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THE VENTURE FINANCE ECOSYSTEM
Michael Danaher
Wilson Sonsini Goodrich & Rosati
26321792
1. Venture Funding Activity
2. Demand Side Dynamics
3. Supply Side Dynamics
4. Dealing with Deflation
5. Other Trends and Fashions
26321793
1. Venture Funding Activity
26321794
The View From on High:Investment Rises Slightly in 2Q’03
Am
ou
nt
Investe
d
($B
)N
um
ber o
f Deals$4.4
$5.7$5.8$7.6
$4.4 $3.5
$7.6$9.3$11.0
$19.2
$23.0$24.8
$26.9
$4.0
442
1786 1713
1427
1239
878801
723 710
563 594530
469 424
$0
$10
$20
$30
$40
2Q00 4Q00 2Q01 4Q01 2Q02 4Q02 2Q03
0
300
600
900
1,200
1,500
1,800
Amount Invested ($B) Number of Deals
Underlying data available in VentureSource
Source: VentureOne/Ernst & Young
26321795
The View From the Ground
Consumer confidence in the venture industry moved strongly up in the Spring
Multiple term sheets – what a concept!
Some instances of valuation giddiness
Overall activity is sharply up
First round deals are up
26321796
2. Demand Side Dynamics
26321797
Confidence is Up
The Market has awakened
1200
1300
1400
1500
1600
1700
1800
1900
2000
J anuary-03 April-03 J uly-03 October-03
Nasdaq Composite Index
26321798
Confidence is Up
0
10
20
30
40
50
60
2001 2002 2003* 2004*
S&P 500 EarningsPer Share
The economy has awakened
Source: Bloomberg & Zachs Investment Research
* Estimated Earnings
26321799
Confidence is Up
The world is adjusting to life after 9/11
The Iraq war ended quickly
263217910
Venture Fund Dynamics:The Clean-up is Mostly Done
In 2001 & 2002 VCs were preoccupied with the care of their existing portfolio
Now that most of the the triage is complete, VCs can focus on investing again
263217911
$2.4
$13.2
$48.8
$83.8
$55.7
$25.7
$16.6$13.2
$6.7$5.6$6.6$3.1
$0
$20
$40
$60
$80
$100
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 IH03
Fu
nd
s R
ais
ed
($
B)
Commitments to Venture Capital Funds
Underlying data available in VentureSource
Source: VentureOne/Ernst & Young
Venture Fund Dynamics
263217912
Nu
mb
er o
f Deals
Source: VentureOne/Ernst & Young
$7.5
$20.3
$35.4
$93.9
$49.2
$17.8$13.1$9.9
19012198
2520
4502
6165
3112
2156
866
$0
$25
$50
$75
$100
1996 1997 1998 1999 2000 2001 2002 1H03
0
1,000
2,000
3,000
4,000
5,000
6,000
Amount Invested ($B) Number of Deals
Underlying data available in VentureSource
Venture Fund Inflow and Outflow
$2.4
$13.2
$48.8
$83.8
$55.7
$25.7
$16.6$13.2
$6.7$5.6$6.6$3.1
$0
$20
$40
$60
$80
$100
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 IH03
Fu
nd
s R
ais
ed
($
B)
Am
ou
nt
Investe
d
($B
)
263217913
Source: VentureOne/Ernst & Young
Underlying data available in VentureSource
Venture Fund Inflows and the Nasdaq
$2.4
$13.2
$48.8
$83.8
$55.7
$25.7
$16.6$13.2
$6.7$5.6$6.6$3.1
$0
$20
$40
$60
$80
$100
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 IH03
Fu
nd
s R
ais
ed
($
B)
263217914
Negative Dynamics
A number of “fair weather funds” are drying up
Many top funds have downsized
Corporate investors are mostly gone
263217915
Corporate Investment is Mostly GoneA
mou
nt
Investe
d
($M
)
Underlying data available in VentureSource
Source: VentureOne/Ernst & Young
$130$142$129$106$242$253
$1,491$1,618
$1,928
$60 $104 $206 $49 $22
70
48
100
41
2429
120
135
2516 15 14 13 7
$0
$500
$1,000
$1,500
$2,000
1Q00 2Q00 3Q00 4Q00 1Q01 2Q01 3Q01 4Q01 1Q02 2Q02 3Q02 4Q02 1Q03 2Q03
0
25
50
75
100
125
Amount Invested ($M) Number of Deals
(except Intel and Cisco)
263217916
First Round Financings
0
500
1000
1500
2000
2500
3000
3500
1997 1998 1999 2000 2001 2002
Series A Deals
Data extrapolated from VentureSource
Source: VentureOne/Ernst & Young
263217917
Negative Dynamics
The Ex-Smoker Syndrome: the Reformed VC
• Excessively risk averse
• Excessively slow
• Excessively LP conscious
263217918
3. Supply Side Dynamics
263217919
“The older but wiser girl is the girl for me.”
