Washtech.com: Venture Capital Investments in the Mid-Atlantic Region
Guest: Nicholas Johnston, Washington Post Staff Writer
Monday, May 6, 2002
Venture capital investments helped drive the technology boom during the late 1990s, with the Washington region consistently reaping a major share of VC dollars invested nationally.
But those investments dropped off significantly in 2001 and into this year, as Washington Post staff writer Nicholas Johnston reported on May 1: "Venture capital investment in the Washington area fell in the first quarter to the lowest point in three years." The $234.6 million in 40 funding deals in the first three months of 2002 "was down 85 percent from the second quarter of 2000 and less than half the funding reported in the fourth quarter of 2001, when many thought the market was leveling off." The first quarter VC numbers were assembled by the PricewaterhouseCoopers/Thomson Venture Economics/National Venture Capital Association MoneyTree Survey. See also Johnston's piece in the May 6 Washington Post.
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We'll be getting started in a moment. Please keep your questions coming.
Nick, thanks for joining us today. Before we get started with questions from our readers, can you tell us what you found to be the most interesting or surprising venture capital funding development in the first quarter of this year?
Nicholas Johnston: Hello everyone. What really surprised people in the first quarter of this year was that levels of venture investing continued to drop. Particularly in the Washington area, where totals plummeted. The turnaround that many expected, particularly in light of the fourth quarter of last year when investment totals looked to be bottoming out, means that a lot of the industry's recent optimism was a bit premature. Times are still pretty tough, and there's a lot of uncertainty as to when things will recover and by how much.
What's happening to the time it takes to land the venture capital, from opening discussions to signing the deal? Are the talks taking longer, shorter, and why?
Nicholas Johnston: Deals that were being done in a matter of days during the boom can now take months. Competition for deals has decreased, so there's a lot less pressure on investors to hurry up. And venture capital due diligence has become excruciating, even for experienced and established companies. Investors want to be completely sure that they've checked out all aspects of a deal--from the management's background, to possible competition to the size of the market. They want a reason, any reason, to say no, when before they wanted reasons to say yes.
How has the number of venture capitalists changed? I assume there are fewer, but has the number dropped significantly?
Nicholas Johnston: Venture capitalists don't die, they only fade away. There will be far fewer venture capitalists doing deals next year than there are now. Everyone agrees on that and expects a major shakeout. But venture firms don't go bankrupt. They can keep right on cashing checks from their management fees, sometimes for as long as a decade. Look for firms that have been unable to raise a new fund, or have started to lose partners. That should be happening a lot over the next 12-18 months. It's just now starting.
It seems like it's the same spin from the VC industry every quarter -- we've hit bottom, things are looking good for the next quarter. From where you stand, do you think the industry is looking at any growth at all in the short-term?
Nicholas Johnston: I got the sense this quarter that the spin had changed--for the last three or four quarters venture investors all had the same answers: we're working on portfolio companies, this is a cyclical business, we've got lots of extra cash to invest, don't worry things are fine. This is the first time it seemed like venture capitalists don't know what's going on. This cyclical downturn is worse than any other, lots of firms are going through tough generational changes and their actually might be too much money in the industry. And in the short term both returns and investment activity will be low.
Biotech, biotech, biotech. All we hear about the local VC scene is biotech. But I just don't see lots of $ going to biotechs. Why the hype?
Nicholas Johnston: How about nanotech, nanotech, nanotech? That will be the next big thing at all the cocktail parties.
But with complicated science and 10 year drug research programs for instance, it was never really realistic for biotech to make up for the decreases in IT investment. And particularly in the Washington area there is not a very mature and large community of biotech investors. Funding for those kinds of companies has gone up recently, but are still a small part of total dollars. Venture capitalists, as they often admit, have an unfortunate herd mentality. Just wait for nanotech.
Nick: What is the state of corporate venture capital in the region as opposed to that portion handled by traditional VCers?
Nicholas Johnston: Corporate venture was the first to go. A lot of companies saw corporate venturing as a way to make a quick buck on new technologies--many were the quintessential momentum investors that came late into venture capital. Most of those are now gone, and though I'm not familiar with the Boston area, very few investment dollars are coming from corporations in the Washington area. Anyone heard from PSINet's giant venture fund lately? Exactly.
But firms that have had a consistent and long term track record of venture investing are still involved. Investors from Intel, for instance, have been lurking around the DC area lately.
What is the average rate of return on VC investments? What percentage of VC investments make money?
