Venture: Keeping the faith

After three years of declining venture capital investment in the technology sector many in the VC community believe the end of 2003 will mark a turning point for the market. The total value of investments for last year is still just a fraction of the levels achieved in 1999 and 2000 but there are signs that some confidence is returning. Louise Cowley looks at developments in the market in 2003 and expectations of what lies ahead.

Market conditions in recent years have been enough to test the faith of the most sanguine technology investor but hopes of a high tech turnaround are now rising. Most venture capitalists expect investment to pick up next year and with rising levels of optimism over both M&A prospects and the capital markets, exits are also beginning to look like a more realistic proposition.

For VCs investing in this sector life has changed dramatically since the heady days of 1999 and 2000. Recent years have been described as a return to normality or a period of back to basics investing but the sting of the burst bubble is still being felt. Investors agree the industry has already paid for the worst excesses of these years, as the weakest deals fell by the wayside and money was lost, but opinions are divided as to whether or not there’s still more bad news to come. Valuations may yet unravel further but lessons have undoubtedly been learnt. Richard Anton, director at Amadeus Capital Partners, says: “Companies raised too much money, at too high values and spent it too quickly, causing down rounds. Capital requirements are smaller now, which is paradoxical as funds are still large, but there’s better husbandry of companies.”

Reflections on the market in 2003

“2003 has been a year of consolidation and business building activity rather than manic deal doing,” says Jeremy Milne, director at Quester. However, with seven new deals completed, last year was far from quiet for the firm. As many VCs are still tending to and protecting their portfolios, the money put into previous investments means there’s generally less capacity to do new deals. “The money is there but the bar is higher,” says Philip Morgan, partner at Global Life Science Ventures. “We need to see evidence of the product, a strong management team and have a belief in the market. The mesh on the sieve is finer as the criteria are more stringent.” Investment levels are down and in what continues to be a cautious climate; start-up numbers are also lower as entrepreneurs are shy of the risks. As a result VCs feel a better balance is developing between investment capacity and deals.

Olivier Protard, managing partner at Sofinnova Partners, believes the market was still in decline in 2003. “It’s a very difficult market but we are witnessing signs of initial recovery, in terms of deal flow, closing deals and potential exits. There are signs of a recovery but it’s not yet a trend; we hope it will accelerate.”

Both entrepreneurs and VCs have more reasonable valuation expectations in the current market. Tim Brown, partner at Alta Berkeley, says: “The valuations ascribed to start-ups have changed, they’re simply not valued as highly. The analysis driving valuations is on fundamental business performance, rather than the profile of the start-up. Real value based on strategic worth and customers is what counts, not whether the financial community thinks it’s a hot deal.” Lower valuations mean equity is still relatively inexpensive, which is good news for the funds that still have cash. However, conservative attitudes and limited growth visibility means there’s a danger of under-investment.

As consolidation of investee companies continues, the market has also seen mergers between VC firms who themselves have been weakened by the current market conditions. Increased M&A among VCs may be rational but such moves are rarely driven by economics and are more often influenced by emotions and egos. A rare exception being the merger between nCoTec and Frontier Ventures late in 2003, although the long friendship and previously shared working career of the founders facilitated this. In merger situations differences in the culture and investment strategy of the firms have to be overcome. And even without the risks inherent in a legacy portfolio, venture capital firms don’t necessarily benefit from economies of scale in the same way their portfolio companies might. Ultimately the question of whether it’s simpler to raise a new fund and make new hires is raised.

Given these considerations, widespread consolidation is an unlikely prospect. There are likely to be more firms that simply fail to raise a follow-on fund in the current fund raising crunch than are acquired by a competitor, but there will doubtless be some fund management changes. The latter is already beginning to happen, such as when Nova Capital Management took over LICA Development Capital’s contracts in 2003.

