Early-Stage VC Funding Stages a Comeback

After years of sluggish deal-making, early stage venture capital investing appears to have made a comeback in the U.S., with about a third of dollars flowing into seed funding and series A rounds in 2004, according to a report released today by Ernst & Young LLP and VentureOne.

The report says U.S. venture capital investment increased to US$20.5 billion across 2,067 deals in 2004. This represents an 8 percent increase over the $18.9 billion invested in U.S. companies in 2003, the first year-to-year increase since the boom days of the year 2000.

"Our research really suggests that we are at the start of the next venture capital cycle, says Bryan Pearce, Ernst & Young's New England Venture Capital Advisory Group leader.

Getting in Early

The highest concentration of deal-making was focused on biopharmaceutical and information technology firms. During 2004, investors sunk $4.3 billion into 228 biopharmaceutical deals and put $11.3 billion into 1,235 information technology companies.

Strikingly, 37 percent of VC deals were early-stage funding rounds in 2004, the highest percentage since 2001.

This is happening, in part, because with portfolio companies fetching good sales prices, many VCs are wrapping up their last series of investments and starting all over again raising new funds from their partners. In 2004, VCs raised $15 billion to $16 billion in fresh funding.

Maturity counts

Because they're starting over, this a logical time for VCs to bet on younger companies. Since it can take five or six years to sell a portfolio company or bring it to IPO, VCs prefer to do their early-stage investing at the beginning of their fund's 10 to 12-year lifecycle, Pearce notes.

On the other hand, the companies that found early-stage investors in 2004 weren't the hope-and-a-prayer types that got funded during the dotcom boom.

"Companies getting their first round of funding today are much more mature than they were in prior years," Pearce says. "They have more complete management teams, in many cases they have revenue before they take the VC money, and the venture investment is being used to expand rather than create technology."

A Hopeful Sign

Investments grew, in part, because venture capital firms made a higher overall estimate of the value of the companies they were funding than they had in prior years.

In 2004, the median pre-investment valuation was a much-improved $12.5 million, compared to the low-water mark of $8.9 million in the second quarter of 2003, the E&Y/VentureOne study found.

But optimism isn't the only reason VCs are making larger investments and valuing target firms more highly.

Over the past year, with market conditions improving substantially, VCs have found it easier to sell their portfolio companies at a good price and easier to bring them to initial public offerings, giving them more cash to throw around.

In 2004, 376 venture-backed companies sold for a total of $22.6 billion, a big jump from 2003 which saw 335 companies sold for only $12.9 billion.

On the other hand, if interest rates were to rise, that could slow down the sale of investors' portfolio companies, not to mention making the public markets less accessible, says Jonathan Skinner, a principal with investment banking firm Adams Harkness.

Continuing historically low interest rates have helped fuel the revitalized IPO market, as public markets generally do well when general economic indicators are positive, Harkness notes. Also, low interest rates have also made debt financing for acquisitions more affordable.

"If interest rates move up, and that acts as a suppresor on the equity market, that would likely have a dampening effect on the M&A market," Skinner says.