Investment Pace Starts To Return To Normal –

After more than two years of holding back on new deals because of too few exits and too much time spent with troubled portfolio companies, venture capitalists were pleased to see the return of a competitive deal-making environment in 2004.

They invested nearly $21 billion in U.S.-based companies last year, eclipsing the $18.9 billion total for 2003, according to the MoneyTree survey conducted by PricewaterhouseCoopers, Thomson Venture Economics (publisher of VCJ) and the National Venture Capital Association. It was notable, however, that Q3 and Q4 fell short of the pace set in Q2. After a big second quarter, when they put about $6 billion to work, VCs invested $4.6 billion in Q3 and $5.3 billion in Q4. The decline contrasts with the previous year, when the amount invested in Q4 surpassed the amount in Q3 by more than $1 billion.

While the numbers show a slowdown in the second half of the year, most VCs say they have been quite busy and that business is getting back to normal. “Last year was different from 03 and 02 in that a large percentage of the deals we did had other venture investors looking at them and being more competitive,” says Michael Brooks, a general partner with Venrock Associates.

“[It] was a year in which the venture industry got back on track,” says Peter Barris, managing general partner of New Enterprise Associates (NEA). “It was clear that activity levels were high on both the fund-raising and disbursement sides of the business.”

NEA led the Top 10 most active investors for the second year in a row, doing 70 deals. Coming in second was Draper Fisher Jurvetson (55 deals), followed by Intel Capital (50 deals). The other seven on the list were U.S. Venture Partners, Sequoia Capital, Polaris Venture Partners, Venrock, Oak Investment Partners, Menlo Ventures and Mobius Venture Capital.

The biggest surprise on the Top 10 was the appearance of Oak. It grabbed the No. 8 spot with 41 deals, up from the No. 77 ranking with 16 deals in 2003. Partners at the private equity firm, based in Westport, Conn., declined to explain the ramp up in deals. It may be related to its close on a new fund, $1.5 billion Oak Investment Partners XI. Oak also stood apart from the other most active venture firms in that it did no life science deals. It funded six companies in the optical space, including BigBear Networks, Mahi Networks, nLight Phontonics and Wave7 Optics. It also invested in Internet companies, such as eStyle and

Three other VCs were new to the Top 10 list: Sequoia Capital (which went from No. 24 in 2003 to No. 5 last year), Menlo Ventures (from No. 14 to a tie for No. 9), and Alta Partners (from 39 to a tie for No. 9).

Sequoia, which is watched closely because of its historically strong returns, did 44 deals, considerably more than the 29 it made in 2003. The firm’s partners prefer to stay mum on their areas of interest, but a look at the list of deals shows that they’re hot and heavy for the Internet. Net-related deals made up the largest number of Sequoia’s deals (nine), outpacing traditional segments like enterprise software (eight deals) and chips (seven).

In general, VCs say there is still plenty of room to invest in the Internet. “The Internet market has grown vastly from where it was and we have barely scratched the surface with what will be possible in the future,” says Heidi Roizen, a managing director with Mobius Venture Capital. “One only needs to look to countries where broadband infrastructure is greater than ours: Uses become different and applications become expanded.”

The renewed interest in the Internet intersected with another hot segment in 2004: consumer-related deals. In one of the biggest rounds of the year, Sequoia Capital and the Fayez Sarofim Investment Partnership pumped $110 million in a Series B for online dating site

USVP General Partner Winston Fu says he expects to see a significant number of consumer deals this year. “Things are generally more consumer-ish,” he says. “The general infrastructure is still the same. The end users and end use is much more consumer oriented. That’s just a general trend. With enterprise customers, the budgets aren’t growing as fast.”

Hyperactive investor Intel Capital took the lead on consumer deals last year, earmarking $200 million for its Digital Home Fund. The Santa Clara, Calif.-based chipmaker used the new fund to make at least a dozen investments in companies like Wisair, an ultrawideband chipset maker; Trymedia, a PC game distributor; and Zinio, a digital magazine distributor. “A lot of the activity in 2004 was plumbing, because we’re at the early stage of getting the infrastructure into the home,” says Scott Darling of Intel. “What will be different in 2005 is that people will be moving up the stack. They’ll be focused more on services and applications.” One area of particular interest for Intel in the New Year is digital video.

For many VCs, the most important trend in 2004 was the emergence of the Asian markets. “Although I suspect the absolute dollar flow is still relatively modest, there is no doubt that a number of U.S. venture firms are getting their feet wet in the China and India markets in particular,” says NEA’s Barris. His firm did several deals in China, mostly in the semiconductor space. “I don’t think you will see a surge in dollars committed to China and India in 2005, but rather a gradual build-up over time as firms figure out the best way to address the opportunities in those markets.”

As much talk as there was about Asia, the Internet and consumer deals, VCs largely stuck to the same large sectors of interest. Software was the biggest segment, with 862 deals totaling $5.05 billion, for 24.13% of the total. It was followed by biotech, which had an 18.27% share with 328 deals for $3.83 billion, and telecom, which had an 8.86% share with 231 deals totaling $1.85 billion. The top five sectors were rounded out by medical devices/equipment (250 deals totaling $1.82 billion for 8.68% of the total) and semiconductors (202 deals worth $1.63 billion for 7.79%).

As for investment stage, there was still no significant increase in the number of brand new deals. Last year, late-stage and expansion-stage deals accounted for 80% of venture funding, compared to 20% for seed-stage and early stage deals. That was unchanged from 2003. However, things seem to be trending toward the center, with both early stage and later-stage deals increasing their shares of the pie over expansion stage and seed-stage. Later-stage increased its share of venture funding last year to 32%, up from 26%, while early stage deals accounted for 18.3% of the total, up modestly from 17.8% in 2003. Expansion-stage deals, which accounted for more than 54% of venture dollars invested in 2003, dropped to 49% in 2004.

There is no consensus about where seed- and early stage deals are headed. A partner from one of the 10 most active venture firms says he expects those deals to be flat or increase this year. He notes that entrepreneurs who self-funded their companies in the downturn are now coming to the market.

“Over the past few years the early stage deals have been a bit more challenging, especially in that second round,” says Warren Packard, a managing director with DFJ. “You can certainly see people moving away more from early stage deals and gravitating toward later-stage deals.” For its part, DFJ has maintained its focus primarily on early stage deals. “It’s not overcrowded and may be underserved to a certain extent, and we feel that heightens our value,” Packard says.

“If you can build a good company and make a good pitch you’ll get a bunch of venture investors coming after you,” Packard adds. “The whole environment feels pretty good, but there’s not a hubris mixed into the equation.”