VC Funding Remains Tight

Venture capital funding for tech companies is bouncing back modestly from what appears to have been a low point late last year.

While VCs are circling companies in such hot growth areas as mobile communications, software-as-a-service and green technology, they are taking a more disciplined approach to investing than years past.

VCs invested a paltry $17.7 billion last year, the lowest level since 1997, representing a sharp 37 percent decline from the $28 billion invested in 2008 and $30 billion in 2007. The figures were released earlier this month by PricewaterhouseCoopers, which published its 15th annual MoneyTree Report.

The report, based on data compiled by Thomson Reuters, showed that funding started to plummet in the fourth quarter of 2008, when the overall economy went into a freefall on the heels of the collapse of Lehman Brothers and AIG. In concert with last summer's recovery, VC funding picked up incrementally in the third quarter, though dropped nominally in the fourth quarter at $5.1 billion and $5 billion respectively.

In a presentation of the report at the March 18 New York Technology Council meeting, PwC partner David Silverman said the market for VC funding and successful exit strategies remains depressed. "I wish I had better news, the venture capital industry followed the overall economy and declined fairly significantly," Silverman said.

"Things are a bit rough out there," said Pimm Fox, anchor of Bloomberg TV's Taking Stock, who moderated a panel discussion of five VCs and the CEO of a company that received funding from one of the firms following Silverman's presentation.

VCs funded 2,795 rounds last year, compared with 3,985 in 2008. Median deal sizes were also down. The average round at $2.8 million last year, compared with $3.3 million in 2008 and $3.8 million in 2007.

So what types of companies are getting the big money? Biotechnology firms got the most last year, $3.5 billion, down 19 percent. A total of 619 software companies received $3 billion in funding last year, down 40 percent.

More than 200 IT services firms received a total of $1.1 billion, down 41 percent for the year. Among other areas: 118 semiconductor firms received $772 million, down 53 percent and 140 telecom companies received $559 million, down 67 percent. The one area that seemed to see the lowest decline were companies that offer networking gear, where $716 million in funding represented a mere 5 percent drop covering 93 deals.

Also over the last year, the study found a shift from later stage companies to earlier stage companies, Silverman said. Investments in later stage companies comprised of nearly $6 billion with 799 deals, down 44 percent over the prior year. Companies receiving expansion funding dropped 47 percent with $5.4 billion allocated to 801 businesses. Early stage funding dropped only 13 percent covering 883 companies for a total of $4.6 billion, though it jumped 32 percent in the fourth quarter, compared to the prior year and up 51 percent from the prior quarter.

"After the tech bubble, we saw a shift going into later stage companies by VCs away from the early stage and only recently have we begun to see a reversal of that trend," Silverman said. "That's good news for companies that are forming young, early stage companies that VCs are beginning to look at them again. We see the same or similar trend for the full year."

Ryan Ziegler, a principal at Edison Venture Fund agreed, saying his firm takes a more practical approach to investing. "We're very disciplined about how we think about creating enterprise value in terms of where we come in to purchase price as well as where we exit," Ziegler said during the panel discussion.

Those seeking funds are seeing higher scrutiny of their business models. "There's less willingness to let it ride now than there used to be," said Vytas Kislieulius, CEO of Collections Marketing Center, a software-as-a-service startup that runs a collections exchange. VCs are looking more closely at the customer sets of the companies they are considering investing in, Kislieulius added. "It takes so much more proof that there's a real market and that there's real customers."

Ziegler said he sees a funding gap between early stage and late stage investors. "Priced right, we can get great entrepreneurs that are typically in between $3 million and $20 million levels, growing those businesses to 30 and 50 and beyond and selling for a multiple of revenue beyond that.  You are still creating venture returns."

Perhaps the worst news from the PwC report was the state of exits. Though IPOs doubled last year over 2008, "it's still at a paltry 13," Silverman said. "That's not a number that's going to be sustainable to bring us back to the levels of venture investment that we saw in prior years."

That's the primary issue, said Hudson Ventures managing director Bill Carson. "Exits are the lifeblood of VCs, because if you don’t get them then you can't get the next one," Carson said.

Many are hopeful that the IPO market will pick up this year. "There's been a little bit of a glimmer of hope in the IPO market but it just hasn’t sustained that momentum yet," Silverman said. "There's an increased number of companies that are registered to go public and this just hasn’t happened in great numbers yet."

On the M&A front, deals were also down -- 262 last year compared with 348 in 2008. However, the average deal size was up $144 million, compared with $115 million. The good news, Silverman said, is that this year is trending toward a marginal increase. Based on the last two quarters, VC funding could bounce back to $20 billion, he said.

The survey did not take into account the growing presence of angel funding, Silverman said in an interview, "You are seeing the early stage angel investors come in and filled the need for funding."

About the Author

Jeffrey Schwartz is editor of Redmond magazine and also covers cloud computing for Virtualization Review's Cloud Report. In addition, he writes the Channeling the Cloud column for Redmond Channel Partner. Follow him on Twitter @JeffreySchwartz.