Nicholas Johnston: According to the National Venture Capital Association, venture investments have returned an average of 18 percent or so over the last 20 years--that's compared to anywhere from 8-10 percent for the stock market. Those venture returns, however, are averaged over an entire portfolio, so maybe one company returned 10 times the money invested, four companies broke even, and the other five went out of business.
In a typical first round of VC funding, what percentage of a company's ownership does the VC investor acquire?
Nicholas Johnston: It varies widely depending on a number of factors, but investors don't want to take too much equity--some needs to be saved for follow on rounds, and a good chunk should be saved for the founders and employers to give them a chance too at a big payoff. But about half of the company can be turned over in a first round of funding.
Tysons Corner, Va.:
In your all reporting of VCs over the past year or so, what's been the most eye-opening aspect of the industry that you've come across? The shear amount of the deals? The way deals are done? etc.
Nicholas Johnston: It's how involved venture capitalists are in the companies they back. They like saying that they are "more than just money," and it's easy to dismiss that. But when a partner commits his firm to a company, he's committing a lot of himself as well. The common view of private equity investing is one of detached financiers. That's not the case with venture capitalists. They know their entrepreneurs very well and work far more closely with them than I thought when I started this beat.
Are you still hearing that VCs nationwide are sitting on billions, waiting for the business climate to improve? Or is the VC industry facing a funding famine?
Nicholas Johnston: That's a really good question. Look for a story on this (hopefully) in the next week or so. For the last year many VCs have been bragging about all the "dry powder" sitting on the sidelines waiting to be invested; an $80 billion sign of the industry's health. Now, funds are returning capital and I heard that at the industry's conference last week in San Francisco that all the extra money is now one of the biggest problems facing the industry. It's unclear now what all this extra money means.
What VC firms in the region are feeling the most pain? Name names!
Nicholas Johnston: I'm only as good as my sources. How about you guys tell me? firstname.lastname@example.org.
My partner and I have started up a company and were wondering what are the prospects of obtaining VC for our company. Does the fact that we are a tech company hurt our chances, even though we cater our product to a traditional, non-tech client base?
Nicholas Johnston: What you should do first and foremost is decide if venture financing is even something you need. Early stage venture capitalists are always complaining that start-ups feel that they HAVE to have venture capital to succeed. That's ridiculous. Only a very small percentage of start-ups successfully raise venture capital. Before even considering venture investment, look at other possible ways of funding your company. And just build your business. You're best off then (and can drive a better deal) if then venture capitalists come to you.
Has the venture capital industry taken any position on two of the hot topics in today's business world -- accounting firm independence and disclosure and accounting for stock options?
Nicholas Johnston: I'm not sure where the industry comes down on accounting firm independence, but concerning stock options the NVCA is vehemently opposed to proposed changes to the accounting of stock options. Venture capitalists see stock options as intrinsic to the success of their companies--that's how cash poor start-ups reward good employees and attract top management. The industry said that the proposed changes could have disastrous consequences for venture backed companies. Lucky for them, it seems the changes don't have much hope of survival in Congress.
Why does the Washington Post business section spend so much time covering the increasingly irrelevant regional venture capital industry? Perhaps it could actually spend time covering profitable companies that matter, such as those in the government IT sector.
Nicholas Johnston: Even after falling nearly 80 percent, I would hardly call a quarter of a billion dollars invested in local companies over three months ($2.7 million a day!) irrelevant. We have people at the Post who cover government contracting and profitable IT companies too.
After your investigating over the past few months, what do you think the mood will be like at the MAVA venture capital event later this month?
Nicholas Johnston: Capital Connection is usually a great event, and probably certainly more optimistic than the investing community at large because it's filled with investors looking to do deals, and the cream of the local start-up crop, picked specifically because they're attractive to venture investors. Even last year's event, in the midst of the industry's meltdown was a good time, and handful of presenting companies snagged funding after it (though I think a few others have gone under).
What's the payday for investors these days? Obviously, the lure of the IPO was out there before the bust. But what attracts investors to risk their money? That a company will sell at a premium?
Nicholas Johnston: Well, that's the catch. Lots of VCs were expecting the IPO market to rebound sometime this year. No longer do they believe that. And up-value acquisitions are also off--right in line with the public markets. Just remember, though, that most venture partnerships are 7-10 year affairs. And with that kind of time on their hands, they can afford to wait. The days of the 18 months from A round to IPO are long gone. And they are not coming back.
(except, of course, for nanotechnology--you heard it here first)
Having spent some time with venture capitalists, I'm wondering what you think of them as people?
