Venture Capital Firms Swarming to Late-Stage Investments

Deal-hungry venture capitalists have been pouring money into late-stage investments -- companies that are near an initial public offering -- at a faster pace than at any time since the mid-1980s.

The late-stage cash is flowing so fast that by the end of the year as many as 300 companies will have registered their intention to go public, according to IPO Vital Signs, a Web-based service for such companies.

Despite this recent uptick in activity, the venture and IPO markets aren't what they were during the tech bubble and may never again be as robust -- or as risky.

The evidence suggests that both venture capitalists -- many of which haven't seen a decent return on an IPO since the bubble burst -- and public investors are being far more diligent in the companies they'll invest in.

The majority of IPOs are now profitable before they go public, a complete reversal from many of their predecessors that debuted in the late '90s.

This is good news for individual investors. IPOs in today's market may not deliver the huge one-day returns to the institutions that bankrolled them as they once did, but they are likely to live longer and deliver more consistent returns to everyday investors, another difference from the late '90s.

During the last three months of 2003, companies nearing their public debut attracted $1.5 billion, the highest level of late-stage investments in two years. For the full year, later-stage investment totaled $4.7 billion, or 26% of all venture capital, the highest level in at least two decades, according to Thomson Venture Economics.

Late-stage investments are typically made in companies ready to go public, and represent a way for venture investors to get a relatively quick return on capital. After the profit-starved years of 2001 and 2002, such investors believe that the stock market will once again reward start-ups. (Early stage investments are those made in companies that are further away from going public, and thus represent a longer-term play.)

Much of the new scrutiny and caution in the venture capital market can be traced to the technology boom and subsequent bust of the tech sector in the late 90s. Tech companies remain a popular choice among venture capital firms, but the VCs are not nearly so quick to write those big checks without doing serious due diligence first.

"The risk/reward is not as good as it used to be," says Tench Coxe, managing director of Sutter Hill Ventures, a venture capital firm based on Sand Hill Road in Menlo Park, ground zero of the Internet bubble. "Every tech segment has a leader" and that scares off potential investors, Coxe said.

Despite last year's big market gains, total VC investment in 2003 was $18.2 billion, down 15% from 2002. That's a smaller decrease than the slide of the previous two years, but still a significant drop, according to the MoneyTree survey, published by PricewaterhouseCoopers, Thomson and the National Venture Capital Association.

"Big institutional investors did not get great returns on their venture investments for several years," said Kathleen Smith, who manages Renaissance Capital's ( IPOSX) IPO Plus fund. "It will take another year or so until it really reverses."

Put simply, venture funds that made investments near the peak of the Internet bubble got caught and suffered horrendous losses, said Lawrence Aragon, a longtime IPO watcher and editor of Private Equity Week.

For example, the Accel VIII fund, which made its initial investments in 2000, lost 26.8% by March 2003, while the InterWest PartnersVII fund of 1999 and InterWest VIII of 2000 lost 28.9% and 32.4%, respectively, according to documents detailing investments made by the University of California.

Contrast that with funds that caught the crest of the IPO wave. One Kleiner Perkins fund from 1996 returned a phenomenal 286.6%, according to the university, while the average return for similar funds in that period was a still-enviable 87%, according to Venture Economics. (More current data won't be available until next month.)
A Slice of VC Life
Software, biotech get big piece of pie
Source: PricewaterhouseCoopers

While it seems likely that funds that made most of their investments in 1999 and 2000 will do poorly, there's no way to predict how funds collecting money now will do. "There's a five-to-10-year horizon for most funds," notes Aragon.

Given recent results, it's not surprising that venture capitalists and their investors have lost their appetite for long-shot investment, and are looking for companies with a track record.

Despite this year's correction, that strategy seems to be working, and that in turn creates opportunities for other investors because higher-quality IPOs are able to better withstand the market's gyrations.

This year's crop of 27 IPOs is easily outperforming the market as a whole, appreciating an average return of 13% as of Tuesday's close. The S&P 500, by contrast, is down fractionally year to date.

"The market is still very picky," said Smith. "Investors are looking for more mature companies now."

According to Renaissance's research site -- -- just 26% of the 479 companies that went public in 199 were profitable before the IPOs. Last year, that ratio was nearly reversed: 70% were profitable, and so far this year 55% were profitable.

Venture Worm Has Turned

Picky or not, the venture environment has improved enormously in the last 15 months. It wasn't long ago that some VCs actually returned money to their investors, saying they couldn't find a profitable place to invest. That doesn't seem to be a problem now. According to IPO Vital Signs, 22 companies already have gone public this year, and another 58 have registered their intention to go public.

Currently, software and biotech start-ups are getting the largest slices of the venture pie. Last year, software attracted $3.6 billion in venture funding, or 20% of the total invested by the VCs in 2003, while biotech was just behind at $3.4 billion, according to the MoneyTree survey.

Software has been a favorite of VCs for some time. In 1999, just before the peak of the bubble, venture funds doled out $53.3 billion, including more than $10 billion to software companies. No sector got more that year. Biotech, for example, was in 10th place, receiving just 4% of the money.

Although the numbers for the first quarter of 2004 have yet to be tallied, a glance at recent funding announcements indicates that both software and biotech are still hot. On March 9, for example, Private Equity Week reported a $12.6 million second-funding round for Agitar Software, a Mountain View Calif.-based provider of tools to automate software testing, and $15 million in funding for nCircle Network Security of San Francisco. The day before, three biotech companies received a total of $40.7 million in venture funding from various sources.

Companies that develop business intelligence software, tools that allow companies to generate reports and derive useful data from the mountains of information stored on their networks, are garnering serious attention -- and serious cash.

Object Reservoir, which helps energy companies make sense of complex geological data, has raised $14 million from a number of companies, including U.S. Venture Partners, which has directed 80% of its software investments toward business analytics software.

Vendavo and Metreo, companies that develop business intelligence software that helps companies analyze retail buying data, have raised more than $40 million each, according to a recent story in the Silicon Valley/San Jose Business Journal.

Other sectors also are likely to be hot in 2004. Wi-Fi (a popular wireless communications technology), storage, and application service providers, companies that develop software for other companies to rent via the Internet, are expected to be strong performers, said Jim Breyer of Accel Partners, a Palo Alto, Calif.-based VC firm with more than $3 billion in assets.

One company that fits that description:, a feisty challenger to Siebel Systems ( SEBL). SalesForce is expected to go public this spring. (Accel Partners is not a major investor in, according to documents on file with the Securities and Exchange Commission.

Meanwhile, two wireless-related companies, Aperto Networks and Colubris Networks, recently received $20 million and $13 million, respectively, in funding, Private Equity Week reported on March 8.

Given that VCs are now pouring money at faster levels into companies that are near an offering means that more IPOs in these sectors are likely in late spring and summer. Unless, of course, the recent slide on Wall Street is a sign that the dormant bear is about to wake up. But for now, the Silicon Valley's money mavens don't sound too worried.

"The current correction was overdue, but good, unique companies will still get financed at decent multiples," said Sandy Robertson, a partner of Menlo Park, Calif.-based Francisco Partners, a technology-based buyout firm with about $2.6 billion in assets.

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