VC Investors Are Down -- But Not Quite Out

There is still cash for startups, but the amount flowing to entrepreneurs has just seen the largest-ever quarter-to-quarter drop

The megabucks IPOs are gone. Dot-com bankruptcies are soaring. And no one is sure of the next big thing, on the Internet or otherwise. Is it any wonder that venture-capital investing has plunged to the lowest level in nearly two years?

Hardly. Nonetheless, the sheer magnitude of the collapse is impressive. In the first quarter of 2001, venture-backed companies raised $10.1 billion, a 40% drop from the fourth quarter of 2000 and a 61% decline vs. the same period a year earlier, according to the PricewaterhouseCoopers Money Tree Survey, which was compiled with research firm VentureOne and released May 2. The decrease marks the largest quarter-to-quarter decline since the accounting firm began tracking VC activity in early 1995.

The VC recoil affected nearly every sector, including those that previously seemed immune to the Internet meltdown, such as biotechnology and telecommunications, which saw quarter-to-quarter equity investments fall 37% and 38% respectively. Yet those were hardly the hardest hit.


  In the semiconductor, electronics, and consumer-and-business service sectors, VC funding fell by more than 50%. And in a sign of the lower valuations VCs are assigning to young companies, the median investment dropped, too -- from $10.9 million at the end of 2000 to $9.5 million in early 2001.

Although these figures signal a return to preboom levels of VC activity, investors are still hungover from their Internet excesses. And that funk isn't likely to lift until the public markets improve and look like they'll stay that way, says Tracy Lefteroff, U.S. managing partner of PricewaterhouseCoopers' private-equity practice. "They're sitting on their cash now," he says. "People are going to want to see some potential liquidity for their portfolio before shoveling cash out again," he says.

The go-slow approach adopted by many VCs means most funds' investing cycles also are returning to more earthbound time frames of three to five years, says Lefteroff. At the height of the dot-com frenzy, some funds were dispersing all their cash within a single year.


  That shift is perhaps most apparent to entrepreneurs seeking early-stage investments. Such fledgling companies raised $2.08 billion in the first quarter, compared to $7.16 billion during the same period a year ago. "It's difficult to be an entrepreneur right now. It is difficult to raise money," says Dave Witherow, the CEO of VentureOne.

Yet Witherow also sees a positive side to the tightening of capital. Entrepreneurs who do manage to raise VC money now face less competition for employees, real estate, and other critical resources. "In the last couple of years, it has been incredibly difficult to build an excellent company," he says. "Now it's difficult to raise money and easier to build a great company."

Susan Williams DeFife has witnessed the change in how VCs operate. As the CEO of a dot-com called, she raised $5.5 million between 1997 and 1999. But after failing to attract enough traffic to support advertising and e-commerce, the site shut down last August. DeFife is now in the middle of raising $6 million for a new company, StreamingText, Inc., a Reston, Va.-based business that creates digital text from audio and visual sources. The difference, she says, is that VCs are now far more demanding. "They want to make sure there's a strong business model and a strong management team. They want to see proprietary technology and they want to see revenues," says DeFife, who adds: "While it takes much longer to raise money, it is a far better process."


  Along with traditional VCs, corporations also have put the brakes on backing for high-risk startups in recent months. Corporate VC activity -- a phenomenon that ballooned with the Internet boom -- was down by 81% in the first quarter. In all, corporations invested $143 million in young companies -- way down from $745 million in the last quarter of 2000. "Corporations are dealing with the trauma of their public-market valuations taking a beating," says Witherow of Venture One. "Therefore, the currency they use to make these investments has been reduced." Undoubtedly, some also grew wary after watching failed ventures depress their corporate earnings.

So what's the outlook? Lefteroff expects the yearend total for investments in venture-backed companies to be around $30 billion. That would still be ahead of 1998's tally of $18 billion, but down significantly from last year's record-setting $87.7 billion. "The good news is, there's still plenty of money out there, and [the VCs] will put it to work," says Lefteroff. The question for many entrepreneurs is simply: When?

By Julie Fields in New York

Edited by Theresa Forsman

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