Heading into 2008, venture capitalists had good reason to feel upbeat. Fund-raising was going strong, markets were up for the prior year, and enthusiasm around technology and the growth of emerging markets was fueling a boom in investment and entrepreneurial activity. Prominent venture capitalists took to musing about how the green revolution could wind up being even bigger than the IT age.
As it turned out, the optimists had it wrong. This past year, to state the obvious, has been a rotten one for the venture industry. Exits were poor. The economy was lousy. Most IPOs didn’t happen. New funds struggled to close. About the only people celebrating were secondary investors suddenly able to snap up assets at bargain prices.
“This economic climate is creating far more significant challenges for our industry than those we saw in 1999-2000,” Roger Novak, a general partner with Novak Biddle Venture Partners, said in a collection of New Year’s predictions gathered by the National Venture Capital Association. “Today’s issues are systemic, with broader, deeper reach and a longer duration. The net result will be a smaller venture capital industry as investors lose partial confidence in the asset class.”
Novak isn’t the only one feeling pessimistic. The Silicon Valley Venture Capitalist Confidence Index, a quarterly survey put out by the University of San Francisco, registered 2.89 on a 5-point scale for the third quarter (with 5 indicating high confidence). The score marked an all-time low for the four-year-old index.
Meanwhile, VCs who once dreamed of 20x returns are settling for smaller rewards, such as avoiding a down round. “Getting a markup these days is cause for jubilation; it’s not expected,” says Gerry Langeler, managing director at OVP Venture Partners. “A flat round looks just fine right now.”
Langeler predicts the trend toward lower private market valuations will continue through this year and probably into 2010, since corrections in the venture industry tend to lag public markets.
Preliminary data for last year indicate that the market had already slowed down. Initial 2008 data for three categories—exits, deal flow and fund-raising—all show venture firms ending the year in a humbler position from where they began.
“No Exit” Revisited
In 1944, philosopher-author Jean-Paul Sartre plotted his play “No Exit” around a vision of Hell in which three irritating people are stuck in a room together for eternity. With a few tweaks, the presciently titled work could also be an existential take on the current venture capital industry. Just substitute the bare room for a boardroom table and the cast for a group of investors doomed to endlessly renegotiate term sheets for a startup no one will buy.
That backdrop would appropriately set the scene for 2008. By the end of the year, it was starting to seem as if the “I” in IPO stood for “impossible.” Just six venture-backed companies managed to go public in the first eleven months of 2008, raising an aggregate $470 million, according to Thomson Reuters (publisher of VCJ). That contrasts with 86 VC-backed IPOs that raised $10.3 billion in 2007. Moreover, five out of last year’s six venture-backed IPOs began trading in the first quarter. No companies went out in Q2, just one made it out in Q3 and none in Q4, as of Dec. 5.
Those who did make it to the public market, meanwhile, had plentiful reason to regret it. As of early December, a sizeable percentage of companies that had carried out IPOs in the prior two years had lost more than three-fourths of their initial value. Thomson Reuters’ Post-Venture Capital Index, which tracks the performance of venture- and PE-backed IPOs, hit it lowest point in more than five years at the end of November.
Meagerness of Acquisitions
M&A provided a healthier exit channel, albeit a less active one than in previous years.
A total of 248 venture-backed companies were acquired in the first 11 months of the year, compared to 330 in the same period a year earlier, according to Thomson Reuters. Companies in the Internet, software, and IT services industries accounted for the largest number of transactions, including a few super-sized deals. Dell’s $1.4 billion purchase of Equalogic, a storage area networking company, stood out as the year’s largest deal. Other pricey transactions included AOL’s $850 million purchase of social networking site Bebo, and eBay’s $945 million purchase of online credit provider Bill Me Later.
Overall, however, disclosed deal prices dipped in 2008. There were a total of 89 M&A transactions with disclosed valuations totaling $13.4 billion, as of the start of December. That was down substantially from the same period a year earlier, when there were 143 deals with disclosed valuations worth a total of $24.6 billion.
Disclosed valuations may have been down in part because private transactions—in which purchase prices are generally not revealed—became more popular in 2008. With public market valuations at multiyear lows, VCs secured exits or partial exits by selling startups to other privately held companies for stock, cash or a combination of both. Foundation Capital, for example, had at least four portfolio companies acquire or get acquired by other VC-backed startups last year.
