And the ugly: venture capital stays on the sidelines as the industry struggles to regain balance

Electronic News, August 12, 2002 by Ed Sperling

Venture capital is alive and well, but it's not being invested with anywhere near the speed or volume it was two years ago because there aren't enough attractive investments.

What that means for the electronics industry as a whole is that venture capital won't right the Listing ship. And while money remains available, investors don't believe they can get an adequate return quickly enough to warrant the risk of putting all of it to work in the technology market.

"For the venture capital community, 20 [percent] to 25 percent return on invested capital is a rational plan given the risk involved," said Mark Jensen, national director of Deloitte & Touche's venture group. "The real enemy is time. To double your money at a 25 percent return would mean less than four years. But that would require a unique company in this environment."

And while some startups are developing interesting technologies or business models, VCs say most can't bring products to market quickly enough to go public and thereby satisfy investors.

Moreover, no one expects that situation to change anytime soon. Jensen said the private investment market typically lags the public markets by about six months. The first requirement is a broad economic recovery, followed by a recovery in the technology arena, and then stability in the stock market. So far, none of those developments has occurred.

Overall, this downturn has proved to be the Perfect Storm for startups and investors alike. In the last two downturns to hit the VC market--one in 1990 and the other in the early 1980s--when IPOs slowed down, the slack was picked up by mergers and acquisitions (M&A). That didn't happen this time because stock prices have dropped so low that most companies don't have the capital or the stock valuations necessary to do the acquisitions, and those that do have cash on hand are reluctant to spend it.

"That's a scary proposition," said Richard Helfrich, managing director of Alameda Capital. "It means VCs are stuck with their portfolio, and they're being forced to put money into companies until the IPO market or M&A opens up."

Particularly hard hit are investments in the communications market, where service providers are struggling for survival and equipment orders have fallen off the map. Helfrich said that with European companies such as Vodaphone paying $500 million a month in interest because its 3G license never paid off, their appetite for new equipment has been seriously curtailed. That leaves investors weighing whether to keep feeding their investments or to write them off as a loss. The decision is particularly tough for companies that received their initial funding prior to 2000 when the investment climate was markedly different.

Given this state of affairs, venture firms are still investing, but only in companies with a seasoned management team, great technology and a clear market opportunity. The deal clincher is having customers that are willing to go on the record vouching for a startup, its technology and their willingness to pay for that technology. Given the dearth of those types of deals, VC firms are fighting over each other to invest in those companies.

"Hot deals are still very competitive," said Mark Klopp, managing director of Eastman Ventures. "They're being bid up and multiple-term sheets are being offered."

Oddly enough, VC firms find themselves competing with the federal government in some of the newer markets such as nanotechnology. Those areas still attracting dollars include convergence, particularly in biotechnology where electronics are being used in organic semiconductors and microelectrical mechanical systems (MEMS), as well as Web services and anything that reduces the cost of ownership for computers. But the process of getting that funding remains far more difficult than in the past, and the money is given out far less freely even though there's plenty available.