David Carratt, managing director of Kennet Venture Partners, says: “Institutions want to commit to technology but there’s a flight to quality. Only about 25% of funds will find it easy to raise new money.” However, Carratt predicts there could be opportunities for new funds to fill the gap at the bottom of the market created by early stage investors refocusing on later stage deals. With casualties expected, all firms need to demonstrate to their investors how they are going to make money at this stage in the economic cycle.

Questioning the early stage VC model

Despite the difficulties of the last few years most VCs are refusing to accept the idea of reducing their long-term return expectations. However, no amount of positive thinking can disguise the losses of recent years and some early stage technology investors are reconsidering their investment strategies. Some VCs believe the late 1990s model of early stage investing is not valid in the current market when company growth and profitable realisations are much harder to achieve.

“There’s not enough liquidity in the European venture capital market. You can’t find follow on finance and companies go broke for lack of investors,” says Carratt. As a result some investors like Kennet are focusing on later stage opportunities, including spinouts and small buyouts of lower risk technology businesses that already have revenues, rather than early stage companies. Early stage VC funding is often used for product development whereas later stage companies more typically need money to expand into a new market.

“There’s often more value in companies created without venture capital, those that are owner-operated with no external finance. Bootstrapped companies are very capital efficient whereas entrepreneurs who’ve raised venture capital tend to rely on it.” Carratt says Kennet will continue to invest in early stage IT companies as well, varying the balance with later stage investments according to the economic cycle.

There are plenty of early stage investors sticking to their guns but they agree the investment assumptions of the 1990s are largely invalid. The model where a company can raise successive rounds, progressing in value, from business angels, then early stage investors and finally late stage funds, is rarely seen today. The $500m-plus exit valuation expectations of the high tech heydays have also disappeared. “The late 1990s funding and exit blueprint was based on the assumption of enthusiastic European capital markets but in reality until the mid 1990s all Alta Berkeley’s IPOs were on NASDAQ. So the norm for us is actually that there are no European markets for early stage tech deals. I guess there will be a window for exit on European exchanges again but it’s dangerous to assume it will open any time soon,” says Brown.

VCs that remain faithful to early stage investing question whether later stage companies really offer a lower risk profile, because higher burn rates and uncertain revenues jeopardise the success of investments that are larger than those made at earlier stages. There are also fears that a lemming-like rush to more developed companies will drive up the price of these deals. Although worrying, this trend would reduce competition for early stage deals making them more attractive. Anton says: “The drift towards later stage means there’s less support of start-ups but that means there’s more opportunities for us and it creates the chance for angels to re-enter the market. We need to rebuild this part of the eco-system.”

Business angels often provide the earliest external financing for start-up companies and in a time of falling valuations they have been worst effected by the problem of dilution. The lack of exits has also hit hard with some individual investors relying on the sale of existing investments to fund new commitments. Early stage venture capital firms face similar problems themselves but are concerned about the impact the long-term withdrawal of business angels could have on deal flow. There is no easy solution to prevent angel investors’ stakes in companies being diluted but VCs are aware that their co-operation is important. “Business angels need to align their interests from day one, not just with the management, but with the other investors,” says Brown.

Industry changes

For the early stage VCs unswayed by the arguments in favour of later stage investing, the current question is how to counter the changes in the market that threaten to reduce returns and extend holding periods. “The temptation for larger funds is to go for later stage companies. Right or wrong it’s not what we’ve chosen to do,” says Protard. He says Sofinnova is sticking to the fundamentals of investing, such as strong proprietary technology. Investments need more time to come to fruition now but there’s still plenty of potential in the early stage sector and VCs are adapting their investment practises, and what they look for in investments, to the market conditions.

The number of VC firms actively investing has fallen and those remaining are wary about how they put their money to work. Co-investing with other funds went out of fashion during the boom but investors are now cautious and as a result less proprietorial about their deals. “Investors were greedy in 2000; we wanted all of the upside for ourselves but now we’re back to building syndicates as we don’t want to be dependent on external finance. You’re in a better negotiating position if the syndicate is in place for the next round,” says Bart Markus of Wellington Partners. In fact many VCs say they will no longer invest alone on deals and that they turn down opportunities if the syndicate is not strong enough.

