a billion dollars in mixed signals
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a look at the numbers
In case you haven't been watching the papers, this quarter the Greater Washington region hit a significant milestone. For the first time, the region had over $1 billion dollars in venture capital invested in local companies. That is a significant threshold we've reached. In addition, both Texas and the Midwest also exceeded a billion dollars this quarter. That tells you that venture capital is growing, it's continuing to thrive, money is available and good deals are getting done.
Here are some of the highlights:
- Local companies raised $1.1 billion this quarter. That's a significant increase over Q1/2000, and it's the fifth quarter in a row that we've set a record. Nationally, $19.6 billion was invested in 1,432 companies. That amount exceeded the $17.2 billion invested in 1,414 companies in Q1 by 14%. As you can see, the dollars that are being invested have continued to increase. It doesn't appear, at least for this quarter, that the market volatility impacted venture capital investments, however, a significant amount of the investments that were made in Q2 were already in the pipeline before the public markets began to experience the volatility of the last 4 or 5 months.
- A look at Greater Washington regional investments by industry show that telecom-related deals continued to receive the bulk of the money during Q2 at about $430 million. This is largely because of the need for telecom companies to build infrastructure and is very consistent with national trends where 8 of the 11 largest deals in the nation were telecom-related companies. Software garnered the second largest amount of investment dollars in the region at $243 million. These two sectors continue to emerge as the dominant sectors in our region.
- The MoneyTree survey tracks investments in a number of key industries. Internet-related companies and products cross those industries, so we also try to break out Internet investments as a sub-industry group to give you an idea of what those numbers look like. In total, we had $785 million invested in Q2/2000 in Internet or Internet-related companies and products. The largest amount of investment in this quarter was in the Access & Infrastructure sector, which is, as I mentioned, a very hot area for Internet companies right now. B2B and B2C have fallen out of favor. B2C is not a very significant piece of the total in our region. We would expect it to continue to decline, and we are expecting that investments in B2B companies also will fall in Q3.
Figure 1:Comparing Internet Sector Deals (in $ millions)
- Formative stage investment are 41% of the total funds invested; expansion stage companies are 50%. We're still having a tremendous number of startups and early stage companies raising their first rounds in the region.
- Average deal size in the region increased to $14.2 million in the second quarter. This is a 40% increase from Q1, and a very significant increase. It's also a 68% increase over Q2/1999. In comparison, the average investment size for the first six months of 2000 on a national basis was $12.9 million, so we're slightly higher than the average investment nationally for the first six months of the year. This is a bit skewed because some companies got pretty significant rounds in the region to increase the average.
the panel: analysis and commentary
Mr. Thompson: This quarter, the average deal size in the region increased by 40% over Q1. Typically, that would indicate that valuations had increased, however the public markets show that's probably not the story. In fact, we've seen valuations fall. Are we in a buyer's or seller's market?
Mr. May: Unfortunately, it all depends on whether you're in the hot telecom and infrastructure space and have a great management team. If you're desirable, you may still be able to match some of the public stock valuations, get exorbitant valuations and force an auction from people like us. On the other hand, if you're like most of the other people we deal with at the earlier stages, you're probably now back at a more reasonable relationship between the funding source and the entrepreneur. Where once the entrepreneur could dictate the price and have a bunch of money chasing it, the bloom is off the rose. In the less-hot areas we're back to a more normal discussion of the value proposition, what you bring to the table and how our money will help you grow.
Mr. Burke: I concur. There has obviously been a rationalization of valuations except in the hot spaces. I think that one reason why deal size and round size have gone up but valuations have not gone up measurably is probably that most groups are now funding to 18 months of cash. We don't want you to have to go back out to private markets within 18 months. If your business model is predicated upon free and easy access to money, you're going to have a hard time. People are raising more money to put away and weather the storm.
Mr. Muleta: I agree, although it's not as much sectors, from my perspective, as it's all about management. People who have done it before will get the money. The money is going to a few people and everybody else is dropping off.
Be reasonable about valuation, that's the story line that I hear. A lot of people come in and say, “I have a great idea; it's worth $50 million.” Nobody wants to hear about that, so I agree with what the others have said. It's a tough market, so you have to be well funded. Money is going to be difficult to come by, so show a plan for 18 to 24 months. The VCs are also thinking that they have to support companies that they have already put money into, so there is more claim on dollars from the hot times. They have to support companies for three or four more rounds than they originally planned because they thought they were going to take them public a lot faster. Those are the market dynamics everybody needs to understand when they are dealing with a VC.
Mr. Thompson: What are your expectations for valuations in the third and fourth quarters, especially for companies that raised their first round in early 2000 or late 1999 and that are now going out for that second round?
