Venture capital forecast: hot with a chance of storms; The venture capital market has come back strongly from its lows in 2001, but concerns linger over funding of startups, exit strategies for companies reluctant to go public and a surfeit of cash for generating realistic returns.

Venture capital has finally shaken off the stigma of the dot-com bubble--but that doesn't necessarily mean that skies are a cloudless blue for companies seeking funding, or for venture capitalist firms themselves.

"In 2004 we showed, statistically speaking, an increase over 2003, but perceptually it ended the steady decline we'd seen going back to the peak in 2000. We've reached the point where industry itself is investing at a steady pace," says Kirk Walden, national director for venture capital research at PricewaterhouseCoopers.

According to the Money Tree Survey produced by his firm, together with Thomson Venture Economics and the National Venture Capital Association, venture capitalists invested $10.6 billion in the first half of 2005, putting them on track to match or top the $21 billion invested in 2004.

Interest in venture capital investing is now so strong that some complain that the supply of funds is far greater than what the industry can economically invest. "I'm still fairly worried about the huge amount of fundamental demand to get into venture capital from private equity investors and pension funds all over the world," says Dixon Doll, cofounder and managing general partner of Doll Capital Management.

"There's just no way there's enough good-quality, top-tier venture capital firms that can responsibly invest and put decent performance behind the aggregate amounts of capital that would like to come into our industry right now," Doll adds. "That's one of the most worrisome things."

But finding enough good investments isn't the only potential headache. Despite the flood of capital looking for venture opportunities, it's harder than ever for startups to raise money. Prior to the bubble, first-time financings accounted for about a third of venture capital invested. That surged to almost 40 percent during the froth of 2000, but these days only a quarter of venture money goes to first-time financings.

Most venture capitalists look for some proof of concept in a track record, and prefer later-stage investments. "The days of closing a deal on the back of cocktail napkin or getting $10 million for a good PowerPoint presentation are gone," says Walden. As traditional venture firms back away from startups, angel investor groups have grown in importance. (Angels are private investors willing to underwrite entrepreneurs.)

In recent years, there has been a trend for angels to form groups that pool their capital, evaluate opportunities and invest cooperatively. According to a report by the Center for Venture Research at the University of New Hampshire's Whittemore School of Business and Economics, angels invested $22.5 billion in 2004, up from $18.1 billion in 2003, and the number of firms receiving angel money increased by 24 percent over the same period.

Venture capitalists have also had to adjust their thinking with respect to exit strategies. Sarbanes-Oxley Section 404-related costs have had a chilling effect on companies wanting to go public via initial public offerings (IPOs), so exit strategies depend increasingly on the mergers and acquisitions market. The geography of venture capital is changing too. Asia, and especially China, are either explicitly or implicitly a factor in almost every venture investment. "With all of our portfolio companies, we insist on a China strategy and a global strategy to make their precious venture capital go farther from Day One," says Doll. "We think that's going to help us deliver better returns for our investors."

In the Beginning

Tim Draper, founder of Draper Fisher Jurvetson, an early investor in Hot-mail and the proud inventor of viral marketing, is something of an anomaly these days, and not only because of his record of success. Draper does venture capital the old-fashioned way.

Consider, for example, his investment in SKYPE. "I got enamored with the spirit of peer-to-peer technology," he recalls, and decided to meet the people who had founded KaZaA, the music file-sharing phenomenon. He planned to invest in KaZaA and "take it in a new direction." When he met the founders, though, they had already sold KaZaA and moved on to another idea that they discussed with him.

"I was so impressed, I said, 'Okay, I'm ready to invest.' Months later, we still hadn't made the investment. They came back and said, 'It's going to be a little different, we're going to use this peer-to-peer technology for telecom. We can actually create a system where people can talk to each other free.'"

That, in brief, was the origin of SKYPE, the global telecommunications network based on peer-to-peer technology. SKYPE doesn't need telephones: Users can call each other from their computers for free. SKYPE makes money on calls to and from traditional phones, and from ancillary services, such as voicemail.

