Size Does Matter: Armed with more money to invest than ever before, VCs are increasingly backing later-stage companies –

Draper Fisher Jurvetson, the Redwood City, Calif. venture capital firm, closed its fifth fund last summer at $183 million – more than twice the size of its previous vehicle raised just two years ago. While the firm continues its long-term commitment to early-stage investing, with so much capital to put to work and just four general partners to manage it, the partners know certain concessions must be made.

“The math is pretty simple,” says Warren Packard, who was named a partner at the firm in September after nearly two years as an associate (VCJ, October 1998, page 20). “It becomes obvious that you can’t keep adding companies to your portfolio.”

Draper Fisher is not alone in its predicament. Limited partners have reaped extraordinary returns from venture capital funds, resowing the industry with their profits – evident in the record-breaking fund-raising pace of the past several years and the swelling size of the average VC fund. And as the size of venture capital vehicles balloons, it becomes increasingly difficult for early-stage specialists to commit the $1 million seed investment that was once an important part of their strategy. Clearly, deploying a $183 million fund in $1 million parcels would be unmanageable. Rather than see funds with 18 managers holding 10 board seats each in 180 companies, the other option – investing larger chunks of equity in a smaller number of companies – has become the new modus operandi for many VCs.

According to Venture Economics Information Services, a data provider affiliated with Venture Capital Journal, of the 2,692 companies to receive venture financing in 1998, only 1,045, a little more than one-third, were classified as early-stage. Which seems to raise the question: Is early-stage investing – once the high-risk, high-return hallmark of the venture capital industry – a dying art?

Not necessarily, say many industry insiders. While it is clear that the venture industry has changed dramatically in the past decade or so, its core mission remains the same: To finance companies that will change the future. And while VC money is often not the first significant investment in a promising start-up these days – angels have been able to invest more capital than ever before, financing companies whose capital requirements fall below what VCs can handle – the industry has found ways to stay true to its purpose. Being a VC generalist has gone the way of the dinosaur; instead, specialization, localization and a more sophisticated approach have secured the VC’s place on the ground floor of the most explosive and important industries today.

Hell’s Angels

Venture capitalists invested a total of $16.02 billion in 1998, a nearly $2 billion increase from 1997 and a more than $6 billion jump from 1996. The steady increase in the amount of capital VCs are putting to work is a direct reflection of their success in fund raising. With returns to limited partners hovering just below 50% for the past several years, VCs have had little problem retaining old investors for new funds or attracting new money.

VCs are not the only investors to be burdened with a lumpy wad of cash under their mattresses. Angels – high-net-worth individuals who invest in seed-stage companies – have become more abundant and more savvy as a result of a decade of prosperity. While such investors used to put out no more than a few hundred thousand dollars at a time, groups of angels, or particularly successful individuals, have lately been able to commit more than $1 million a pop, a sum once reserved for professional investment firms.

Tech Coast Angels, an angel investor network founded by former venture capitalist Ken Deemer, is one of the multitude of such groups to emerge in recent years. Mr. Deemer is a former general partner of the now defunct InterVen Partners in Los Angeles. After the firm wound up its activities several years ago, Mr. Deemer founded Tech Coast to continue his own investment activities and to encourage co-investment opportunities for investors like himself.

The gap between what a venture capitalist considers a minimum investment and the seed capital requirements of many start-ups is certainly widening, Mr. Deemer says. And funding sources like his are there to take advantage of the opportunities that arise from that gap. While angel networks do not constitute a formal pool of money – individual investors decide whether they are interested in deals on a case-by-case basis – Mr. Deemer says that some experts predict that the amount of angel money out there is almost equal to the amount of venture capital available.

VCs have been known to grumble that the new generation of individual investors often beats them to some of the best deals, but angels undeniably fill an important role. While many VC firms, like Draper Fisher, remain committed to seed- and early-stage investing, logistically, there is a limit to what they can manage.

