The Year of Predictable Progress –

Not all years are created equal.

Twelve months ago in this space, we wrote that 2003 represented a vital turning point for the wounded venture capital industry, as investors belatedly acknowledged past mistakes and began planting seeds for post-New Economy success. In short, they were rebuilding the franchise.

But 2004 served more like a coda than the main event. In fact, the defining characteristic of 2004 may have been the near-uniform predictability with which it unfolded. Market watchers expected increased disbursement and fund-raising volume, and it happened. They expected the public and private exit windows to re-open, and it happened. They expected many states to resolve their public disclosure issues, and it happened. They expected venture capitalists to continue their aversion to dot-com companies, and…

Well, three out of four ain’t bad.

None of this is to say that the past year isn’t worth a comprehensive review, or that it didn’t contain plenty of highlights, profits and pitfalls. Instead, it simply is to suggest that when the VC history books are written, 2004 will not receive its own chapter.

Venture capitalists entered 2004 with a dichotomous objective. On the one hand, they wanted to maintain a gradual investment pace elevation, after having tied off 10 straight quarters of disbursement decline in early 2003. On the other, they wanted to voluntarily curb the amount of new capital commitments under management, in the face of a ravenous limited partner community. Such goals may seem

inherently contradictory, but they were viewed as essential to avoiding the peaks and valleys that had caused so much sickness.

In terms of steadily increasing disbursement levels, the year was an unqualified success. Venture capitalists invested about $21 billion in about 2,400 U.S.-based companies, according to the MoneyTree survey conducted by PricewaterHouseCoopers, the National Venture Capital Association and Thomson Venture Economics (publisher of VCJ). This represents a 10.5% increase over 2003 disbursement totals.

The average deal size rose from $6.7 million per deal in 2003 to $7.3 million per deal in 2004, while both the average and median pre-money valuations also increased. Industry preferences stayed relatively constant, with the only change being that the life sciences sector stole about 2% of the information technology sector’s market share, although IT continued to dominate by a 2-to-1 ratio.


Venture capitalists also resisted the urge to raise another series of mega-funds, with most brand-name firms capping new vehicles at between $250 million and $400 million. All of this was made particularly difficult by limited partners, whose checkbooks had been fattened by increases in public market returns, increased allocations to alternative investments and an influx of wealthy foreign players. In fact, it wasn’t unusual for a firm to turn down 2x or 3x targeted commitments, with all but a select few unwilling to abandon their original memoranda terms.

It is important to note, however, that fund-raising discipline didn’t correspond with fund-raising inaction. According to preliminary data, 160 U.S.-based venture funds raised approximately $16.55 billion, a 44% increase over the amount raised by 147 funds a year earlier.

Also increasing in 2004 were VC-backed exits, which served as cyclical fuel for both the disbursement and fund-raising engines. On the IPO front, 91 venture-backed companies raised approximately $9.88 billion, which is more than was raised in the previous three years combined. Included in that total were six Chinese and five Israeli issuers pricing on U.S. exchanges, including the year’s largest venture-backed offering from Shanghai-based Semiconductor Manufacturing International Corp. (SMIC).

Merger and acquisition activity also received a boost, as strategic buyers were willing to pay premiums for subsumable businesses that could increase short-term revenue and long-term profitability. The average value of a venture-backed M&A deal in 2004 was about 40% higher than it was in 2003, even though the overall amount of debt financing remained virtually stable.

The Unexpected

Most of 2004 may have gone as planned, but the year was not without its share of minor surprises. The most notable hiccup may have come in September, when Texas Attorney General Greg Abbott said that VC funds receiving public money should disclose portfolio company-level information. Abbott’s predecessor had drawn the line at fund-level information, like internal rates of return, and had been imitated by top lawmen in other states. Colorado even codified the model last April, while other states like Michigan and Massachusetts passed their own versions of disclosure-limitation laws.

Following strong pressure from local VCs and institutional investors, Abbott relented. A fund-level disclosure bill is expected to be discussed by Texas legislators early this year, while states like California and Illinois are said to be considering a similar measure.

Another surprise in 2004 can be found in increased investment totals, as VCs exhibited unusual enthusiasm toward both the biopharmaceutical and Internet-specific spaces. In fact, some might even suggest that it was over-enthusiasm, reminiscent of 1999.

Jazz Pharmaceuticals Inc., for example, managed to secure $250 million in Series B funding commitments without milestone strings attached, despite not having any product. A $75 million Series B round for dot-com also raised eyebrows, as it simultaneously served as a significant liquidity event for company founders and angel investors.

This isn’t to say that either deal was bad, but each already has its imitators. It is those imitators-and how easily they receive funding-that should be carefully watched in 2005. Market analysts say that the franchise is still fragile, despite being rebuilt in 2003 and buttressed in 2004. The key for venture capitalists in 2005 will be to balance a recognition of that vulnerability with their traditional predilection toward risk. If they can do so, returns and respect will continue to grow.