Decrease in First Rounds Could Signal Bad Times Ahead –

Forget the good news that venture investments increased in the fourth quarter. If you drill down into the data, you’ll find a disturbing trend that, history tells us, has far-ranging implications. That is, the proportion of venture funding going to first-round investments sunk to its lowest level ever in the last two quarters of 2001.

First-round deals accounted for just 16% of the total pie in Q3 and 18% in Q4, according to Venture Economics (VE).

You couldn’t have started a company in the second half of 2001 even if you were selling tomorrow’s winning lottery numbers. And, the relatively low attention paid to new companies may forecast long-term declines in capital invested in venture-backed companies and even declines in the industry’s returns.

VCs say they were too distracted by wounded portfolio companies to start new ones over the past six months. But, in fact, the portion of the purse that went to seeding companies has steadily declined since 1996, when 49% of venture funding went to fresh startups.

Just 193 companies received their first round of funding in Q4 2001, according to VE. That’s a raw number that hasn’t been seen since 1996.

The drop in new startups will definitely help slow the intake on the cumbersome pipeline of private venture-backed companies built over the last few years, and it may reflect the industry’s subconscious efforts to clean out the supply of venture-backed companies.

However, if VCs stop feeding the pipeline for too long, they won’t have any companies to buy at advanced stages of the funding cycle. In the past, declines in the portion of VC attention to new companies have led to general declines in money coming into all levels of the industry (see Figure 1).

Changes in first-round funding statistics have led trend changes in the amount of money invested in private companies by three-to-four years. With the ratio of first-round investments continuing to trend downward, VCs will continue to spend less overall on private companies for at least three years, if history is a guide.

The 1996 peak of 49% of funding going to fresh startups (point A1 in Figure 1) preceded the end of ever-increasing VC investments in private companies in 2000 (point A2). Before that, a 1990 increase in the first-round investment ratio (point B1) led to the 1994 start of the VC bubble (point B2).

If the last 20 years are any indicator, the rate of change of VCs’ overall investment activity will generally continue to decrease, and VE will be reporting more funding dips than increases over the next dozen or so quarters.

For a variety of possible reasons, venture funds perform better in years when a higher percentage of investments is made in first-round companies (see Figure 2). Maybe early-stage investments generally net better returns, or the correlation may indicate that VCs do better when they aren’t triaging wounded portfolios.

Whatever the case, this trend bodes poorly for vintage year 1999, 2000 and 2001 funds. Many people in the industry have already given up on the 1999 and 2000 vintage years, but we’ll have to wait until the second quarter to find out what the pundits think when VE releases updated year-end 2001 return numbers.

When the PricewaterhouseCoopers/Venture Economics/National Venture Capital Association MoneyTree Survey on investments by VCs came out in February, the pundits were quick to point out that VCs racked up their third most-active investing year ever in 2001. It all sounded so great that at first glance one limited partner interpreted a New York Times article to mean that the fourth quarter was wildly profitable for the industry.

“I don’t know of a fund out there that didn’t have write-downs of at least 25% of its portfolio in the last quarter of 2002,” says the LP, who has invested in hundred of VC funds.

Last quarter’s minor victory of stabilized investment numbers should not go unnoticed, but that slight uptick has absolutely nothing to do with returns and may not be sustainable if these charts are any indication.