-- The Music Man
263217920
The Entrepreneurs
More realistic about valuations
More patient about building a company, and building a career
More down-to-earth
More plentiful
More hard core technology plans
More thrifty
263217921
4. Dealing With Deflation
263217922
The Old Days of the New Economy
The market rewarded
•First to market
•Scale (e.g. engineer head count)
•Revenue prospects
Earnings didn’t matter
•The rational response: go fast, spend big, never mind the losses
263217923
Earnings Really Didn’t Matter
Year OfferingsPercent profitable
in IPO year
1999 47 49%
2000 66 9%
2001 13 31%
The WSGR IPO Universe*
(Company and Underwriter Side)
* An unofficial compilation
263217924
Exit Valuations Are Now Earnings Driven
IPO’s Require Profits
Acquirers want accretive acquisitions
•No big premiums for “time to market”
263217925
The Venture Industry Responds:Valuations Remain Down
Med
ian
Am
ou
nt
Investe
d (
$M
)
Underlying data available in VentureSource
Source: VentureOne/Ernst & Young
$6.7$6.2
$4.3$0.8
$0
$5
$10
$15
$20
$25
2Q00 3Q00 4Q00 1Q01 2Q01 3Q01 4Q01 1Q02 2Q02 3Q02 4Q02 1Q03 2Q03
Later Round Second Round First Round Seed Round
263217926
The Venture Industry Responds:Deal Size Remains Down
Med
ian
Am
ou
nt
Investe
d (
$M
)
Underlying data available in VentureSource
Source: VentureOne/Ernst & Young
$100
$17
$39
$14
$5
$13
$3$5$0
$20
$40
$60
$80
$100
1Q00 2Q00 3Q00 4Q00 1Q01 2Q01 3Q01 4Q01 1Q02 2Q02 3Q02 4Q02 1Q03 2Q03
Later Rounds
Second Round
First Round
Seed
263217927
The Entrepreneurs Respond:Run Silent, Run Cheap
Smaller budget business plans
Lower headcount, smaller salaries, cheaper facilities, leased equipment, smaller marketing budgets…
Focus, do less, outsource
Aim right—sell, design, build
Overseas Design Centers
263217928
The Entrepreneurs Respond:Run Silent, Run Cheap
Some great businesses are being built on $200k to $300k per month
263217929
5) Other Trends and Fashions
263217930
Proceed With Caution
Show me the customers
Almost every deal is syndicated
More first round deals are traunched
263217931
Other Deal Terms
Often smaller shares for founders (especially outside Silicon Valley)
Investors prefer plain vanilla deals when possible
•No cumulative dividends, weighted average anti-dilution
•Liquidation preferences: usually 1x participating preferred, often without caps
•Redemption rights (but why bother?)
263217932
Market Dislocations
Fewer dislocations (un-served sectors) than years past
•Most will consider first round, second round and mezzanine
•Seed rounds are still a problem – the angel market is still decimated
263217933
Market Dislocations
Out of fashion
•Optics
•Telecom services
In fashion
• Network security, homeland security (government sales!), wireless, consumer electronics, biotech