Increasingly the investors required to finance a start-up to exit are in place from the first round, as early stage investors can’t rely on being able to find new investors for follow-on rounds. This practise also means the original investors avoid their stakes being excessively diluted in later rounds. Brown says: “In the past we often only needed cash from the later stage investors as most of the work building the company had already been done. Now we work with co-investors from an earlier stage for longer so it’s more important you choose someone with complimentary business building skills as well as cash.” He believes the market is evolving to a smaller number of sector-focused VCs that are more agnostic about the stage they invest at.

Most VC firms report the pool of funds they regularly co-invest with has shrunk but in many cases still looks a lot like it did before the late 1990s boom. Everyone’s invested alongside a fund that’s withdrawn from the market and as a result, VCs are more careful about who they co-invest with. Firms are increasing the amount of capital they reserve to support each new investee company in follow-on rounds and want stable co-investors that also have the reserves needed for future rounds. “Bringing in new investors is reassuring, it can be good for the valuation of the company and they bring a fresh approach?but you’d still expect internal sources (existing investors) to put up majority of any new money,” says Morgan.

How are deals changing?

As it has become harder for start-ups to secure funding VCs have been able to take more control over investment conditions. Investors can be more demanding on terms such as intellectual property, where they expect the rights to the patent. While entrepreneurs recognise making concessions is what it takes to raise money now, Europe’s first generation of second time entrepreneurs, equipped with experienced lawyers, are becoming more savvy and as a result term negotiations can be protracted. Milne says: “Term sheets are almost a legal document in their own right, they’re not a one page headline valuation, they’re getting longer and longer.” Long-term sheets are not necessarily more complicated as a long list of terms is becoming standard and once agreed legal work can be done more quickly.

The success of a deal relies on a balance that keeps the entrepreneur motivated and VCs are aware of the need for a decent level of upside to motivate management teams. “Until 2000 the entrepreneur was king, they could almost organise bids from investors. Now we can demand a lot and probably get it but low valuations and too much control in a deal can be negative as it limits the energy and passion of the entrepreneur. There’s a point you can’t go beyond,” says Protard. This is especially true in a market such as today’s where VCs are more dependent on the management of their investee companies to execute the business plan than they were when capital markets guaranteed successful exits.

When it comes to investment terms VCs will probably continue to have the upper hand for some time yet but investors have noticed the slight improvement in confidence, led by the US, means there are hints that terms are now beginning to firm up both here and in the US.

Some optimism may be returning to the market but caution is still the sentiment that rules investment decisions and practises. The time and effort put into due diligence has increased and deals take longer to reach completion. It’s not just investors that are more circumspect, entrepreneurs are also asking more questions and increasing the due diligence they do on potential investors. “In 2000 we did a deal in a week, now it takes a minimum of three months but is more likely to take six,” says Markus.

The number of deals done per partner has fallen to more sensible pre-bubble levels of one or two a year and these deals tend to be smaller. Although some ambitious deals are being done, investors are more hesitant about large, capital-intensive deals. “Raising huge rounds is not necessarily a sign of success,” says Milne. And with valuations still low, VCs continue to get reasonable sized stakes for smaller amounts.

VCs accept it takes longer to build companies now but the venture industry and the management teams it backs have had to get smarter and more economical about the process. The drop in investment sizes reflects the move towards increase capital efficiency, developing companies on a smaller budget. “Companies manage cash resources well so they can last longer before raising their next finance round, which is more likely to be on attractive terms. Investments still need to cover periods of negative cash flow but we can achieve a lot,” says Anton.

Tim Brown encourages companies to look at low cost manufacturing in Korea and China, where R&D and engineering skills are also developing rapidly. “Product development within start-ups must be more efficient than for their corporate competitors, who already tap into such resources,” he says. The focus is on keeping costs and spending under control and moving towards profitability as soon as possible with customers funding the growth of the business as much as possible.

