More Venture Capitalists Keep Their Wallets Closed

Volatile markets and spending cuts prompt investors to stay away from startups.
Venture-capital markets continued their downward spiral last quarter, reaching levels reminiscent of 1998, according to the quarterly PricewaterhouseCoopers/VentureEconomics/National Venture Capital Association MoneyTree Survey released Tuesday, as volatile markets and spending cuts prompted investors to keep their wallets closed.

In the third quarter of 2002, investors pumped only $4.5 billion into 647 entrepreneurial companies, a decrease of 26% from the prior quarter, which saw $6 billion of funding to 838 startups. The last time investing during a single quarter was below $5 billion was the first quarter of 1998, when it was $4.2 billion.

While IT startups consistently gain venture capitalists' attention, software companies continue to gather the largest amounts of cash despite a 10% drop in funding from the prior quarter. Representing 22% of total investment dollars, 180 software companies got funding, totaling $993 million. "Software is once again leading VC back to its roots, being the largest category in all of 2 but the last 10 years," says Tracy Lefteroff, global managing partner of the venture-capital practice at PricewaterhouseCoopers. He says that software companies are a safer bet for investors, as they have lower initial capital requirements and early milestones for achievements.

Meanwhile, telecommunications and networking companies continue to struggle amid a down market and the bitter taste of corporate malfeasance. Telecommunications, the second-largest industry category, fell 32% to $555 million in 67 companies and the networking category saw a comparable decline of 34% to $341 million in 39 deals.

While startups at all stages are struggling in this down market, the stakes are highest for new companies who want to gain first-time funding. Only 159 entrepreneurs received first-time funding in the third quarter, compared with 214 in the second quarter. Software startups took 30% of that money. But the good news is that the amount of money going into first-time investment rounds is increasing: These companies received $1.03 billion--23% of overall funding dollars compared with 20% of all funding dollars last quarter. Yet at the peak of the investment boom in 2000, first-time funding was $9 billion going toward 900 companies, more than the overall total for the third quarter 2002. "What we're clearly seeing in these data is a return to the pre-bubble environment," says Bob Grady, a general partner at Carlyle Group, a VC firm. "This isn't necessarily bad news because we're investing in a more-sustainable pace, and that's a requirement for a return to a positive investment environment."

Grady and other VC investment analysts agree that investors are seeing a longer development cycle before they can cash out on their investment through either merger or initial public offerings of their companies: They're now looking at four to five years' involvement with the companies they back, as opposed to about two years during the economic boom.

Overall, the tightened investment belts and commitment from VCs to invest long-term mean that only the brightest and the best entrepreneurs will get money. "We're moving back to a place that will allow us to build better companies," says Allan Ferguson, 3i Group venture-capital firm managing director. "We have more bright people around the table, the good entrepreneurs are back in the marketplace and the ones looking for a quick buck have gone elsewhere."