Did Rise in Stealth Deals Hurt Q3 Tally?

More companies are remaining in stealth mode following their first rounds of VC funding, and some investors are blaming this phenomenon for the third quarter drop in venture capital investments.

The rise of stealth is, in part, a backlash to the go-go days of the late 1990s, when press releases were prepared in tandem with term sheets. During the glory days, portfolio company executives and VCs were looking to build their brands, and everyone felt that the best way to entice prospective customers or leads was to be plastered all over glossy tech magazines. Products were important, and revenue was OK, but buzz was essential.

It isn’t terribly fair to blame aggressive marketing for the tech bubble collapse, but VCs are still hell-bent on purging most of the vestiges of how investing was conducted from 1999 through 2001. The result is a new conventional wisdom that promotes the virtues of remaining beneath the popular radar, and staying away from the horrors of PR.

In a Nov. 14 interview with the San Jose Mercury News, John Doerr of Kleiner Perkins Caufield & Byers suggested that premature press has a tendency to create a series of copycat competitors. His colleague, Ray Lane, said: “It’s worse than that. By talking too early, they produce weak competitors… A strong competitor is good for you in an early market, because it helps build the market. A weak competitor, it turns off a client. … It’s not good for the original idea.”

The VCs were responding to a question about whether or not an increase in stealth financings had artificially driven down the third quarter disbursement results, which showed that VCs invested nearly 25% less in the third quarter of 2004 than during the previous quarter. Almost all third quarters experience some measure of decline of investments, as a result of summer vacations, but rarely is the drop so precipitous.

VCs did just over 600 deals in the third quarter – their lowest quarterly number of deals done in nine years – down from 692 in the third quarter of 2003 and down from nearly 800 in the second quarter, according to the MoneyTree Survey from PricewaterhouseCoopers, Thomson Venture Economics (publisher of PE Week) and the National Venture Capital Association

Neither Doerr nor Lane commented on the correlation of stealth companies and the number of the MoneyTree’s disclosed Q3 deals.

Kirk Walden, national director of venture capital research with PricewaterhouseCoopers, says that a large percentage of the data is compiled from VC firm survey responses, and that the firms retain the option to mark certain deals as confidential.

In 2003, a total of 40 deals were marked this way (although some of those designations were later removed). Through the first three quarters of 2004, however, VCs kept 50 companies close to the vest when filling out the surveys. Extrapolated to year’s end, at least 65 companies would be marked as confidential in all of 2004, a 62.5% increase over last year.

Walden does not know why individual companies are marked as confidential. He attributes much of it to the reasons given by Doerr and Lane, but acknowledges that an increase in VC-centric fear of disclosure also could play a role. Either way, the fact remains that a greater number of companies are being marked as confidential in 2004 than in 2003.

Transaction details for each of those confidential companies, however, are still entered into the PricewaterhouseCoopers system for the purpose of data aggregation. For instance, last week, AirTight Networks announced it raised $10 million in a Series A deal from Walden International, Blueprint Ventures and other investors (see PE Week, 11/15/04). The money was raised during the second quarter, but AirTight emerged from stealth last week as it prepares to unveil its product later this month. The $10 million deal was included in the MoneyTree’s Q2 report.

So while stealth companies may be on the rise, they still are represented in the quarterly data. It could be argued that returned surveys are less likely to include stealth deals as opposed to “public” deals, but even a generous estimate of such reticence would not make up the Q2/Q3 funding gap.

The majority of stealth deals are for seed-stage or early stage companies, which averaged about $2.9 million and $4.5 million per deal, respectively, in Q3 (or a combined 21% of all disbursed dollars). Given such paltry deal amounts, not even a 150% increase in reported seed-stage and early stage deals would have helped Q3 match up to its predecessor.

Moreover, any systematic increase in survey reporting also would undoubtedly come with a corresponding increase in non-stealth deal reporting, although to a lesser degree.

Meanwhile, the market is still searching to explain the Q3 disbursement drop, while simultaneously hoping for a substantial rise in the fourth quarter.

Email Daniel.Primack@thomson.com