Wanted: A Few More Good Startups

While venture-capital funds took in a lot of fresh cash in the third quarter, not so much went out. That could mean problems down the road

By Justin Hibbard

When is a lot of cash not necessarily a good thing? Consider the state of venture-capital firms these days. The National Venture Capital Assn. (NVCA) and Thomson Venture Economics reported on Nov. 1 that these firms raised $5.5 billion in the third quarter, a 78% increase over the second quarter.

However, during that period, VCs invested just $4.3 billion in 601 companies, a 27% cash decline from the second quarter, according to the two organizations and PricewaterhouseCoopers. Most of the money invested over the last three months came from earlier fund-raising, rather than from the most recent quarter.

Simply put, if venture capitalists are finding fewer investment opportunities, what they will do with the new money they've amassed? "What concerns me is that you're going to see over the next couple of quarters an increased level of early-stage investing," says Mark Heesen, president of the NVCA.


  Because investments in tech startups are typically small -- around $5 million -- a cash-rich venture-capital industry could wind up doing too many mediocre deals or bidding up the valuations of young companies in order to use all of its money, Heesen says. That could lead to disappointing returns three to four years after they make their initial investments.

Some temporary factors may be distorting the picture. The third quarter is notoriously slow for venture investing, and the industry is still on track to invest more money this year than in 2003. In addition, fund-raising by VC firms slowed to a trickle during the past three years, as the U.S. economy and stock markets struggled. As a result, with many companies running short on funds, they've piled into the market as the economy and the stock market have brightened.

Still, it remains unclear whether the sums venture capitalists are raising match the number of opportunities. "There are some great ventures out there, but the universe is finite," says Ted Schlein, a partner at Kleiner Perkins Caufield & Byers in Menlo Park, Calif. "Just because you put more gas in a car doesn't mean you make it go faster."


  Schlein's firm was fortunate to back Google (GOOG ), which raised $1.2 billion in its third-quarter initial public offering. The deal fueled hopes that a flood of venture-backed IPOs might ride the search giant's coattails.

Fourteen companies, including Google, raised $1.72 billion through IPOs during the quarter -- the second-best quarter on record. But seven venture-backed outfits withdrew from registration during the period, according to market researcher VentureOne. Clearly, the public markets remain open only to an elite class of companies.

The mismatch between available capital and returns doesn't seem to deter venture capitalists. "If you believe in your strategy, you believe you can outperform the law of averages," says Steve Bowsher, a partner at Interwest Partners, a Menlo Park (Calif.) VC firm. Who wants to be the first to back down?

Hibbard is a correspondent in BusinessWeek's Silicon Valley bureau

Before it's here, it's on the Bloomberg Terminal.