2004: A Step in the right Direction?

The numbers are better, but that’s not saying much

By Frank Demmler

The numbers are coming in and 2004 was better than 2003 in most respects. Of course, 2003 wasn’t much to write home about.

According to figures recently released by the National Venture Capital Association (NVCA), the highlights are:

· Venture capital funds raised $17.6 billion in 2004, up from $10.6 billion in 2003.

· Venture capital funds invested $20.9 billion in portfolio companies, up from $18.9 billion the prior year.

Let’s put this into some perspective.

Venture Capital Flow of Funds

Venture capital firms manage venture capital funds. Let me explain.

1. A group of people gets together and decides to go into the venture capital business together. They create a firm.
2. This firm then becomes the general partner of a limited partnership. The limited partnership is the proposed venture capital fund.
3. They hang out a shingle and announce that they are raising a venture capital fund of some targeted amount.
4. If everything goes according to plan, they then raise money for their venture capital fund, primarily from institutional investors, such as pension funds and insurance companies.
5. With their venture capital fund in place, the venture capitalists make investments in portfolio companies.
6. The portfolio companies are sold or they go public.
7. The proceeds from these transactions are distributed to the investors.
8. If the investors are pleased with the results, the venture capital management company (the firm) will seek investment into a new limited partnership, designated with Roman numeral II. (Actually, follow on funds are often raised
9. And so it goes.

For example, Adams Capital Management, manages three venture capital funds ACM I, ACM II and ACM III that total over $700 million.

Capital Raised by Venture Capital Funds

OK, so the process starts with venture capitalists raising money from institutional investors. Where does $17.6 billion fit in the overall scheme of things? Let’s take a look at the high and low points of recent years.

1989 Peak $5.6 billion

1991 Trough $1.7 billion

1994 Rebound $7.6 billion

1998 Internet infancy $29.4 billion

2000 Internet BOOM $106.1 billion

2002 Internet BUST $3.7 billion

2004 Return to normalcy? $17.6 billion

Let’s say it’s encouraging. The extreme swings of recent years, and their consequences, have caused a suspension of “normal” behavior by venture capital funds, particularly in their avoidance of early stage companies.

A Look Behind the 2004 Numbers

Almost 75% of the capital raised went into follow on funds (Roman numerals), meaning that it is still extremely difficult for new partnerships to get traction with institutional investors. For entrepreneurs, that means that the universe of potential investors aren’t likely to have changed, but perhaps they will have new funds from which to invest.

Locally, Draper Triangle had an initial closing on its second fund in 2004, and PA Early Stage closed its third fund and opened an office in Pittsburgh. Let’s hope that other venture capitalists are successful in raising new funds in 2005.

Venture capitalists invested:

• $20.9 billion in 2,876 deals;
• in 796 companies receiving first-time venture capital investment across all stages, of which early stage companies were a subset;
• in 841 deals in companies classified as early stage by the NVCA, meaning that many of these investments were follow on investments in existing portfolio companies; and
• 27% of the capital in Life Sciences companies, near the industry’s all time high.

I leave it you to decide whether you think things have improved appreciably.

Regional Musings

It’s pretty sobering when you think about the size of the Pittsburgh Region in the context of these national statistics. Overall, we’re probably behind our “fair share” of venture capital, deals and invested capital. Yet our collective aspirations require us to exceed our pro rata share, by a significant margin. We’ve got our work cut out for us.

Frank Demmler is Associate Teaching Professor of Entrepreneurship at the Donald H. Jones Center for Entrepreneurship at the Tepper School of Business at Carnegie Mellon University. Previously he was president & CEO of the Future Fund, general partner of the Pittsburgh Seed Fund, co-founder & investment advisor to the Western Pennsylvania Adventure Capital Fund, as well as vice president, venture development, for The Enterprise Corporation of Pittsburgh. An archive of this series of articles can be found at my website.