Funding products, not just ideas: venture capitalists are busy once again funneling money into new and growing companies--but with limits. 'We're not handing them the keys to the Porsche up front,' says one.

In June, New York-based software firm Powerllel Corp. snared $5.6 million in a first-round financing led by Kodiak Capital and Castille Partners, two respected Boston-area venture capital firms. And now, it seems, the sky's the limit as other firms are lining up to write checks when the firm next goes to market.

"Investors are calling us, and they're excited about our momentum in the market," says Powerllel president Eliot Listman, noting that revenues are projected at $1 million this year, up from negligible numbers in 2003. Powerllel's biggest selling point is that it boasts real-time solutions to real-world problems: its "parallel processing" software slashes to minutes the time it takes Wall Street firms to tot up complex logarithmic computations involved in hedging risks--tasks that still can take up to 12 hours to complete.

Similarly, the same software--which is compatible with the IBM, Microsoft, Hewlett-Packard and Veritas software platforms most commonly in use--can dramatically cut through the welter of calculations involved in drug interactions and which are required for pharmaceutical companies' regulatory filings. And, it has applications for the utility and energy industries as well.

Meanwhile, the fact that Powerllel boasts practical software applications has sustained Listman, his two partners and what are now Powerllel's 15 employees in the aftermath of the dotcom bubble's collapse in 2000-01. "What we had going for us was the fact that this was not just interesting technology, but something that can save a firm over $1 million in just the next 12 to 18 months," he says.

And now, amid signs of general economic recovery in the U.S., a steady stock market and a rebound in investor appetite for initial public offerings (IPOs), venture capital firms are once again on the prowl for good entrepreneurial financings. That means that companies like Powerllel are emerging as prime beneficiaries. Listman says that the company is poised to raise $8 million to $10 million during the next financing round.

And what Powerllel is experiencing is, by all accounts, taking place across the board. The most recent MoneyTree Survey reports that, in the second quarter of 2004, venture capital financings continued to rise as $5.6 billion was funneled into 761 companies, up from $5.0 billion in the previous quarter.

Moreover, the MoneyTree Survey, conducted jointly by the National Venture Capital Association, PricewaterhouseCoopers and Thomson Venture Economics, notes that financing for companies receiving their first round of venture capital rebounded in the second quarter to the highest level in two years. Some $1.2 billion went to 208 companies experiencing first-round financings, a 22 percent increase over the $981 million that went to 172 first-time financings during the previous quarter.

Michelle Jeffers, senior communications manager at VentureOne, a San Francisco research organization, remarked on the significance of this trend. "We think venture capital investors are regaining interest in laying the groundwork for the technological innovations of the future."

No matter what their stage of VC funding, companies on the receiving end are typically of higher quality than their counterparts during the bubble years. "What you are increasingly seeing is companies [getting VC funding] that have customers, revenues and sometimes even positive cash flow," says Kirk Walden, national director of venture capital research at PricewaterhouseCoopers. "This means there probably won't be another Webvan," he adds, referring to the notorious online grocer that went bankrupt in 2001.

"Business is a lot different," agrees Edwin Goodman, a partner at Milestone Venture Partners, a Manhattan venture capital firm. "During the bubble, an entrepreneur would come in and say, 'I have an idea and it's worth $10 million. The deal is closing at the end of next week.' And companies got a surfeit of cash. It was a crazy time."

Venetia Kontogouris, a managing director at Trident Capital, a Westport, Conn., venture firm, says that the pressure to get a piece of the action in the next big thing has dissipated. "We will walk away from deals if they're too expensive," she says, "even if we like the company."

Grove Street Advisors in Wellesley, Mass., currently parcels out $3.5 billion to venture capital firms and monitors their progress for employee pension funds for several states, including California and Florida. Clinton Harris, a partner at Grove Street, sees a markedly changed environment from the bubble's heyday, but believes that the industry has turned the post-bubble corner. "The economy has been coming back, and entrepreneurs are trying to start businesses and competition for deals is increasing," he says. "That's a bad thing for us, but good for the entrepreneur."

Even so, venture capitalists are much more circumspect. Before investing, they are spending more time on due diligence--"six weeks, not a few days," says Bill Ericson, a general partner at Mohr Davidow Ventures in Palo Alto, Calif.--and selecting companies that receive money with greater care. "Our investment criterion now is whether customers are willing to buy a company's products," he says.

Last September, MDV led the Bseries financing in ParAllele Bio-Science, a privately held provider of genetic-discovery tools, ponying up $7 million and acting as a catalyst in raising $22.5 million. What appealed to MDV about ParAllele was the fact that its tools "allow you to determine how genetic variation in different types of people affects their predilection for such diseases as diabetes and cancer," says Ericson, who took a seat on the company's board.

But before MDV opened its wallet to ParAllele, it thoroughly vetted the company and its technology. ParAllele got stellar reviews from the scientific community and, so far, MDV's bet appears to be paying off: since May, ParAllele's fortunes have been bolstered as Roche, Affymetrix Inc., Merck & Co. and the National Cancer Institute have forged partnerships with the South San Francisco company.

A similar investment philosophy prevails at Life Sciences Greenhouse of Central Pennsylvania, a $30 million venture capital firm based in Harrisburg that specializes in making what CEO Mel Billingsley characterizes as "pre-seed" investments in fledgling Keystone State companies with promising technology. "The need for early-stage funding has never been greater," Billingsley says.