“It’s tough for us to do a lot less than $1 million,” Mr. Packard says, explaining that the firm generally commits between $1 million and $5 million per round, but its average commitment is closer to $3.5 million.

Yet not everyone is willing to concede that the maturation of angel investors has pushed back the seed market. “I don’t think it’s a matter of venture capitalists shying away from early-stage, but rather being pulled to later-stage,” says Jesse Reyes, managing director of Venture Economics.

Mr. Reyes identifies several reasons for the trend. First, short-term returns are better in later-stage vehicles, allowing fund managers to impress limited partners and earn reinvestments in subsequent partnerships. Second, as funds become longer in the tooth, general partners are often tempted to make follow-on investments in successful companies in their portfolios. And third, as more investment banks launch their own venture funds, a more valuation-conscious approach leads to later-stage vehicles. “With early-stage, it’s always about technology, but with later-stage, it’s about price,” he explains.

McVenture Capitalist

Mr. Reyes’ point makes it easier to understand why an early-stage investor like Draper Fisher must commit an average of $3.5 million per deal. Valuations for early-stage Internet companies, fueled by a cut-throat public market, are sky-high, necessitating larger investments in order to get into the best deals, even in companies at very raw stages of development.

Computer software and services far and away received more venture money than any other group in 1998. The sector witnessed 855 companies receive $5.43 billion, each figure encompassing nearly one-third of all venture capital disbursements. Its average deal size of $6.35 million per company was bested only by the equally hot communications sector ($7.81 million per company) and topped the traditionally pricey medical/health-related sector ($6.12 million per company).

To combat increasing competition from more aggressive angels, as well as to better manage smaller investments in far-flung deals, some VCs have taken a cue from fast-food chains and “franchised” their operations. While the idea is not necessarily a new one, firms with growing pools of capital under management have increasingly tried this strategy by opening satellite offices in remote locales, overseen by local managers. The logic behind such operations is that they provide greater access to local markets and an ability to make earlier-stage investments.

Upper Lake Growth Capital, a $35 million St. Paul Venture Capital satellite fund wrapped in January (VCJ, January, page 19), is an example of this trend. St. Paul Venture Capital, a Bloomington, Minn.-based early-stage investor that manages roughly $800 million, last fall announced plans to back several smaller early-stage funds in San Francisco, Minneapolis, Boston and somewhere else on the East Coast, run by local managers.

The medical-focused Upper Lake was founded by David Stassen, a VC-turned-entrepreneur who ran one of St. Paul’s portfolio companies before returning to the investment side to manage the satellite. Mr. Stassen, by virtue of his fund’s size, is better able to make a seed-stage investment and commit the time necessary to nurture it than the managers of the much larger St. Paul. And if and when one of Upper Lake’s portfolio companies continues to show progress and needs another round of financing, St. Paul is waiting in the wings.

The result of this arrangement is firms do not have to worry about missing a deal because an early-stage company’s capital requirements fell below what a large firm like St. Paul could capably manage. “[Larger funds] look for fully-baked ideas,” Mr. Stassen says. “We look at concepts, half-baked ideas.”

Draper Fisher revealed a similar strategy earlier this year. The firm in January opened Draper Atlantic, a satellite fund on the East Coast, to take advantage of deal flow spawned from technology companies like America Online Inc. and MCI Worldcom Inc. (VCJ, February, page 14).

As a traditional early-stage firm grows larger, it must choose several strategies, Mr. Packard says. It can eventually put a limit on the amount of capital it raises, thereby keeping the firm’s capital pool at a manageable size for smaller early-stage investments, or it can continue to raise larger vehicles and add more staff to manage the greater number of investments. Another option is to begin to segment the firm’s funds as they become larger, slating a certain amount of capital for different growth stages and managing each pool separately.

And finally, the firm can try franchising, delegating capital to independent managers who manage the money as a separate fund.