Draper expects that software developers will take advantage of SKYPE's application program interface (API) to create a host of other applications for SKYPE. And that kind of thing is what keeps the excitement in venture capital. "I love the idea of something that can immediately spread to the entire planet," he says. He describes venture capital as a three-legged stool that depends on a market potential, unique technology and people who are "extraordinarily passionate about what they do, and in it for the long run. It has to be all that matters to them."

Most venture capitalists don't share Draper's enthusiasm for early-stage investing, or his tolerance for risk. Many seem to be looking for an elusive combination of low risk and high return. Proof of concept is high on the list of things they demand, and track records offer the best proof.

Walden tells the story of a venture capitalist who recently went with an entrepreneur to talk with two potential customers. "What the venture capitalist wanted to know was, 'If this entrepreneur would make this product, you will buy it--right?'" The potential customer wouldn't answer the question directly. But even the fact that a venture capitalist would ask it represents a change in the culture of the VC business.

It's not just that VCs are becoming more risk-averse. Ironically, John Igoe, co-chair of the private equity/venture practice group at the West Palm Beach, Fla., branch of law firm Edwards & Angell, says that very volume of money pouring into venture capital funds may be responsible for general avoidance of early-stage investing. "There's pressure to get these large funds invested, and with limited resources, it's difficult to do that in a number of small investments. A startup company investment is going to be in single-digit millions, as opposed to later stage, when you can invest $10 million at a time."

Helping to fill the gap for entrepreneurs are angel groups. "Ten years ago, I don't think there was an angel group in Florida, but now there are several," Igoe says. The Kansas City-based Kaufmann Foundation, dedicated to promoting entrepreneurship, sponsored formation of the Angel Capital Association in late 2003. The association now has 200 member organizations--three of which are ranked near the top of the MoneyTree survey as leading sources of capital for entrepreneurs. Marianne Hudson, a spokesperson for the association, says, "We think angels are responsible for 90 percent of the outside equity--after friends and family--for startups."

Geography of Venture Capital

"We have the distinction of launching our firm within five days of the peak of the Nasdaq [index, in 2000]," reflects Jonathan Roberts, a partner in Ignition, a venture capital firm formed by a group of former Microsoft Corp. and McCaw Cellular executives--and joined this year by former Microsoft CFO John Connors.

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Ignition has a distinctive, if not unique, approach. "We operate in teams of four on a given focus area," Roberts explains. "Within each team, we form a thesis on where we think areas of opportunity are, the key business and technical trends and, given that, the best types of deals. We have a very active entrepreneur-in-residence program where an inspired entrepreneur comes in and works with a team, and we help the entrepreneur develop the business."

Over half of Ignition's deals are proprietary, he says, and of the approximately 40 deals Ignition has done, roughly 70 percent have been with entrepreneurs in the Pacific Northwest. In fact, Roberts believes that geography is part of what makes Ignition's model work.

"I think our model is very well suited to the Seattle and Northwest market, because we have an incomplete ecosystem up here," he explains. "We do not have a huge stable of serial entrepreneurs. We don't have a ton of angel money funding the market; there's a lot of large and dominant companies, but not a lot in the midrange that creates the management talent that is the engine of startups. So, our operating approach is very well suited to this market. I would not presume to say that it is the ideal for Silicon Valley."

Geography clearly matters in venture capital, affecting everything from business models to the supply of capital. Tracy Lefteroff, global managing partner of the venture capital practice at PricewaterhouseCoopers, notes that "a lot of people in Europe are very risk-averse and have a different view on work-life balance than we do in the U.S. A lot of cultural issues make it more difficult for a venture capital-backed startup to be successful in Europe." In the U.S., Silicon Valley still stakes the lion's share of venture capital, but pockets of venture opportunity open in what seem some unlikely places.

Reston, Va.-based Spacevest, for example, has a particular--though not exclusive--focus on technologies related to aerospace and telecommunications. Says chairman John Higginbotham, "Our firm is in tune with the interconnections with the public and private sector. We have a robust government market in the Mid-Atlantic region, but people sometimes underestimate the amount of telecommunications and information technology activity in the region. Incredible talent, very entrepreneurial companies, a robust market [that is] probably underserved and a bit overlooked--fortunately for us."

