Q1 Decline Belies Steady Investment Pace –

Venture capitalists invested fewer dollars in the first quarter than some industry observers would have liked, but people inside the industry say that the small decline belies a healthy market and that venture-backed companies have as much money as they need.

While some attribute the decline to an increase in “stealth” rounds and overseas investments, others see the decline as a natural fluctuation attributable to a tighter exit market and an increase in early stage deals, which require less capital. Either way, there is a general feeling that the industry is well within a healthy range of deal volume.

One particularly bright spot was first-time deals, which totaled $1.2 billion in Q1, up from a quarterly average of $1.1 billion last year. Also, first-time investments accounted for 26% of all funding in the first quarter, compared to 21% for all of 2004 and the highest percentage since 2000. No one particular sector accounts for the rise in first- time deals.

Overall, 674 U.S.-based companies raised about $4.63 billion in the first quarter of 2005, according to the MoneyTree Survey conducted by PricewaterhouseCoopers, the National Venture Capital Association and Thomson Venture Economics (publisher of VCJ). That represents about a 14% drop in deal volume and a nearly 15% decrease in disbursement volume from the $5.44 billion raised by 776 companies in the preceding quarter. Compared to the first three months of 2004, the number of deals was flat but the total dollar amount invested was down by about 8% from $5.03 billion.

Putting Q1 into context, it was the 12th consecutive quarter of venture investing that fell in the range of $4 billion to $6 billion.

“Q1 always gives people a time to pause,” says Seth Rudnick, a general partner with Canaan Partners, an early stage technology and health care investor based in Menlo Park. “My sense is that deal flow is just as dense as ever.”

“I don’t think it’s a worrisome trend at all,” says Guy Nohra, a director with Alta Partners, a San Francisco-based health care and technology investor. “It’s guys catching their breath after a busy 2004.”

Life sciences investing dropped significantly in the first quarter. The sector saw 129 companies take in $1.08 billion, the lowest quarterly life sciences total in two years. The Q1 life sciences numbers were down substantially from the $1.6 billion that VCs put into 162 life sciences companies in Q4.

The drop in life sciences investing “was pretty much across the board in the biotech sector,” says Mark Heesen, president of the NVCA. “That’s actually a good thing. There have been some in the venture capital industry who thought that the biotech sector was heating up too much.”

Overall, life sciences-related investments accounted for 19% of all of the quarter’s VC deals and 23% of Q1 venture dollars.

Software remained the largest single investment sector, accounting for 24% of all invested VC dollars and 29% of all venture deals in Q1. A total of 198 software developers pulled in $1.1 billion in the first quarter. The related “IT services” sector reached a two-year high during the same period, bringing home $302 million, while telecom deals continued their decline.

A theory popular with the NVCA is that more venture deals are being kept in “stealth mode” and not announced or otherwise publicized. “When I have gone and talked to VCs and asked if they’re giving data the answer is no,’ that they are not letting out these early stage deals,” Heesen says. “They think they have the next eBay or Google and they want to keep things under wraps.”

The same argument was used in the third quarter of last year, when disbursement volume fell more than 23 percent. At that time, VCJ pointed out that the MoneyTree Survey in fact tracks stealth deals through surveys with confidential deal information that is included in quarterly totals but not broken out for individual stealth companies (i.e., no company or investor names are disclosed).

The venture community is divided over the impact of stealth deals. Deepak Kamra, a Canaan Partners GP who focuses on IT investments, says he hasn’t seen more stealth deals than in the past. “The bubble days saw a lot more of that,” he says.

The MoneyTree Survey reports 16 stealth deals in Q1, just two less than the total confidential submissions in Q4. It’s worth noting that stealth deals tend to be seed-stage or early stage, so even a large number of such deals wouldn’t have a tremendous impact on the quarterly investment total.

Late stage deals continue to dominate the number of deals and total dollars invested by venture capitalists. The first-quarter total of $1.8 billion for late stage was down from Q4’s total of $2.2 billion, but it was still the second-highest amount invested in more than three years. Similarly, while the 175 late stage deals done in Q1 were well behind the 210 done in the prior quarter, the Q1 total was the second-highest figure in the past four years. Michael Butler, chairman and CEO of advisory firm Cascadia Capital, says that the Q1 decrease in late stage deals contributed considerably to the overall decrease in disbursements.

Rudnick says he expects that the lagging IPO market will result in smaller late stage deals, as VCs plan on needing to fund companies for longer periods of time. “People are a little more cautious about funding late stage since the chances of converting to profitability through an IPO is weaker,” he says. “Late stage deals therefore are being funded for less and for longer periods of time.”

The number of early stage deals remains steady, but the amount invested in them continues to fall. Except for a surge to 231 in Q3 of last year, the number of early stage deals has been between 180 and 212 for the past 11 quarters. However, the total dollar amount going to early stage fell to its lowest point since the first quarter of 2003. The Q1 total of $752 million was substantially less than the $958 million invested in the prior quarter.

Industry watchers say demand for venture dollars is down because more venture-backed companies are managing to stay in the black. “We’re coming through some tough times and a lot of companies that have made it through these past years don’t need as much,” says Kamra of Canaan Partners.

Another explanation being offered for the drop in Q1 disbursements is that investors are spending additional time on international deals that don’t get tracked by the MoneyTree Survey. Venture firms are increasingly looking overseas for deals. Many VC firms have European partners or offices and are eager to break into the market in China as well as other parts of Asia.

“A lot of U.S. venture capital firms are starting to ask us about opportunities in London and Europe and Asia,” says Butler, who adds that Cascadia is considering opening a London office due to increased interest in Europe. “At the very least a lot of attention is being diverted away from the U.S. market to overseas and in all probability there is capital being diverted overseas as well.”

Additional reporting by Dan Primack.

Email: matthew.sheahan@thomson.com