shiva Corp. and Wind River Systems (to name only a few)
have in common? They all received their initial funding from venture capitalists
in the most recent dark recessionary period of 1990-1992. We are at a
similar inflection point now. Venture capitalists with money will find
many opportunities over the next year among fledgling companies seeking
capital for growth. Many of these firms will address markets born in response
to the events of September.
I believe the return of economic growth will lead to the re-emergence
of the IPO market in the latter half of 2002 in ample time for venture
capitalists to harvest some of the portfolio seedlings they are currently
planting.
--
Ed Goodman is the co-founder, along with Todd Pietri of Milestone
Venture Partners, which focuses on early-stage, enterprise information
technology companies in the New York metropolitan area.
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