But the most important geography in the venture market is Asia, and specifically China. Doll isn't the only venture capitalist to emphasize the importance of an Asia strategy to aspiring entrepreneurs. Although Ignition, for example, has not invested directly in China, Roberts notes that a number of ventures in the firm's portfolio do testing and development work in Asia. One of Higginbotham's portfolio firms, Protostar, is targeting Asia with a new approach to satellite broadcasting.

Doll Capital Management is one of the most active Silicon Valley venture firms in China--and that's saying something. "Not a week goes by that there are not some new funds being organized or new partnerships between Silicon Valley venture firms and Chinese firms," Doll says. "But the Chinese venture capital market is the wild, Wild West. There's a tremendous shortage of really competent management talent in the Chinese market."

Exit strategies are also challenging. "When we start up an investment in China, we have to put in place all the mechanisms to take it public on the Nasdaq or NYSE (New York Stock Exchange) or in Hong Kong because the markets in China won't be reformed in the next seven to 10 years to allow startups to go public inside China and get the money out," Doll explains. A recent government regulation has cast a further pall over the Chinese market by making it more difficult to set up the offshore vehicles that make such arrangements possible. Although Doll says that valuations on early-stage venture investments in China are still attractive, mid-and later-stage valuations are "definitely experiencing a bubble."

The Sarbanes-Oxley Chill

Meanwhile, exit strategies have gotten more challenging in the U.S., where accounting regulations have all but shut the door on prospects for an IPO exit. Mike Maher, CFO of U.S. Venture Partners, says, "Sarbanes-Oxley is making it extremely difficult for our portfolio companies to go public." The cost of compliance with the Act's Section 404 for public companies is so onerous that IPOs are decidedly unattractive to many venture investors and entrepreneurs.

Says Mark Heeson, president of the National Venture Capital Association, "It has tilted the scale more towards being acquired because you don't have to pay as much to be acquired, you don't have to put up with the hassles of Sarbanes-Oxley as much. So, today we are seeing more companies that had the potential to go public looking much more seriously at being acquired. If that trend continues, it will have long-term significance in the U.S. economy."

But the cost of Sarbanes-Oxley internal controls and audits isn't the only problem. Some venture-backed firms are having trouble getting their audits done at all. Maher, for example, is now surveying his portfolio companies to find out precisely how many have not yet completed their 2004 audits.

"Most of the Big Four have had to spend so much time on the Sarbanes-Oxley audits of big public companies that they have had no time to devote to the private companies. These private companies have provisions in many of their borrowing agreements, and in most of our investment documents, that require delivery of audited financial statements within 90 to 120 days of yearend--and they can't do it."

In sum, venture capital investing has clearly gotten past the stigma of the go-go tech bubble years. Venture capitalists have become much more demanding of entrepreneurs, and there's little to argue with in that. Sarbanes-Oxley concerns, which regulators already seem likely to address, must take a back seat to the question of how long the venture capital discipline can hold.

Some observers believe that the venture capital world operates on roughly a 10-year cycle, running from caution to euphoria to crash, and back. If the past pattern holds, venture firms are now midway between the last crash and the next bout of euphoric over-investment. But there is reason to hope that the industry has learned lessons that will endure.

Gregory J. Millman ([e-mail]) is a freelance business writer in New Jersey and a frequent contributor to Financial Executive.

RELATED ARTICLE: takeaways

* The venture capital market seems to be thriving, based on cash pouring into the funds and the aggregate investments being made.

* Concerns are being raised about a number of issues, such as the challenge of an exit strategy when companies are increasingly reluctant to go public.

* Sarbanes-Oxley compliance costs are driving many small companies away from the IPO market and toward the notion of being acquired.

* Asia, and particularly China, is an increasing focus for VC firms, who are asking entrepreneurs about their strategy for that part of the world.