For this reason skills such as marketing and sales, which are not traditionally the forte of those developing new technology, are increasingly important in start-ups and VCs sometimes choose to replace key management. “Entrepreneurs realise that they need to bring in an experienced management team if they are going to attract customers, investors and talented staff,” says Milne. The high number of companies that were victims of the high tech crash made customers wary about buying from small businesses, especially those providing software and IT services. This means the sales team of start-ups in these areas have their work cut out for them and such companies are therefore

more customer-service orientated than previously.

In life sciences the battle to keep start-up costs down can be trickier because there are fewer ways to reduce the cost of getting a drug on to market and biotech companies rarely have revenues that can be used to fund development. Investors are focusing on companies with more developed products such as those with human clinical data, rather than just proof of principle. Preference is also given to companies with more than one product in the pipeline, although a balance must be maintained as resources could be stretched by too many different projects.

Investors anticipate longer holding periods and lower exit valuations but they still have an eye on the possibilities for realising investments. Technology companies need to be benchmarked globally rather than just against their European competitors as M&A approaches from the US looking more likely. Flotations are also more likely on NASDAQ than a listing on a European market. “Successful IPOs in the US require more than just a Delaware holding company. You need to understand what the US markets require…for instance two thirds of the companies we have backed in our sixth fund have had a US presence within 12 months of inception,” says Brown.

2004: cause for optimism?

The first signs of a turnaround in the fortunes of early stage tech VCs and the companies they back is indicated by a thaw in the IT spending of large corporates. Markus says more customers are now buying from start-ups. “This was a key inhibitor of significant growth in 2001, 2002 and early 2003. Customers are very careful about buying from start-ups as they fear they’re not going to be there in a year but the wave of bankruptcies is receding.” Confidence in young businesses is boosted by partnerships with the big IT names, which are beginning to take a more active interest in innovation once again. David Carratt is optimistic, expecting positive growth in IT spending next year, especially in the US: “I’m more positive than I was a year ago, then you couldn’t forecast the end of slow tech spending, now we’re looking at an increase in the US.”

Increased spending is being bolstered by talk of a recovery in the capital markets as the trend for public-to-private takeovers begins to reverse and IPO prospects improve. For now attention is focused on the US markets and most VCs are still too guarded to call the shift in mood a recovery. “There was a significant increase in public stocks earlier this year so there is some confidence. There have been some secondary offerings, the first signs of green shoots. It’s still a small window but at least we can think about it now, whereas you couldn’t a year ago,” says Morgan.

For now NASDAQ offers technology companies a more realistic shot at a listing than the European markets and with fewer established companies listed on Europe’s technology markets, confidence in a European revival is much lower. “The big problem in Europe has always been liquidity and the age of the markets? A stable base is lacking in Europe and it will take the market to go through two cycles to get there,” says Markus. Expectation about the public markets may be higher but not everyone subscribes to the idea and even the most positive thinkers aren’t expecting a smooth ride.

As markets begin to suggest a recovery there is a gradual improvement in confidence and this implies that M&A activity should pick up. Investors report more US corporates are indeed making acquisition approaches to European-based start-ups. The rate of profitable trade sales remains low for now but negotiations seem to be underway, recognising that VCs are nurturing businesses of strategic value. The increase in investment widely expected for 2004 coupled with a surge of interest in later stage companies could see secondary sales to VCs also providing a number of exits.

The last couple of years have been a period of shifting assumptions for those investing in early stage technology companies. It takes hard work and a long time to build companies in the current market and expectations are that 2004 will be an evolutionary, rather than revolutionary, year. Times could get tougher still for those seeking first round and seed financing and 2004 offers no immediate relief from the lack of liquidity that continues to blight portfolios. However, there is confidence about deal flow, both the number and quality of companies being seen, and investment levels are expected to increase. Cautious optimism, a phrase much over-used in recent years, continues to describe the market’s mood but it looks like 2004 will see more VCs placing the emphasis on optimism.