Venture Capital Update Q4 2004


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Venture Capital Update Q4 2004

  1. 1. Venture Capital Update Q4 2004 At Silicon Valley Bank, understanding the industries we serve is fundamental. Like you, we track, study and analyze the activity in our markets and, as your partner, we want to share our findings. This report chronicles venture capital activity in Q4 2004 and includes commentary from our vantage point in the industry regarding what it all means. We seek out and consolidate the most compelling data, pointing to the trends in the technology and life science industries. We invite your opinions and encourage ongoing dialogue regarding the opportunities ahead of us. U.S. Equity Investing Activity U.S. Equity Investing Activity (by quarter) (1999-2004) ($B) ($B) Source: VentureOne and Ernst & Young Source: VentureOne and Ernst & Young Quarterly Venture Capital Report Quarterly Venture Capital Report Seeking Equilibrium By Aaron Gershenberg and Brian Rodde, SVB Capital Is there too much capital in venture capital? Today, general partners (GPs) and limited partners (LPs) both complain of an excess of capital, reminiscent of the industry in 2001. This was the first time in the history of the industry that funds began to return un-invested capital to investors, and it included such memorable moments as Crosspoint Ventures returning $1 billion in commitments to LPs. We see three themes at the heart of the debate over whether there is too much capital in the venture industry today: 1) Valuations – the pace at which interim private round valuations are being bid up is faster than the rise of public and M&A comparables 2) Oversubscribed funds – top-tier funds are turning away billions of dollars of LP demand 3) Future industry liquidity – IPO and M&A markets are unlikely to generate sufficient liquidity, and will deliver disappointing near-term returns industry-wide Despite potential issues related to these themes, we at SVB Capital do not believe the venture industry is overcapitalized. Rather, the behavior we’re observing among GPs and LPs suggests an industry that is both highly competitive and seeking equilibrium. Industry-wide returns may be disappointing and even negative (similar to results seen in domestic buyouts). However, the equilibrium of demand and supply of capital to the industry is driven by expectations of future, top-quartile venture returns. GPs and LPs are investing based on their ability to garner such top-quartile returns, which they believe, and SVB Capital agrees, will be compelling relative to other comparable investment opportunities for many years. SVB Capital 1 March 2005
  2. 2. U.S. Venture-Backed IPOs Valuations of private companies are being Deals & Dollars ($M) bid up faster than those of public and M&A comparables. Our observations, and data from VentureOne regarding trends in valuations by round and sector for the venture industry, indicate that private company valuations have been increasing at a faster rate than comparable public market and M&A valuations. The most promising private companies, demonstrating significant revenue traction, commonly receive unsolicited term sheets for tens of millions of dollars at triple digit valuations. Both GPs and LPs are concerned that significant amounts of capital are being invested in these companies at valuations that cannot possibly generate compelling returns based on potential exit values. Although there is certainly an excess of capital available for investment in these instances, we believe it is a result of the intense competition, rather than evidence of overcapitalization in Source: VentureOne and Ernst & Young Quarterly Venture Capital Report the industry. While new investors (buyers) complain about high interim valuations, those who already own significant positions Region Focus All Industries - 4Q04 (sellers) love them. Early investors are able to buy significant ownership at low prices and are rewarded with huge step-up valuations when the companies execute. In addition, these early investors will be disproportionately rewarded when these successful companies are sold (privately through M&A, or publicly through IPO). While valuations may be driven in part by revenue traction and in part by emotion, it’s worth considering the fact that innovative venture-backed companies effectively take a great deal of Research and Development risk off the balance sheet for Fortune 1000 companies. Acquiring new customers and ready-made marketshare through acquisition can be a far more cost- effective proposition for these established companies than long-term R&D, and one for which they are often willing to pay a premium. Nevertheless, buyers willing to pay high prices in follow-on rounds take the chance that private or public markets may not support the valuations when it Source: VentureOne and Ernst & Young comes time to sell the company. Neither early nor follow-on investors know which of their Post Money Valuation Report ($M) - 4Q04 investments, if any, will develop into the next Sun, Cisco, Yahoo or eBay. Exceptional companies like these will achieve liquidity results representing tens of multiples of invested capital, richly rewarding all of their investors. In these rare cases, interim valuations become meaningless. Given the competitive nature of the venture industry, we are most encouraged by investors who have recently taken to stealth investing, or investing off-the-beaten-path, in an effort to gain a competitive advantage. We believe these investors have a greater opportunity to generate top-quartile returns than those who imitate one another. Forward thinking GPs are investors who for example, after an intense wave of Source: VentureOne negative e-commerce press, decide that e-commerce is a SVB Capital 2 March 2005