While aggregate returns are down, many VCs remain upbeat about the appetite of public companies for M&A. Acquirers, they say, continue to exhibit a keen interest in fast-growing startups, though often at reduced valuations from a year or so ago.
“There’s not a sense of panic or the world’s ending,” says Kyle Lefkoff, general partner at Boulder Ventures, which sold two of its portfolio companies last year: Era, a developer of airport traffic management software purchased by SRA, and Left Hand Networks, a storage area networking company bought by Hewlett-Packard.
Panic might be a more apt term to describe the state of mind among limited partners, most of whom have weathered double-digit declines in their stock portfolios.
Most VCs VCJ spoke with expect 2009 to be a tough year for fund-raising. It appeared that LPs had already slowed down their commitments in the fourth quarter. Preliminary data from Thomson Reuters show that just 20 U.S.-based venture funds raised $1.4 billion in Q4 (as of Dec. 5). That was down considerably from Q4 2007, when 84 U.S.-based VC funds raised $11.6 billion.
Preliminary data for 2008 show 195 U.S. venture funds raised about $27 billion, according to Thomson Reuters. That’s down from 250 U.S. venture funds that raised more than $35 billion in 2007.
“Raising money is going to be challenging with pension funds being hit harder and more quickly than they have at any other period in recent times,” says Kevin Kemmerer, vice president at Safeguard Scientifics.
The one bright spot for 2008 fund-raisers was cleantech, with several dedicated funds getting raised. Foundation Capital, Kleiner Perkins Caufield & Byers and RockPort Capital collectively raised $1.7 billion for funds that will focus heavily or exclusively on the clean energy industry.
Last year’s fund-raising total also got a boost from several veteran firms raising follow-on funds. These included a $929.5 million growth fund raised by Sequoia Capital, the $900 million 10th fund raised by Austin Ventures, and the $800 million eighth fund raised by Lightspeed Venture Partners.
Given that cheap is the new black, it wouldn’t be surprising if venture capitalists invested less money last year than they did in 2007. Official data aren’t due out till late January, but preliminary data show that deal making slowed in the wake of the U.S. financial crisis, and most venture capitalists VCJ spoke with said they expect to see fourth-quarter deal making decline.
As of Dec. 7, U.S. venture firms had invested about $24 billion in 2,759 companies, according to preliminary data gathered by Thomson Reuters. For all of 2007, U.S. VCs invested $28.8 billion in 3,213 companies.
“I’d venture to guess that the Q4 slowdown is going to be acute,” says Venky Ganesan, a managing director at Globespan Capital Partners, an early stage tech investor. “You can’t have the destruction of 40% of investor capital, or $10 trillion, and not have an effect on the economy.”
Ganesan adds that “Globespan will continue to look at a lot of stuff, but the bar has gone really high and there’s no urgency of doing investments.”
Sanjay Subhedar, a general partner at early stage investor Storm Ventures, also expects to see deal making slow down “significantly in terms of investments in Q4 and certainly in Q1 and Q2 of next year .”
The slowdown underscores a change in attitude among venture investors, who had been routinely bidding up valuations for the first half of the year, says Safeguard’s Kemmerer.
“The mindset was the sooner you could put out capital, the sooner you could raise your next fund,” he says. “That’s certainly completely stopped as of the end of Q3.”
Still, at least one market segment is expected to continue to see lots of deal making: cleantech. Last year marked the fifth consecutive year of growth for cleantech deals. As of Dec. 7, U.S. venture firms had invested about $3.7 billion in 198 cleantech startups for the year, up considerably from 2007, when they invested $2.65 billion in 192 cleantech startups, according to Thomson Reuters.
Many expect the trend to continue, even in an economy in recession. In the NVCA’s predictions for the New Year, Ray Leach, CEO of JumpStart Inc., a seed stage investor based in Cleveland, opined: “Cleantech investing is going to come on strong in 2009 despite lower energy prices because there will be so much attention paid by governments around the world. By 2010, cleantech will be the largest dollar segment for investing in the venture industry.”
Additional reporting by Lawrence Aragon and Alexander Haislip