In addition to Draper Atlantic, Draper Fisher in recent years also has launched funds in Los Angeles, Utah and Alaska. “It makes a lot of sense to have your money out there in areas that are not traditional VC areas,” Mr. Packard says. “There are entrepreneurs in all of these areas.”

While the bulk of VC investments continues to go to traditional hubs such as California and Massachusetts, which together received more than 15% of all venture capital dollars in 1998, less well-known areas such as Virginia, North Carolina and Minnesota have received increased attention of late, prompting VCs to find ways to source deals and manage investments in these markets.

It remains important to remember, however, that all of these industry developments – venture capital’s growth into new areas, the continuing fund-raising boom and the rise of angel investors – all are precariously tied to the nation’s resiliently vibrant economy. The entire structure could crumble at the first sign that the Bear has finally awakened from its long hibernation.

Millenial Misgivings

The public market downturn at the end of the third quarter of 1998 was nearly that very moment. As the initial public offering market dried up, venture capitalists grew conservative in order to preserve capital for their existing portfolios in what many were concerned was the beginning of a long-feared correction.

In the fourth quarter of 1998, venture capitalists invested only $3.53 billion in 666 companies, compared with the average of $4.17 billion in 935 companies for the first three quarters of the year. While the investment pace in the fourth quarter historically is slower because of the holidays, the drop-off cannot be ignored.

“I think people may have been hesitating,” says Roger Kasker, a managing director at Boston-based TA Associates. The market downturn soured investors appetites, making it difficult to close investments that had been in the works earlier in the year, he explains.

“It certainly did have an impact,” Mr. Packard adds. “People were definitely [thinking] that this was the Bear.”

Had Wall Street not bounced back late in the year, the effects could have been even more dramatic. Angel money likely would have dried up, limited partners may have grown disillusioned at diminished returns on their investments and venture capitalists may have had more difficulty raising money. And although these problems were largely avoided in 1998, they are inevitable once the cyclical economy takes a more extended turn for the worse.

“I’ve been saying for five years, fund-raising has to slow down,” Venture Economics’ Mr. Reyes says, explaining that the public markets cannot sustain the rates of return limited partners have become accustomed to and which have fueled the growth of venture funds. Emphasizing that he does not want to sound like a prophet of doom, Mr. Reyes is quick to acknowledge that the number of venture-backed mergers and acquisitions has risen in recent years, helping somewhat to offset the effects of a slower IPO market. However, later-stage vehicles, their portfolios heavy with public companies, are especially dependent on the public market to provide good returns, he adds.

And a prolonged downturn could be especially disastrous to first-time funds that are investing their maiden vehicle as the bad news hits.

“It’s relatively easy to raise a first fund,” Mr. Reyes says, explaining that a first-time vehicle’s limited partners are attracted to its promise, while fund raising its second and third incarnations attracts investors because of its performance.

“Investors don’t make the same mistakes twice,” he adds.

However, for now, most VCs are content with the status quo and do not anticipate any major concerns in the near future.

“I suspect we’re going to see a very strong quarter,” Mr. Packard predicts.