Like MDV, Life Sciences Greenhouse prefers to invest in companies engaged in producing sophisticated tools, rather than in the direct development of therapeutic drugs. This is largely because the regulatory hurdles imposed by the Food and Drug Administration are less forbidding. Life Sciences Greenhouse invests up to $500,000 in favored firms, releasing the money in incremental dollops as milestones are met--a common post-bubble practice. "We don't give them the keys to the Porsche up front," Billingsley says.

Pennsylvania-based GlucoLight Corp. and NanoHorizons Inc. are companies that fit that Billingsley's No. 1 criterion: they have to solve a market problem. Bethlehem-based GlucoLight is developing a low-cost, non-invasive monitor for blood glucose that can be used at home by diabetics, who currently number 17 million in the U.S. and whose ranks are expected to double by 2025. Diabetes monitoring is a $2.5 billion market and, so far, the FDA has not approved a non-invasive product for self-monitoring of blood sugar.

A College Station start-up, NanoHorizons is a developer of nanotechnology products that includes QuickMass, "a gadget that analyzes drugs and their structures and the effects they have on a target at much more sensitive levels than has existed before," Billlingsley says.

Though still in its infancy, NanoHorizons has already formed strategic alliances with Shimadzu, a Japanese manufacture of throughput screening instrumentation, and Arrow International, a Reading, Pa.-based manufacturer of medical devices. Such strategic alliances are an important indicator that NanoHorizons products will have practical applications--and earn investors a return. "These are companies with established products and eventually a pathway to the market," says Billingsley.

By all accounts, the quality of entrepreneurial businesses is superior to the superficial companies that predominated in the late 1990s. As an example, MDV's Ericson cites portfolio company Shutterfly, an online photography service. Redwood City, Calif.-based Shutterfly has not only toughed it out over the last several years but has begun showing a profit. Ericson says it should have more seasoning before embarking on a public offering. "Another year of building the business, and it can go public from a position of strength," he says.

That thinking contrasts sharply with the mindset of the bubble era. "With the dot-coms, everyone thought we could expedite the baby's birth," says Trident's Kontogouris. "But we are back in the environment where we spend time with the management team, build businesses and view what has to be done from customer's point of view."

Moreover, she notes that, because of The Sarbanes-Oxley Act, fewer companies are going to go public as easily as they once did. Kontogouris estimates that Sarbanes-Oxley has tacked on $750,000 to $1 million to the cost of doing an IPO. "A lot of people don't understand that the world has changed radically in terms of requirements of going public," she says.

Even so, it does not make sense to manage a company with the goal of selling out to an acquirer, says Paul Phillips, managing director at Bank of America Securities and head of technology investment banking. "A company might want to sell itself, but that decision is also up to the buyer," he notes.

According to VentureOne's Jeffers, 24 companies went public in the second quarter, an upswing from the paucity of IPOs in recent quarters--but far short of the 40 IPOs per quarter averaged during 1992-2000. She reports that M & A activity is up markedly, however, during the first half of 2004, counting 88 transactions worth $11.3 billion, about equal to 1999 levels.

With both the IPO market and M & A business returning to robust health--witness the flurry of attention over the proposed IPO of Internet search giant Google--it should come as no surprise that institutional investors are jostling to gain entrance to venture capital funds, whose return on capital of more than 20 percent annually "has exceeded almost any index on a performance basis," notes Ron Weissman, a partner at Apax Partners, one of the largest VC firms in the world.

Which means that established firms with the best reputations remain the most coveted by investors. "What's happened is that there's a huge amount of money trying to get into good venture funds," says Grove Street's Harris. "But the VC industry is smaller and more disciplined. So a proven, high-quality team is currently able to line up investors before it issues a private placement memorandum. That means that in the current environment, most funds are spoken for even before the fundraising starts. It's a buyer's market."

Venture Capital Funding Rises

($ mil.)

Stage             2002      2003      2004*

Startup/Seed     266.0     373.8     163.2
Early Stage    4,179.5   3,501.8   2,021.7
Expansion     12,701.9  10,201.1   5,329.1
Later Stage    4,472.1   4,698.9   3,117.2
Totals        21,619.5  18,775.6  10,631.1

*2004 through first half only
Source: MoneyTree Survey

RELATED ARTICLE: New Technologies Draw Interest

New and developing companies in biotechnology, biomechanics and medical devices have caught many investors' eyes, says Stephen J. DeGroat, chairman and CEO of Jesup & Lamont Securities Corp., a boutique investment bank in New York. The firm has been working with a number of smaller companies in those areas, many of them Nasdaq-listed, with market capitalizations up to about $500 million, DeGroat says.

The firm has 15 research analysts who help uncover emerging companies, and Jesup & Lamont will take executives from those firms around to introduce them to institutional investors, DeGroat says. The firm also does conventional investment banking work such as fairness opinions, valuation analysis and merger and acquisition advisory services. "In the small-cap medical market, many companies really need to grow by acquisition," he adds.

DeGroat mentions other new technologies that are drawing investor interest: "class D power amplification," a kind of digital sound enhancement; micro-electronic mechanical systems, or MEMS; and human tissue engineering.

While many institutional investors are still on the sidelines, and access to capital isn't what it was in the late '90s, "a clever CFO can prosper on the Street," DeGroat says, if he or she can make a case for funding a growing company that has attractive products.

--Jeffrey Marshall

Paul Sweeney is a freelance business writer in Austin, Texas, and a frequent contributor to Financial Executive. He can be reached at 512.499.8749.