  3. 3. Most Active Investors - 4Q04 great place to be investing. They are firms that began commuting to China and India five years ago, before it became standard. They are, at times, contrarian and visionary GPs who also have strong company-building skills. It is easy to forget that Google’s backers invested in the company at a time when search engine investments were considered “passé”. Oversubscribed top-tier funds are turning away billions of dollars of LP demand. Since 2003, when Sequoia raised its latest fund, there have been a select number of top-tier firms that have been extremely oversubscribed by LPs. The excess demand Source: VentureOne and Ernst & Young Quarterly Venture Capital Report from LPs has primarily been directed at brand-name firms with long track records of top-quartile realized returns. Again, some industry insiders point to the imbalance of supply and demand between top-tier GPs and LPs as an indication of overcapitalization of the venture firm and thus the industry. U.S. VC-Backed Liquidity Events by Supply: GPs are constricting supply by Industry 2002-2004 raising smaller funds with fewer LPs. When the Nasdaq began its 3,000-point descent five years ago, valuations of private, venture-backed companies declined dramatically. This plunge reduced the amount of capital that venture firms could efficiently invest in any one company while earning a compelling return, causing many GPs to reduce the sizes of their funds in 2001 and 2002. GPs raising new funds had a choice: they could either reduce the fund size or add partners and do more deals. Most chose to reduce fund sizes. Today, as GPs go out to raise new funds, many continue to strictly limit the size of the funds and the number of LPs in each. For many, having fewer LPs eases administration of Source: VentureOne and Ernst & Young Quarterly Venture Capital Report the funds. It also allows them to address new concerns surrounding the Freedom of Information Act (FOIA), which requires certain LPs, such as many public universities, to publicly disclose proprietary information about their investments, including information about the venture firm and, in at least one case, its portfolio companies. As a result of this requirement, many firms are not inviting FOIA LPs U.S. IPOs vs. M&As into new funds. Demand: Excess LP demand is coming from two distinct classes of investors. Things have changed on the demand side as well in recent years, and two groups of LPs are driving growing demand for top-quartile investments. The first group of LPs wants to reduce the number of firms in their portfolios, while increasing their commitments to select funds. This LP strategy concentrates dollars in the hands of the best-performing funds in an effort to maximize potential returns while Source: VentureOne and Ernst & Young Quarterly Venture Capital Report minimizing the administrative costs associated with tracking numerous funds. The second group of LPs comprises SVB Capital 3 March 2005
  4. 4. investors who are new to the venture capital asset class. U.S. VC-Backed M&A Activity, 2003-2004 Using modern portfolio theory, they seek to generate superior returns through portfolio strategies, which include invest- ($B) ments in assets with the least correlation (assets that perform independent of returns in other asset classes), and the highest potential returns. The venture capital industry has historically demonstrated these characteristics better than many investment alternatives. LPs in this group have billions of dollars of capital that they want to diversify into low-correlated assets in order to reduce risk and increase returns. Add to this changing demand scenario the fact that venture firms have fewer competitors today than they did in 2000. Source: VentureOne and Ernst & Young Many firms have not been able to raise follow-on funds. Quarterly Venture Capital Report Gone are the days of first-time venture firms comprising successful CEOs, investment bankers, lawyers or account- ants, able to raise $200-300 million. Along with the decline in numbers of institutionally backed venture firms, most angel and corporate investors have been sidelined. LPs are Perspective doing their part by being more judicious about what they The jump in M&A transactions in 2004 is a return to a healthier are willing to invest in. They are doing extensive background pace within the technology industry and we believe the outlook checks, measuring portfolios against stated investment for 2005 is even more promising, particularly among software companies, in the early part of the year. However, the lines are strategies, and demanding referenceable track records of blurring between hardware and software companies, as we’ve significant liquidity or value creation. seen a lot of systems companies interested in software firms and/or divisions. SVB Alliant’s experience mirrored the So while there is excess demand for the top-quartile increased number of transactions completed in 2004. The firm performers, it does not indicate overcapitalization at the closed 35 technology industry M&A transactions last year, one firm or the industry level. The majority of venture capitalists of the most productive years in its 15-year history. are facing significant challenges in raising follow-on funds. SVB Alliant is a subsidiary of Silicon Valley Bancshares and While the brand name, top-tier venture firms have been able offers investment banking services to technology and life science to raise capital easily, it is not clear they will be the only companies. ones who generate top-tier results going forward. * IPO and M&A markets are unlikely to generate sufficient liquidity, resulting in disappointing near-term returns industry-wide. Last year, 174 funds raised $17.6 billion, an increase of 65 percent over 2003. 2004 commitments were a fraction of U.S. Deal Flow by Round Class the $106 billion committed to venture capital in 2000, according to Venture Economics. Studies of the capital “overhang,” or capital that has been previously committed and yet to be invested, suggest between $40 and $60 billion in capital is available to be invested by venture firms today. This is in addition to the more than $100 billion already invested during 1999 and 2000. LPs hope to get 50 cents on the dollar for those investments. As a reference point, with the exception of the “tech bubble,” a good year in terms of liquidity for the industry is $10 billion. Source: VentureOne and Ernst & Young Quarterly Venture Capital Report Judging from these numbers, it is clear that the industry cannot generate sufficient liquidity and is bound to deliver disappointing returns for 1999 and 2000 vintages. SVB Capital 4 March 2005