Mr. Muleta: Everybody would like to see an uptick, but I think you're going to go back and say, “My funding horizon is a little bit longer, so do the same valuation, just increase the capital reserve so we won't be desperate for cash. We want to time the market when we go public or go for a private placement, so we would like to get a broader base of support and bring in people who are strategic and validate the idea.” Those are the kinds of words the VCs will want to hear. They don't care to get another VC into it, they want to hear that Intel is going to buy your product or Thomson Publishing is going to buy your content or partner with you because it's a good model. That's where the value is going to show up, and that's why I think a lot of corporate venture funds are being formed to take advantage of that opportunity.
Mr. Burke: Some of our companies are doing a small uptick or an even round. More importantly, though, now you're going to have to look very carefully at the milestones you have accomplished since your first round. Did you accomplish them? Were they significant? You just don't have the luxury you had before. Also, it's important to look at who you are going to bring into a round if you do expand it. A lot of the newer funds are pretty strapped with having to support their existing investments, so you're going to have to look for the funds and corporate ventures that have the deeper pockets.
Mr. May: A lot depends on whether the original round was a long time ago or just recently, and whether you were able to be realistic about the objectives you set at the time you made the promises. In the end, good deals with management teams will get funded and gradually get an uptick. If, however, you took advantage of the rapid curve and assumed it could continue like Q1, then you set yourself up for a fall once things got more normalized. If you look at the chart, it was an unrealistic curve.
If you look at some lists of deals today, they don’t even get down to transactions below $3.5 million. Two or three years ago, that would have been the norm. In fact, we would have loved a $3.5 million transaction as the norm. Now it's at the bottom, and they cut it off as too small to list. There's still a lot of money in the early stages; it's just not being counted because of the mega-deals. Most people in the audience probably are not in the $50 million range wondering if they're going to get a second or third round.
on building management teams
Mr. Thompson: It is often very difficult for startup companies to pull together a top management team. Management talent is not around in excess, and there is a lot of competition for it. In addition, it looks like the VC industry is becoming more hesitant to put money into companies that don't have strong management. There has been some discussion in the press about the ability of companies with a 20- or 25-year old CEO to still raise money. Even in that first round, is the CEO going to be taken out for one that has experience?
Mr. Burke: The VC mantra has always been that we invest in management, and we still do. One mistake that a lot of the young companies make is filling their advisory boards and their boards of directors with industry luminaries who have big names and backgrounds but don't do anything. That may have worked in the past, but we still invest in management and we still invest in you. We want to see a board of advisors that is really going to make a contribution and help you. It's not a mark against you that you're 25 years old; that really hasn't changed. We want to invest in the smart people.
Mr. May: A lot has to do with your track record in whatever business you have been in and what your peers think of you. Whether it's a team out of Nextel or some other company, the key thing is how successful you were, your track record. As John noted, there is a difference between “gray hairs” as window dressing and as advisors¾the true angels advisors and early stage backers who believe in you, are at risk with you and are integral to your decision-making. If you're a younger, more inexperienced entrepreneur, one of the best things a VC can see is, as someone called it¾ “adult supervision” ¾that you've listened to advisors and used some of the best intermediary service providers in town. You don't have to have a management team that's all full-time, super-experienced and top-flight; it could be that you've bundled yourself with a service provider team, an advisory board or some angel investors that you're listening to and that we can verify that you’re integrating. That's how you grow your team.
Mr. Muleta: Honesty is what counts. You have to be good at what you do and be an expert in order to convince somebody that you ought to get funded, that you have a brilliant idea in this particular niche or sector. The next thing is to admit what you are good at and what you’re not good at¾not good at marketing or accounting or finance or whatever. The key is to present yourself and say, “Yes, these are management holes that I need to fix in order to get there, but I can't get there until I get funded.” It doesn't mean that you're coming from a position of weakness, and it shows a level of self-awareness at least. Talk about your strengths, then talk about your weaknesses, then say, “That's why I need the money.” The main reason you need the money is not to build the Web site, it is to attract the management that gets you the right Web site, or the right business model, or whatever. The money is for the people, and you have to make that case. You cannot attract talented, high-end people unless you're financed, and that's what people need to hear.
I'll do a pitch for PSINet Ventures and say that one of the things we offer is services for equity. One of the ways of using your cash wisely so that you can hire the right people is to do a deal with somebody like us so you can get the Web site up and still use your cash for recruitment. That's why we started our fund, because we realized that a lot of entrepreneurs had to ask themselves, “Do I build the Web site, get my engine up and running or should I hire the talented person who is going to convince John May to invest cash in me?” We set up the structure because we realized where the market was heading.
Regarding advisory boards, if someone is on your advisory board, it doesn't really mean much. It may just mean you have his or business card and she's agreed to listen to you. If you can show that you've had a deeper relationship¾meaning that you used to work for that person¾then it means something to me. He may just be a nice guy who has a hard time saying no, so make sure that you get somebody who is going to be of value, someone who can call John May and say that you worked together and have it mean something.
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