Chip Deals Set Record Pace, Trouble Ahead? –

This may go down as the year of the semiconductor. Venture investors are on pace to blow past the record pace they set in 2000, when they pumped $2.6 billion into 156 chip startups.

VCs invested $805 million in 65 chip-related startups in the second quarter, bringing the tally for the first half of the year to 125 deals totaling $1.6 billion, according to original research by Venture Capital Journal. Venture capitalists are on pace to invest in excess of $3 billion in 250 chip-related startups this year.

There is no indication that the pace will slow. The second quarter surpassed each of the previous five quarters (see Table 1), as investors shoveled money into startups making fabless semiconductors, electronic design software (EDA), semiconductor materials and packaging, in addition to those that manufacture chips.

The most active venture firms in the second quarter of 2004 were 3i and TL Ventures, which each made four investments. Sequoia Capital, Smart Technology Ventures and Venrock Associates each made three investments. Twenty other firms made two chip investments apiece: Adams Capital Management, Allegis Capital, Arch Venture Partners, August Capital, Austin Ventures, Clearstone Ventures, Cordova Ventures, Doughty Hanson Technology Ventures, Granite Ventures, Hotung Capital, JatoTech Ventures, JK&B Capital, Kodiak Venture Partners, Mellon Ventures, Menlo Ventures, NEA, Smart Technology Ventures, Technology Venture Partners, and Walden International.

About 140 other VC firms made a single investment in the sector during the quarter.

Intel (via Intel Capital and the Intel Communications Fund) was the most active corporate investor with a total of five investments, followed by Samsung (via Samsung Corp. and Samsung Ventures) with two investments. It could be argued that Texas Instruments, which invests in semiconductor startups through Granite Ventures, should be included here with a total of three investments between Granite (two) and TI (one). Toshiba Corp. and Nokia Ventures each made a single investment.

While the amount of the average investment has remained about the same, at just over $12 million over the last six quarters, overall investments have shifted toward seed, A, and B rounds during the first half of the year.

The largest piece of the semiconductor investment pie is fables chipmakers. Forty-eight such companies took down $609 million in Q2, outpacing all other segments. The next largest investment area was EDA startups, eight of which pulled in $71 million.

When divided into technology sub-sectors one group dominates: communications. It accounted for 40% of all the chip investments in the second quarter. VCs are also showing increasing interest in processors. They funded seven companies in that sub sector, including startups creating re-configurable or re-programmable Systems on a Chip (SOC).

Three small sub-categories in Q1-sensors, biotech-related semiconductor startups and power management-fell off the map during Q2. Video, imaging, and sound-related startups also saw a big decline, falling by almost half. Storage remained about the same, although a close look shows that Q1 emphasized DRAM, static, or novel memory technologies, while Q2 saw a rise in money going to storage for network devices.

While they pour record amounts of money into chip companies, VCs can’t expect a quick exit from those deals in the public markets. SMIC (NYSE:SMI), which boasts the year’s largest venture-backed IPO, is trading at 30% below its offering price. Meanwhile, Atheros (Nasdaq: ATHR) is trading slightly below its initial price after a strong start and UltraClean (Nasdaq UCTT) and SiRF Technology (Nasdaq: SiRF) are both flat.

To make matters worse, the public market turned sour on chip stocks in July. Merrill Lynch issued a bearish report on the semiconductor industry on July 12 that prompted Wall Street to sell off shares in chip companies and other technology companies. NetLogic Microsystems (Nasdaq: NETL), was able to price at $12 a share on July 8, but the following day of trading it slipped to $10 per share. The network processor maker is backed by the likes of Sevin Rosen Funds, which holds a 10% stake in the company.

The bearishness raises questions about whether other chip startups in the IPO queue will be able to go public. Chip companies on deck include the following:

* Nextest Systems (proposed Nasdaq ticker :NEXT), a test equipment maker. Needham Capital Partners holds a 9.4% stake in the company and J&W Seligman holds a 7.83% stake.

* Memec (proposed NYSE ticker:MEC), a distribution services company. Permira Funds, a Schroder-related investor, owns 69% of the startup and Schroder Venture Funds U.S. owns 7 percent.

* Volterra Semiconductor (proposed Nasdaq ticker:VLTR), a maker of power management semiconductors. Kleiner Perkins is the largest venture investor in the company, with a 21% stake, followed by Invesco (10%), Morgenthaler (8%) and Integral Capital (6%).

* DisplayTech (proposed Nasdaq ticker: LCOS), a maker of micro-displays for cameras and camcorders. Its largest venture backer is Fleming U.S. Discovery Partners, which owns about 45% of the company. Fleming’s sole limited partner is JPMP Capital Partners.

* Ikanos (proposed Nasdaq ticker: IKAN), a maker of programmable semiconductor devices that deliver ultra-wide bandwidth data over copper. Sequoia is its biggest venture backer, with a 15% stake, followed by Greylock (11%), Walden (13%) and, Telesoft (10%).

M&A Yard Sale?

VCs appear to be faring better with mergers and acquisitions than IPOs for their chip portfolio companies. But, again, the results are mixed. Ten of the 18 M&A semiconductor transactions in the second quarter were for venture-backed companies. Of those 10 deals, only two were clear wins for VC backers, while many were clearly money-losing investments for venture investors and still other deals were quietly swept away from public scrutiny.

It was another banner quarter for new funds flowing to semiconductor startups. But as we begin another quarter it is looking ever more doubtful that semiconductor investments from the 1998 to 2001 vintage funds will be repaid. The bulk of exits from those vintages, the majority of which are coming from M&A exits, are not repaying invested capital, and the IPO channel is filling with deals whose long-term viability may be questioned. One has to wonder if and when VCs and their LPs are going to tighten the purse strings on this sector or whether it will continue to absorb ever-increasing amounts of money.