  5. 5. U.S. Cumulative Uninvested Further, until public market valuations increase substantial- ($B) ly, the industry is going to be challenged to generate com- pelling “median” returns for any vintage. For some industry observers, these recent disappointing industry returns and expected industry returns are proof of overcapitalization. If an LP’s goal was to generate returns at the median of the industry, then we would agree. But no LP, including SVB Capital, invests with the purpose of achieving median returns. Every LP is in search of top-quartile returns and develops a strategy to achieve it. The same is true for GPs. All VC firms invest with a stated purpose of achieving top- quartile returns. Retrospectively, it is clear that the industry became overcapitalized in 2000 when the Nasdaq fell from Source: Venture Economics 5000 to 1500 and the industry had invested over $100 billion. While top quartile returns for this vintage of fund will be Commitments to U.S. Venture Capital Funds disappointing, many investors lost much larger fortunes in ($B) the public markets. Looking forward with this perspective, we believe the industry over the longer term will generate compelling top-quartile returns. The best indication that the venture capital industry is not overcapitalized is compelling top-quartile returns. While company valuations are high and continue to rise, break-out companies will also continue to generate many multiples of invested capital. There are fewer venture firms today than five years ago, and they’re investing less capital, but competition for entrée into funds and for good investments Source: Venture Economics is still extremely intense. This is good for the industry. Competition forces ingenuity, creativity and highly differ- entiated strategies to maximize returns. We believe that most firms are right-sized for the strategies they are Regional Spotlight employing, and that the top-quartile will generate Venture capital and private equity firms invested about U.S. compelling returns. $1.1 billion in 66 Indian companies during 2004, an amount significantly higher than the $507 million invested in Indian There are many macroeconomic factors that bode well for companies in 2003 (TSJ Media division of Arun Enterprises; the future. CIOs and researchers expect technology spend- 2004 annual report). ing to continue to increase – IDC anticipates 5.6% growth in IT spending for the next 12 months and approximately The VC appetite for Indian investments and the supply of fundable 6% compounded annual growth through 2008 (IDC companies in India will likely remain consistent from 2004 to Blackbook, 3/05). Economists predict that technology spend- 2005, based on the experiences of the SVB India Advisors team ing will continue to increase as a percentage of GNP. located in Bangalore since Fall 2004. The team expects early Developing economies such as India and China are becom- stage and seed stage funding will continue to lag behind private ing major markets for sales as well as development, spurring equity and equity infusions in listed companies. However, the team is also noticing an increasing number of new cross-border new company formation as well as venture investment. company formations where companies are global in nature from day one and their primary operations are in India. Despite the travails of the last five years, venture capital con- tinues to offer an irresistible allure to both GPs and LPs SVB India Advisors Pvt. Ltd. is a subsidiary of Silicon Valley who know that if they’re visionary enough to identify an Bank. It is based in Bangalore to provide consulting and business emerging market, and smart (or lucky) enough to bet on the services to SVB clients and venture capital partners. right players in that market, they can reap tremendous rewards. The darling of the alternative asset class in 2004, venture capital will continue to hold that title for the fore- 04_india * seeable future. VC SVB Capital 5 March 2005
  6. 6. Cumulative Fund Type Performance as of 09/30/04 Cumulative Vintage Year Performance as of 09/30/04 Calculation Type: IRR Venture Capital Funds (only) Calculation Type: IRR Source: Thomson Financial Venture Economics/NVCA Source: Thomson Financial Venture Economics/NVCA Equity Financing* for U.S. Venture-Backed Companies, by Industry Group (2002-2004) *Equity financings include cash investments by professional venture capital firms, corporations, other private equity firms, and individuals into companies that have received at least one round of venture funding Source: VentureOne and Ernst & Young SVB Tech Investors Forum ISO Newsletter Silicon Valley Bank will highlight some of the SVB Asset Management, Silicon Valley Bank’s registered investment advisor best fast-growth technology companies around affiliate publishes a weekly newsletter offering timely economic news at its second annual SVB Tech Investor Forum about the technology and life science markets, and the private equity and September 7-8 in San Francisco. venture capital industries. The Investment Strategy Outlook (ISO) newsletter offers readers unique insight and analysis. * * * If you are unable to access the links within this document, please copy and paste the web address to your web browser. This update is for informational purposes only and is not a solicitation or recommendation that any particular investor should invest in any particular industry, security, or fund. SVB Asset Management (“SAM”) and SVB Securities (“SVBS”) are non-bank affiliates of Silicon Valley Bank. SVB Alliant is a wholly owned broker-dealer subsidiary of Silicon Valley Bancshares. Investments, products and services recommended by or offered through SAM, SVBS and SVB Alliant are not FDIC insured, are not bank guaranteed and may lose value. The information presented in this update is based in most part on information from third-party sources that we believe to be reliable, but which have not been independently verified by SVB Capital and as such, we do not represent that the information is accurate or complete. Opinions expressed are current opinions solely of SVB Capital. SVB Capital 6 March 2005