More VC Funds for Startups

December 05 / January 06 By: Eric Billingsley Volume 3 Number 6

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In the summer of 2004, Bryan Mistele, who heads a company called Inrix in Kirtland, Wash., wasn't getting very far in his efforts to raise a Series A round of venture capital. His company was developing software to deliver high quality, real-time reporting of traffic flow information. "Everybody (referring to venture capitalists) was interested, but they wanted to see the technology work," says Mistele.

Mistele shifted his game plan. He was able to strike a deal with Microsoft to spin out an existing, tested and already functioning technology to predict traffic conditions. The marriage of Mistele's original business model and technology with the existing and market-ready Microsoft technology caught the eye of investors immediately.

After only six weeks of fundraising, Mistele received his first term sheet from a VC firm followed shortly thereafter by five more term sheets from other firms. Inrix eventually landed a $6.1 million Series A round of funding in April 2005.

Mistele's experience may be indicative of the current venture capital climate: VC fund-raising and investments are on the rise. And according to investors there is increased interest in seed and early stage companies. However, VCs say they've not forgotten the dotcom bubble—€”the last major cycle of fund raising and investing—€”and are spreading investment dollars to a broad spectrum of industries and to companies with solid business models and, preferably, product.

"What we've seen in 2004 and 2005 has really been a steady leveling of investment dollars and fundraising," says Josh Grove, research analyst with VentureOne, a unit of Dow Jones Newswires and publisher of VentureSource. "We will definitely see more early stage investing due to the increased level of fund raising and still quite a bit in later-stage companies."

Venture Capital Cycles
Generally speaking, venture capital fund raising and investing trends are cyclical. The last major fund raising and investment cycle, the dotcom bubble, occurred in the late 1990s and peaked in 2000. After 2000, fund raising dipped steadily, reaching its lowest point in 2003. Investments also began a downward trend during the same period, likewise reaching its lowest point in 2003. Venture fund raising and investments have shown signs of a rebound since.

"Venture firms sort of ebb and flow when it comes to raising money," says Michael Brooks, general partner of Venrock Associates in New York, a firm that focuses a high percentage of investments on seed and early stage companies. "The message is clear that we're at a point where a number of funds have recently raised a substantial amount of money."

In fact, 27 venture capital firms raised $5.91 billion in the third quarter of this year, a 16 percent increase over the same period in 2004, according to VentureOne.

Much of the overhang—€”money that was raised but not invested—€”from the last cycle has been invested and many of the dotcom era companies have matured, according to Grove. The good news for entrepreneurs is that a new fundraising cycle typically means increased investments in seed and early stage companies. Total venture investments in calendar year 2005 are expected to meet or exceed the $21.7 billion invested in 2002, which is the highest level in the prior three years, according to the MoneyTree report by the National Venture Capital Association (NVCA), PriceWaterhouseCoopers and Thomson Venture Economics.

First-time financings of companies are expected to reach a four-year high in 2005. As of Q3, 69 percent of first-time financings went to startup and early stage companies. Investments in startup/seed stage companies also spiked in Q2 at $437 million, compared to $99.5 million in Q2 2004.

Hot industries/technologies
So what industries and technologies are receiving the benefit of this trend? Unlike the late 1990s, when a large percentage of money was invested into primarily internet companies, markets have changed and VCs are spreading their money around. The largest number of first-time financings in Q3 was given to the software and life sciences sectors, according to the MoneyTree report. First-time investments in telecommunications, largely related to the wireless sector, reached a four-year high. Media and entertainment and industrial/energy were also strong.

Mark Heesen, president of the NVCA, says most of the young companies receiving investments from venture capital firms are those who've previously landed a seed round.

The top five industries receiving overall venture investments are software, biotechnology, telecommunications, networking and equipment and medical devices and equipment.

Timothy Draper of Draper Fisher Jurvetson, an early stage venture capital firm, says his company is particularly interested in all forms of information technology and communications, peer-to-peer technologies, clean tech and nanotechnology.

Venrock's Brooks says his firm has invested in wireless and software security projects, material sciences such as nanotechnology as well as healthcare, including biotechnology and advances in the genome. He says about half of his firm's investments go to entrepreneurs that the company has worked with in the past.

According to Heesen there is increased interest in the energy sector but it hasn't taken off yet. "There are a lot of people kicking the tires but they haven't jumped in the pool," he says.

A recent article in Business 2.0 also noted that "consumer internet startup companies are again in vogue, [and] investors are pulling out their wallets when they hear the right combination of buzzwords: blogs, social networking, user-generated content."

Entrepreneurs are optimistic
Tim Healy, CEO and co-founder of Boston—€“based EnerNoc, which provides demand response technologies used by the power industry, spent nearly a year raising a seed round back in 2002. However, now that his company has product and there is more demand for energy related technologies, he recently raised a $7.75 million Series B without a problem. "I received four term sheets in a relatively short period of time," says Healy.

Some have questioned whether the current venture capital climate may be the start of another investment bubble. But NCVA's Mark Heesen says no. "Are we concerned about growing a frothiness here? The answer is absolutely not," said Heesen in the Q3 MoneyTree report. "There is simply not enough money coming into the asset class to support the kind of exuberance we saw in the late 1990s, and that's a good thing. That said, we are beginning to look more closely at early stage investment levels, which have not risen at the rate we would have expected."

Heesen says VCs are doing their homework prior to investing in companies. Generally speaking, following the dotcom bubble burst investors began scrutinizing companies more thoroughly before providing them with capital. Under the microscope has been the quality of management teams, business model and market opportunity, among other factors.

"The investment environment is much more disciplined," he says, adding, "VCs are often giving fewer dollars that need to last longer." He says this is a healthy sign. "The venture community could have raised more money than it did but we want to avoid the bubble scenario." He says investors are also spreading their money to a larger variety of industries.

Timothy Draper says the overall mission and investment strategy of his firm has not changed but the markets have changed significantly, which can affect the internal rate of return and investment horizon—€”the length of time one expects to keep a sum of money invested. "If we just focus on investing in what we believe is a great entrepreneur focused on an important mission, we think our investors will be rewarded," says Draper.

"Heesen anticipates continued improvement in early-stage investing over the next year. For entrepreneurs such as Bryan Mistele of Inrix, there's no better time than the present to start looking for the next round of funding. "At some point in 2006 we will likely seek out a Series B," he says.

Eric Billingsley is a freelance writer based in Albuquerque.