Nicholas Johnston: I've actually been very surprised at how open and interesting most of them have been. The expectation is that they are very distant and wealthy and not too interested. But (and all this affection I'm showering on them can't hurt next time I call one about a bad deal), I've found them to be fascinating. They've been surprisingly open to me, allowing access to deals, as well as being very free with the thoughts on what is happening in their industry. And their whole job, pretty much, is really just to take giant piles of money and give them to really smart people with good ideas. What could be more fun than that?
(well, following them around and asking questions about their business runs a close second)
2000 was the record year for VC investing. Was 2000 an aberration, or do people in the industry really think that they'll surpass that level at some point in the near future?
Nicholas Johnston: Without a doubt 2000 was an aberration. A fluke. A bubble. Not normal. Investors, in fact, like to call the last couple of quarters "a return to normalcy." Just do the math: $100 billion plus invested in 2000 at an 18 percent annual return? Well, I can't do the math, but in a couple of quarters at those rates you've got to be creating a company the size of Microsoft every few months. Venture capital would take over the world! Fortunately, investment levels have dropped to a more sensible level. Where they will stay.
What's going on with the angel market? Has that all dried up?
Nicholas Johnston: It seems that way sometimes. Levels of angel investment are even harder to track than normal venture capital investment, so the sense of the market is almost completely anecdotal. And in the last year the anecdotes have been brutal. Angels are not investing other people's money. They're investing their own. And recently for them it's come down to either remodeling their kitchen or putting $50,000 in a start-up. I would think that local angels have been cooking in very nice kitchens lately.
Paula Argento, Corporate and Venture Attorney:
Nick, what prospects do you see for reorganization and restructuring opportunities in the area, and also what do you think about companies reaching out to foreign investors?
Nicholas Johnston: I would think that most venture backed companies are so small, that a restructuring or reorganization isn't really in the cards. Usually, a start-up will just be shuttered and investors will try to recoup as much as they can by selling the IPO.
There have been a handful of deals locally that were led by foreign investors, but I've rarely met any of them. They're a whole different ball game from local investing, one I wouldn't try without experienced help.
Falls Church, Va.:
Do VCs bother with "small" business ideas, where a funding amount would total only several hundred thousand dollars?
It seems all the focus in this session today have been on millions and billions of dollars, but what about the small fry?
Nicholas Johnston: You've kind of got the question backwards. It not so much a small investment, but the size of the return. A $100,000 investment that yields a $300,000 return is pretty good. But not for a $150 million venture fund. Most of their investments are larger because they have to generate larger returns to make the economics work. Sometimes they'll make tiny investments like that of a couple hundred thousand dollars, but they do so expecting a big payoff.
The small fry, then, is left to try with angel investors. Um. How about a Small Business Administration Loan, actually?
Today's Washington Post reports that some funds are actually giving money back to investors because fund managers don't believe they can effectively invest all the money they've brought in. Would this perhaps create more opportunities for start-ups whose funding requirements are in the seed, angel, or very early stage (i.e. not VC)?
Nicholas Johnston: I wouldn't think so. Because that money is not being returned to people who are likely to put it in even earlier stage investing. Most of this money is coming from giant institutions. When they reallocate their investment portfolios, they don't make angel investments, then buy $5 billion worth of corporate bonds.
Are VCs more or less willing to fund a second round? Are they putting less up front and providing some more later to see how the company may perform for awhile?
Nicholas Johnston: Funding in 'tranches,' as they call it, is definitely cropping up more in some rounds. A VC will close a $9 million round for a company, but the start-up just gets 3 million up front, and two other $3 million chunks when certain milestones are hit. The use of these rounds varies from fund to fund (some don't like putting that kind of pressure on companies, others like those kinds of checks). Second rounds are also getting a bit bigger, as investors want to give companies enough cash to survive for up to 18 months.
In general, I'm of the opinion that so much in tech over the past decade or so has been "technology in search of a market" versus "a market in search of technology."
In other words, most VC money has gone to companies that make something "cool" versus solving a concrete market need. For example, 95% of .coms, software and "wireless" technologies were interesting in their own right, but really don't address a serious market need.
Do you see this changing? Are there companies actually creating products people need, or is it still a bunch of geeks excited about technology for technology's sake?
Nicholas Johnston: That's definitely changed. If your technology does not have a defined market where the venture capitalist can call someone up who will say "Yes Bob, I will PAY MONEY for this product and or service," you will be hard pressed to raise venture financing. There are still a bunch of geeks excited about cool technology (that's what it always is), but the geeks now know purchasing managers who will pay for the cool technology.
Looks like we're out of time for today. Thanks everybody for stopping by, and if you've got tips or news on venture capital or local venture-backed companies, don't hesitate to drop me a line at email@example.com.
And remember: nanotechnology.