The 2002 Venture Capital Outlook –

Although it is always treacherous to pick bottoms, I feel comfortable that in the wake of the sluggish economy of 2001 and the horrific events of this past September, 2002 will prove to be a year of substantial recovery leading to robust growth in 2003. The larger economy and the venture capital markets enjoyed exuberant growth from 1992 through the first quarter of 2000-a remarkable eight-year run. The venture community, in particular, grew at a spectacular and unsustainable pace from the point at which it discovered the Internet circa 1994.

Historically, the entire venture community-about 700 firms operating in 48 states-raised from $3.5 billion to $5 billion annually and, in turn, invested this money in promising young companies offering the prospect of explosive growth. Commencing in 1995, investors, principally institutions, committed capital to venture partnerships which, in large measure, supported companies linked to the growth and changing business models fostered by Internet technology. This annual allocation of investment capital to venture partnerships grew to an astonishing $105 billion in the apex year of 2000.

Venture Capital Withering and Dying

Those provocative but woefully misleading words were the featured headline in a story published in The New York Times on Oct. 21, 2001. To paraphrase Mark Twain, reports of the death of the industry are greatly exaggerated. In fact, during the third quarter of 2001, venture capitalists in the U.S. invested $7.7 billion in 873 companies while 46 venture funds replenished their coffers by raising $6.2 billion. All the other private-equity markets in the world would be thrilled if they could point to comparable ferment.

Nevertheless, the Times piece did reflect the perspective of many observers who view the record of the last several months from the lofty peak of the Ides of March 2000. At that point, a number of factors coalesced, marking the end of a year of easy victories and spectacular returns. During the first quarter of 2000, the storm cloud of leading economic indicators darkened, signaling an increasingly troubled economy. Along with the broader decline in the public markets, which accelerated around April 1, 2000, thousands of public Internet-enabled companies saw their market capitalizations shrink. In turn, the initial public-offering market dried up. And the task of raising capital for aborning venture capital funds and countless venture-backed operating companies proved daunting, if not impossible.

Throughout the second and third quarters of 2000, the picture grew darker by all conventional measures, punctuated by the unimaginable evil of Sept. 11. The World Trade Center disaster aggravated and accelerated all the negative economic trends that had been evident earlier.

A Diverse, Complex Financial Community

The venture capital community is not monolithic, and it is misleading to treat it as such. The industry consists of hundreds of firms with a myriad of different investment strategies, and this complexity has become more pronounced accompanying the astounding growth during the past several years.

With the exception of a small number of partnerships that, for various reasons, are planning to close their doors, all these firms are engaged at some point along the inexorable and repetitive life cycle of venture capital partnerships. They are spending their time in some combination of raising capital, investing capital, fostering portfolio companies and harvesting returns.

Today, the market is substantially bifurcated. On one side of the great divide are those firms that raised significant funds in 1997 and 1998 and invested heavily in 1999 and early 2000. Within this segment of the industry, the disciplined and cautious firms were greatly outnumbered by those captivated by “Bubble Theology,” the embracing of momentum and the prospect of ever-escalating prices in order to harvest successfully. In some cases, they invested in companies with indefensible business models and were left with struggling portfolios when the IPO take-out option evaporated with dizzying speed and private equity pricing of later financing rounds also collapsed.

These unhappy firms, in the current market, are unable to raise money for their quality portfolio companies, let alone for their ugly ducklings, and they lack sufficient cash to support the portfolios by themselves. This is resulting in the worst performance numbers for the industry in many years and will worsen as general partners face up to the harsh reality of taking additional portfolio mark-downs and write-offs over the next 12 to 18 months.

The Bright Side

Fortunately, there is a bright side to this bleak picture due to the venture life cycle to which I referred briefly. Many firms due to prescience and/or luck were in a capital-raising mode primarily in 1999 and did not participate harmfully in the binge investing so commonplace.

Accordingly, they have closed sometimes very large funds in 2000 and are sitting with large cash reserves in a down market with many entrepreneurs slashing prices and adding attractive deal features. In short, this is a market which venture capitalists with cash dream about and rarely encounter. Experienced institutional investors apparently share this view, for despite all the poor macro-economic news, they are continuing to invest in venture partnerships at a robust pace, an estimated $40 billion in 2001, which would rank as the third highest year in the industry’s history, exceeded only by exuberant 1999 ($60 billion) and frenzied 2000 ($105 billion.

What About 2002?

I believe that, for the most part, the move away from early-stage risk, which was palpable in 2001, will increase next year. The liquid VCs are investing in, and will continue to seek out, promising young companies that have completed products, customers and sales. And yes, in some cases, these firms will even have profits! These investments will include series B and series C round financings and PIPES (private investments in public equities). With sales momentum; attractive, low, entry-level deal pricing; the capacity to absorb significant capital infusions; and shorter time horizons to exit through being acquired or tapping the public market-these companies offer investors the most appealing risk/reward prospects.

One unhappy ramification of these market dynamics is that even the worthiest start-ups are going to continue to find it almost impossible to raise capital from traditional venture funds in 2002.

The Sputnik Syndrome

Even the mostly grisly of clouds have silver linings, and I see three emerging as a product of the Sept. 11th tragedy. Just as the former Soviet Union’s success in space in the early 1960s led President Kennedy to challenge the nation to respond, something comparable is abroad in the land now. I believe the recent influx of dozens of security-oriented investment proposals, is a tiny reflection of what is going on nationally. Over the next several years, government, corporations and other institutions will devote enormous resources in pursuit of heightened security. Within the venture world, this will encompass, among others, companies that provide firewall protection for communications systems; encryption software companies; enterprises devoted to monitoring and analyzing communications to identify potential threats; data-mining companies to provide useful and faster analysis of much potentially valuable information that is available but has not been usefully sifted, etc., etc.

The second area of opportunity is much more immediate from a New Yorker’s standpoint. It was recently estimated in an overview piece in the Times that the “Information Technology Rebuild” in downtown Manhattan will cost approximately $3.8 billion. Based on the prerequisite cleaning up of the WTC site which will take about a year and the subsequent new construction that will unfold there, the IT investment should begin to come on line by the middle of 2003 and will most probably continue for two to three years thereafter. Of course, the IBMs and EDSs of the world will play a major role, but there should also be plenty of business for entrepreneurial IT firms with select applications.

The third silver lining is the macro-economic response of the Federal Government. Balanced budgets have been set aside along with a long list of laudable but, in these circumstances, postponable government initiatives including social security reform, health-care insurance expansion and education reform. All efforts are now focused on national security and tax and spending plans which will re-ignite economic growth. The national economic pump will be primed, and GDP growth will return robustly by the second half of 2002. This can only help entrepreneurs, venture capitalists and the country.

Adversity is the breeding ground of opportunity, and now is such a time. Do you know what companies like Starbucks, Intuit, Palm Computing, RF Micro Devices, Shiva Corp. and Wind River Systems (to name only a few) have in common? They all received their initial funding from venture capitalists in the most recent dark recessionary period of 1990-1992. We are at a similar inflection point now. Venture capitalists with money will find many opportunities over the next year among fledgling companies seeking capital for growth. Many of these firms will address markets born in response to the events of September.

I believe the return of economic growth will lead to the re-emergence of the IPO market in the latter half of 2002 in ample time for venture capitalists to harvest some of the portfolio seedlings they are currently planting.

Ed Goodman is the co-founder, along with Todd Pietri, of Milestone Venture Partners, which focuses on early-stage, enterprise information technology companies in the New York metropolitan area.