Early-Stage Surge Is No Cause for Celebration –

Don’t believe everything you read.

One of every four investments in the second quarter was a Series A round, but the number of early-stage deals is not on the rise. Many of them are a decade old or headed by entrepreneurs with long histories of success. Others are spinouts or mergers. Most have a product on the market and some degree of customer traction. And some are reporting annual revenue of $4 million.

Few fit the two-guys-in-a-garage stereotype. “People are not investing in two guys in a garage you’ve never heard before,” says the man whose firm was built on those deals, Palo Alto, Calif.-based Garage Technology Ventures’ Guy Kawasaki.

During the second quarter, more than 150 companies reported raising their first round of venture capital, bringing the total number of companies that have raised their first-ever round of venture capital this year to nearly 300, according to the PricewaterhouseCoopers/Thomson Venture Economics/National Venture Capital Association’s quarterly Money Tree Survey. Together these first-timers raised $1.45 billion in the first half of the year with software companies attracting the most attention.

Although the level of venture capital investment has been declining steadily in recent years following the economic recession, the drop off has been most pronounced among early-stage investors. In 1999, for every dollar spent on new financing, $2.50 was spent in follow-on financing. In 2002, for every dollar spent funding new companies, $4 was spent financing follow-on deals. Today, seed-stage companies account for just 2% of all the startups raising venture capital. Early-stage venture capitalists say that trend is likely to continue for at least another year.

“The market dictates reality,” says Roger Novak, founder of Bethesda, Md.-based Novak Biddle Venture Partners. “I’m after projects and companies that are capital efficient,” he says. “We’re looking at where venture capital will be used as a catalyst, not a launch pad.”

Companies that can use venture capital as a springboard are expansion-stage companies. In the second quarter, 325 expansion-stage companies raised more than $2.25 billion for an average deal size of more than $7 million. In comparison, early stage companies received an average deal of less than $5 million. With long customer histories and profit figures in sight, expansion-stage companies use venture capital to propel them into new markets, whether they are technology deals or in the life sciences sector, not to get ramped up as a startup would do with capital infusion.

For example, SterilMed Inc., a Minneapolis-based company that cleans and repackages used medical devices, closed its first ever round of venture capital in May. But the company closed the deal on its ninth birthday and is far from being a startup. The $10 million round-financed by Ascension Health Ventures, First Analysis, Prism Opportunity Fund and Sterling Ventures-is earmarked growth capital for a multimillion-dollar operation that has partnerships in place with hospital chains in Connecticut and Ohio.

RackSaver is another so-called early-stage company. The San Diego company has been building Linux servers for customers like special effects guru Industrial Light & Magic for more than a decade. RackSaver was self-financed until June, when the company secured $6.2 million in a Series A round financed by Celerity Partners and Voyager Capital. The veteran company already has annual revenue in the tens of millions of dollars. Armed with a sack of venture capital, it plans to double in size and attack new markets.

What’s happening is that venture capitalists are taking advantage of rock-bottom valuations to invest in companies that have past the research and development stage.

“It’s a worrying trend that the amount of seed capital has declined precipitously, and that the bulk of venture capital is going into late-stage expansion companies,” says William Bygrave, the Hamilton Professor for Free Enterprise at Babson College in Boston.

The technical risk makes a seed-stage deal as expensive for venture capitalists as an equity position in a company that’s already cleared major technical hurdles.

“It’s not just about proof-of-concept anymore,” says Maria Walker, an administrative partner with Forward Ventures in San Diego. “A company needs to have a technology that investors feel comfortable backing.”

Technical hurdles factor out of the equation completely when a company uses venture capital to finance a spinout or merger and then calls it a Series A round.

Comverge, the maker of a wireless device used to monitor and reduce residential power consumption, was a wholly owned subsidiary of Florham Park, N.J.-based software developer Data Systems & Software Inc. (DSSI) until December 2002 when Comverge secured a $2 million revolving line of credit financed by Laurus Master Fund Ltd. Four months later, in April, the company secured a $13 million Series A round with commitments from Nth Power Technologies, EON Venture Partners, Easton Hunt Capital Partners, EnerTech Capital and Shell Internet Ventures. DSSI still holds a 35% stake in Comverge.

Part of the reason expansion stage companies win out over startups when raising cash is that investors tend to believe they can mitigate risk by investing only with experienced and proven entrepreneurs.

Craig Malloy, founder of a, Austin-based video conferencing company acquired by a larger player in the same market, was mulling his options when he got a call from Norwest Venture Partners. Why not start another company, asked Norwest Venture Partner Vab Goel. Five years later, Malloy’s latest videoconferencing startup, KMV Technologies in Austin, has closed an $18 million Series A round in May with commitments from Austin Ventures, Norwest and Redpoint Ventures. Mallot’s new company, although labeled as early-stage, is far from budding thanks to the experienced founder and VC backing. KMV expects to have a product on the market within two years.

As Forward Ventures’ Joel Martin explains, the current three-year old downturn in the venture capital market has made investors too cautious to make risky bets with seed-stage companies.

“We’re absolutely not in the business of funding science projects,” he says. “We need to see a product.”

In June, Martin led Forward’s investment in San Diego-based Analgesix. It’s a company that exists only on paper. What Forward Ventures has done is create a holding company to fund the research of two University of California San Diego scientists. There’s no overhead or management costs. If the technology has promise, Forward will own claims to the intellectual property and will build a company around it. It’s a first for Forward, but Martin says the firm will likely use its investment in Analgesix as a model for funding seed-stage companies.

Overall, he says, the firm is trying to fund companies that are further along in product development. So, in other words, don’t expect the uptick in Series A deals to repeat at the end of the current quarter.

Meanwhile, Forward, like others, is holding more reserves for follow-on deals. The firm is taking larger positions in the companies that it funds, and it is also dividing its investments into multiple tranches.

These steps indicate that venture capitalists aren’t feeling ready to finance early-stage companies quite yet. Anecdotal evidence points in the same direction: Companies scoring Series A rounds in the third quarter have operating histories and management teams with track records.

Former Netscape CTO Erich Hahn brought his own brand of star power to a $7 million Series A round in July for ProofPoint, a Cupertino, Calif. anti-spammer he now heads. And Spring Street Networks, a 2001 Nerve.com spinout that has the technology to power online personals in New York, closed its first institutional round with $6 million in July. Boston.com and TheOnion.com are already customers.

Even Garage’s Kawasaki agrees. “Every venture capitalist today would say they need a proven team, technology and business model,” he says.

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