Disbursements per Company by State

01/01/98 to 12/31/98

Rounds 1 to 99




California 1276 981 693 425 6478.64 5.08 6.60

Massachusetts 383 296 350 251 1801.08 4.70 6.08

Texas 176 140 207 167 841.61 4.78 6.01

New York 147 114 157 132 742.89 5.05 6.52

Colorado 118 85 140 111 601.83 5.10 7.08

Washington 106 79 136 107 466.88 4.40 5.91

Illinois 72 59 98 77 464.49 6.45 7.87

New Jersey 77 62 115 85 402.64 5.23 6.49

Virginia 81 64 135 106 398.18 4.92 6.22

Pennsylvania 139 120 111 97 342.28 2.46 2.85

Georgia 98 80 121 96 342.27 3.49 4.28

Maryland 63 41 79 66 323.39 5.13 7.89

Florida 53 47 91 76 269.99 5.09 5.74

Minnesota 81 61 75 61 267.39 3.30 4.38

Connecticut 73 57 95 78 265.79 3.64 4.66

North Carolina 75 55 86 67 250.33 3.34 4.55

Ohio 50 41 56 49 196.94 3.94 4.80

Missouri 19 15 38 33 157.47 8.29 10.50

Michigan 34 21 39 34 146.06 4.30 6.96

Tennessee 30 22 44 40 145.33 4.84 6.61

Arizona 34 20 63 48 141.28 4.16 7.06

Utah 29 24 36 32 97.12 3.35 4.05

Louisiana 19 14 15 11 95.52 5.03 6.82

New Hampshire 22 18 38 31 85.72 3.90 4.76

Unknown 41 35 34 30 83.48 2.04 2.39

Source: Venture Economics Information Services

Disbursements per Company by State (continued)

01/01/98 to 12/31/98

Rounds 1 to 99




Alabama 14 14 23 14 78.83 5.63 5.63

Wisconsin 13 10 10 9 76.61 5.89 7.66

Idaho 8 5 21 17 67.24 8.41 13.45

Kentucky 16 14 22 22 57.09 3.57 4.08

D. of Columbia 6 5 21 19 54.93 9.15 10.99

Oklahoma 17 11 22 19 50.28 2.96 4.57

Oregon 21 18 30 26 48.07 2.29 2.67

South Carolina 12 9 12 11 37.42 3.12 4.16

Indiana 6 6 9 8 34.30 5.72 5.72

Iowa 15 11 21 18 27.52 1.83 2.50

New Mexico 5 4 5 5 14.60 2.92 3.65

Rhode Island 5 5 10 10 11.70 2.34 2.34

Delaware 6 4 13 13 11.05 1.84 2.76

Kansas 7 7 7 7 10.50 1.50 1.50

Maine 5 5 5 5 8.27 1.65 1.65

Arkansas 3 1 6 5 7.00 2.33 7.00

Mississippi 3 1 2 2 4.50 1.50 4.50

Nebraska 3 3 3 3 4.46 1.49 1.49

West Virginia 1 1 1 1 2.00 2.00 2.00

Nevada 2 2 2 2 1.00 .50 .50

North Dakota 1 1 2 2 .50 .50 .50

Hawaii 3 3 2 2 .43 .14 .14

Vermont 2 1 2 2 .13 .07 .13

TOTAL 3470 2692 3303 2532 16017.01 4.62 5.95

Source: Venture Economics Information Services

Disbursements per Company by Industry Minor Group

01/01/89 to 12/31/98

Rounds 1 to 99



Industry Minor Group RND RND CMP CMP $MIL INV

Computer Software & Services 1139 32.82 875 32.50 5428.47 33.89

Communications 468 13.49 359 13.34 2763.45 17.25

Medical/Health Related 502 14.47 373 13.86 2221.24 13.87

Other Products 387 11.15 311 11.55 1622.52 10.13

Consumer Related 270 7.78 223 8.28 1085.49 6.78

Biotechnology 241 6.95 182 6.76 1022.45 6.38

Semiconductors/Other Electronics

177 5.10 149 5.53 834.88 5.21

Computer Hardware 180 5.19 135 5.01 727.27 4.54

Industrial/Energy 106 3.05 85 3.16 311.26 1.94

TOTAL 3470 2692 16017.01

Source: Venture Economics Information Services

Disbursements per Company by Quarter01/01/98 to 12/31/98

Rounds 1 to 99




1998-2 952 952 699 495 4690.74 4.93 4.93

1998-3 926 926 653 466 4180.12 4.51 4.51

1998-1 926 926 688 485 3617.05 3.91 3.91

1998-4 666 666 558 401 3529.11 5.30 5.30

Source: Venture Economics Information Services