Raising the bar

Signaling tougher new standards by limited partners, just eight new venture funds were raised in the third quarter, the lowest total for new funds in four years.

Overall, U.S.-based VCs raised $6 billion for 59 funds during in Q3, down from 83 firms that raised $9 billion in Q2, according to Thomson Financial (publisher of VCJ). The number of funds is also lower than the 68 that raised $5.5 billion during the third quarter of 2006.

“A lot of LPs are still committed to VC, but they are less likely to take risks,” says Fred Wang, a general partner at Trinity Ventures. “Funds that have track records get more money than they know what to do with. Others, those without a track record, are having a tough time.”

Nobody knows that better than lawyer Bill Campbell and John Miner, the former president of Intel Capital. The two raised a $2 million venture fund during the third quarter to invest in only one startup. The two plan to raise a second fund under the Altien Investors’ moniker to invest in another startup over then next year.

The unusual structure allows the nascent firm to get experience and build a track record that it can put in front of LPs. “The institutional investors who we spoke with were intrigued with both of our backgrounds,” says Campbell, who has worked with startups as an attorney for 30 years. “But that’s different from a track record. They said they’d be interested on fund three.”

Even funds that have been around for a long time are getting more scrutiny from LPs. For example, 18-year-old Hummer Winblad Venture Partners closed on $183.5 million toward a $200 million sixth fund in Q3. The new fund will be less than half the $424 million Hummer Winblad raised for its fifth fund in 2000. The firm admitted that some of its LPs didn’t return due to the poor performance of its fourth fund, which was raised in 1999.

A lot of LPs are still committed to VC, but they are less likely to take risks.”

Fred Wang

The tougher LP standards are good for the industry, says Gerry Langeler, a managing director at OVP Venture Partners. “The business now appears appropriately hard,” he says. “There are people saying it’s too hard and we should all get out of the business. It’s a wonderful thing they’re saying that because it scares off the people who aren’t serious.”

By Langeler’s estimate, the industry is about half the size it was during the dot-com boom. In 2000, 1,156 different firms made at least one new investment, but that number fell to 597 last year, he says. (See Langeler’s column on the subject in the October issue of VCJ.)

Fewer funds helps winnow down the number of startups addressing the same limited market niches. Wang says he saw too many companies getting funding, even in 2004. “When we started looking at the video and photo sharing market three years ago, we came across 140 companies that were some sort of version of the two,” he says. “That was a very crowded market.”

A fund-raising slow down should help bring valuations back in line with historical norms. Langeler crunched the numbers for OVP’s sixth fund just to see what the valuation trend looked like over time. “We had the lowest pre-money values in that fund that we’d had since the 1980s,” he says. “You had to go back to fund two to find valuations at the same levels. At least we know that the economics are right going in.”

Most experts recognize that venture fund-raising goes in cycles. The dot-com boom helped make those cycles more pronounced. “Everyone got on the same page after the bubble,” Wang says. “There were a lot of funds that held off during the 2002-2003 time range.”

Those funds are likely to be investing now and then back out on the market again in several years. “You might see a relatively light 2008, then somewhat of a resurgence in 2009 and 2010,” Langeler says.

There are people saying [VC] is too hard and we should all get out of the business. It’s a wonderful thing they’re saying that because it scares off the people who aren’t serious.

Gerry Langeler

Third-quarter recap

Venture firms investing at the earliest stages accounted for more than a third of the fund-raising total during the third quarter, reversing a trend toward growth stage investing that looked strong in the second quarter.

Of the 59 funds raised, 18 seed and early stage vehicles raised more than $2 billion. The number would have been higher if several traditionally early stage firms had not moved into balanced stage investing. “There seems to have been a recent trend of firms going to later stage funds or from early stage to mixed or multi-staged,” says Langeler. “By the time you see a trend, it’s probably too late for it and maybe that’s a caution flag to show that there’s good reason to stay focused on your investment thesis.”

A handful of firms succumbed to stage creep during the quarter. Ignition Partners, known for its early stage investments in the Pacific Northwest, announced it had raised its first fund dedicated to growth deals. And Mohr Davidow Ventures raised $580 million in September, which was 45% larger than the $400 million fund it raised in 2005.

Other large balanced staged funds to close during the quarter include Battery Ventures, which raised $750 million for fund VIII, and Bessemer Venture Partners, which raised $625 million for fund VII.

Still, the balanced stage funds might be filling a necessary gap. “Early stage and Series B investors are doing better than they were a couple of years ago,” says Granite Ventures Managing Director Len Rand. “Getting a Series B done at anything other than a down round was nearly impossible.” More money in the category may help ease that downward valuation pressure.

Early stage and Series B investors are doing better than they were a couple of years ago. Getting a Series B done at anything other than a down round was nearly impossible.”

Len Rand

Growth investing has become increasingly popular among many VC firms, especially those that have had success investing in other stages. Sequoia Capital may have kicked off this trend during the last boom. It raised the $350 million Sequoia Capital Franchise Fund targeted at growth stage opportunities in 1999 and has raised a handful of growth funds since.

Other early stage players have added growth investing to their mandate since then. Draper Fisher Jurvetson has finished raising a $300 million growth fund, and North Bridge Venture Partners closed $545 million toward its first $550 million growth fund during the second quarter.

“Some funds have become asset managers,” says Wang. “Because they have access to assets, they go ahead and raise a fund and then figure out how to put it to work.”

LP interest in growth funds has likely perked up because the performance of those funds has improved over the past year. Balanced stage funds returned 25.4% and growth funds returned 23.5% between the first quarter of 2006 and the first quarter of 2007, according to the latest performance index by Thomson Financial.

Still, early stage funds still hold the best record of returns over the past 10 years, returning an average of 40 percent. It’s hard for LPs to ignore that figure, even when recent results haven’t been so hot.

“The surprising thing to me is that [the venture market] hasn’t corrected more,” says Wang. “Some LPs are getting more conservative, but there’s still a lot of capital out there.”