Venture Capital 2007: The Year of the Echo

Thanks to the long-awaited impact of the 2000 technology burst, the ripples created by the SEC’s anticipated SOX reform, and the reverberations from the Democrats’ seizure of Congress, 2007 could go down as the “Year of the Echo.” At first glance, such a convergence threatens to turn the year into a confusing cacophony—a virtual echo chamber. However, echoes can be invaluable predictive tools—as any meteorologist or air traffic controller can tell you. By reading the echoes on our industry radar, so to speak, we can make some calculated guesses about what lies ahead for 2007.

Every year since the technology boom went bust in 2001, participants in the venture space have been waiting for its echo, the point when all the lessons learned, ramifications felt and settled fallout swing back around and deliver the final impact. By most indications, that echo will finally be heard in 2007.

It is time for the 1998-2000 investments that have yet to exit to live or die. And in some cases the same holds true for the firms that made these investment decisions. For the most part, there is a relative bullishness on the part of venture firms toward the current crop of portfolio companies. Ironically, many in this group are bubble survivors, promising companies “pulled from the wreckage” of the dot-com crash and nurtured back to exit readiness. Unlike most startups, these companies have achieved wisdom beyond their years, having experienced the layoffs, financial scandals, vagaries of SOX, and stock option imbroglio of recent years. Having weathered more than five years of this environment, 2007 will be the year we see the 1998-2000 alumni either vindicated or jettisoned. The venture firms are ready to move on to their next funds and newer investments.

IPO rebound

Thankfully, we do expect a stronger U.S. IPO market in 2007 compared with 2006. Of course, “stronger” is a relative term: Regulatory pressures will continue to have a chilling effect on the number of new U.S. listings, and less regulated foreign exchanges like London, Hong Kong and Toronto will continue to exert a strong pull. However, 2007 will likely experience a bump in IPO exits across sector lines, with improvements in IT, life sciences and communications. Ideally, we would like to see a doubling of the IPO volume in 2007, although that may indeed be an aggressive wish. Correspondingly, the mergers and acquisitions market will continue to see robust traffic in exits. These stronger traditional exit routes will be competition for buyout firms that have recently shown an interest in acquiring portfolio companies as a temporary alternative to the IPO or M&A path.

Democrats may take a more aggressive stance with the Chinese government on policy issues such as China’s manipulation of the Yuan’s value relative to the dollar, intellectual property rights, human rights abuses, and the ever-burgeoning Sino-American trade imbalance.”

Mark Heesen, President, NVCA

Another sign of health we expect to see in 2007 is a decline in industry fund-raising, which would be in accordance with traditional industry cycles. Most firms will have wrapped up their latest fund-raising efforts in 2006, and will thus turn their attention to investing it. As usual, there will be some “cleaning up” of remaining capital by firms that haven’t fully invested their previous funds, as well as some calculated “off-cycle” soliciting by opportunists, but for the most part, industry emphasis will shift from fund-raising to new deal flow and due diligence. Again, the decline will be cyclical and welcome as the industry can only invest so much money successfully. We would be concerned if 2007 saw a major increase in fund-raising levels. In any case, we predict having to echo this sentiment repeatedly to those who continue to think bigger is better. Those intimately involved in venture capital know differently.

Based on where the venture industry is in its cycle and on the excitement that results from having new funds in hand, we expect venture investment in 2007 to surpass 2006 levels. While we don’t see this “echo” outstripping its source (i.e. we don’t anticipate seeing any $50 billion quarters), venture capital investment into companies could very well reach $30 billion for the year. We expect a good portion of that increase to be driven by seed and early stage investment, as firms continue to deploy newly raised funds. This bodes well for entrepreneurs and the long term prospects of the industry as a whole. Venture capital returns also figure to rise modestly thanks to the rebound in the IPO market and continued M&A strength.

Fewer VC firms

Like boom echo, the “post bubble purge”—the anticipated exit en masse of the latecomers and also-ran firms that built the bubble up—has remained a yearly favorite for industry observers and prognosticators. While skeptics looking to crow will again be disappointed, we do expect to see the number of venture firms decrease in 2007. As this more mature and discerning fund-raising cycle of 2004-2006 draws to a close, we will see firms—and there are some—that did not reach their performance goals that simply have to fold. When balanced with the creation of emerging funds, we are predicting a slight decrease in total VC firms in the industry.

While NVCA strives for bipartisanship and maintains strong working relationships on both sides of the isle on Capitol Hill, we can’t help but see some potential reverberations in the venture marketplace as the Democrats reassume control of Congress.

Doing business in China, for example, may become more challenging for venture firms, as the Democrats may take a more aggressive stance with the Chinese government on policy issues such as China’s manipulation of the Yuan’s value relative to the dollar, intellectual property rights, human rights abuses, and the ever-burgeoning Sino-American trade imbalance. Even mere rhetoric could lead to policy changes on the part of the Chinese government, which is not known for accepting criticism graciously. Given their strict control of the economy and lack of electoral accountability, Chinese leaders could very quickly make it very difficult for firms to get their money out of the country, thus chilling investment interest. If it occurs, such a development may drive interest in other global investment communities such as India.

It is time for the 1998-2000 investments that have yet to exit to live or die. And in some cases the same holds true for the firms that made these investment decisions.”

Mark Heesen, President, NVCA

From a sector standpoint, firms in life sciences may also face increased challenges under a Democratic Congress. Closer oversight of the Food and Drug Administration (including more investigations of its practices) may lead to more caution on the part of regulators—in turn slowing the pre-market approval process for drugs and medical devices. Smaller players in the pharmaceutical space may feel these effects most acutely, as the additional wait time and regulatory approval costs eat into their margins.

The reverberations from the Democratic takeover will certainly create opportunities to counteract its challenges. Clean tech, for example, may experience a boost in 2007 through tax credits and increased research at government labs, which in turn could attract more venture interest. Likewise, efforts to allow companies receiving venture capital dollars to participate in the Small Business Innovative Research (SBIR) grant process may finally be successful as the Democrats are a group that largely understands this issue very well.

SOX relief

One prospect that appears to have remained on track despite the Congressional power shift is reform of the Sarbanes-Oxley Act. Even so, SOX relief figures to be regulatory in nature, as opposed to legislative, meaning that changes in enforcement will come from more liberal interpretation of the law’s stipulations on the part of the SEC, rather than by amendments passed by lawmakers. This raises an important question: Will the accounting firms take their lead from changes in SEC interpretation, or will they continue to favor strict readings of the law’s provisions and thus perpetuate what has become a very lucrative status quo?

In all, the echoes on our 2007 radar appear promising, if not exactly crystal clear. Like weathermen, we may not get every detail right. But like air traffic controllers, we know enough about the general atmospheric conditions and potential spells of turbulence to help venture capitalists chart a prudent and productive course.

Mark Heesen is President of the National Venture Capital Association. He may be reached at mheesen@nvca.org.