"Not as Much Ventured, but More to Gain?"
October 31, 2004
By Gary Rivlin

San Jose, Calif. - WHEN members of the Early Stage Venture Capital Alliance gathered here last month for its annual golf outing, the conversation turned - as it invariably does when venture capitalists congregate these days - to the resurgence of fierce competition among firms seeking to invest in promising start-ups.

Silicon Valley is again silly with venture capitalists jostling one another to own a piece of any young technology company with a plausible business model. And with this heightened competition comes fear that the exorbitant inflation that hit the venture industry in the late 1990's will return as investors again start throwing millions after the cockamamie and the absurd.

So the good news in the venture world last week was the seemingly bad news that venture investing was down in the third quarter - way down. After five consecutive quarters of robust growth, the research concern VentureOne found, the amount venture capitalists invested fell 15 percent, to $4.6 billion, from $5.4 billion in the second quarter.

Other data last week were even more dismal - or more encouraging, depending on one's perspective. By the calculations of PricewaterhouseCoopers, Thomson Venture Economics and the National Venture Capital Association, the three firms that publish the quarterly MoneyTree Survey, venture investing in the third quarter fell by 26 percent, in dollar terms, from the second quarter. The 601 deals that venture capitalists consummated from July through September were the fewest in any quarter since 1996.

It is unclear whether this is a sign of real restraint or just a pause in a resumption of the kind of reckless rush that led to the tech bubble and bust, some investors said. But, they added, it is at least a move in the right direction. "As a venture investor, this is great news," said Mitchell Kertzman, a venture capitalist at Hummer Winblad Venture Partners in San Francisco. "I'd like to see these numbers go down by more. Too much money being invested leads to an undisciplined environment. It leads to bidding wars."

Mr. Kertzman's view was seconded by more than a half-dozen other venture capitalists, and by Mark G. Heesen, the president of the National Venture Capital Association. "To be frank, a 25 percent increase in venture investing would be more alarming" than a steep decline, he said in a statement.

At the height of the Internet boom, venture firms collectively invested $23 billion to $29 billion a quarter. That figure plummeted to less than $5 billion a quarter by mid-2002 and held steady in the $4 billion range through the third quarter of 2003. But venture investing jumped 36 percent from the fourth quarter of last year to the second quarter this year, to $5.9 billion, the MoneyTree survey showed. That prompted venture capitalists to fret over a return to the crazy days of 1999 and 2000, when hype was high but the return on investment was depressingly low, if not negative.

"In my opinion, the entrepreneurial activity we've seen doesn't justify the increase in the rate of investing we've been seeing," said Paul Koontz, a partner at Foundation Capital a venture capital firm in Menlo Park, Calif. "There just aren't that many great ideas tied to great teams to explain that kind of increase in investment."

Part of the problem is that while the number of money-making ideas worthy of a venture investment may be limited, there is a chronic overabundance of venture capitalists, left from the boom years when the number of venture firms more than doubled.

"There's just too much money in the market chasing too few deals," said John C. Occhipinti, managing partner at the Woodside Fund in Redwood Shores, Calif. A year ago, a start-up considered itself fortunate if one venture firm was willing to cut a check for an ownership stake. Today, Mr. Occhipinti said, "it's not uncommon to have six or seven or more firms competing on a single deal."

Examples abound. Jack Danahy, chief executive of Ounce Labs, a software security start-up in Waltham, Mass., closed on a first round of financing in February. Since then, Mr. Danahy figures that he has heard from 20 venture capitalists interested in investing in future rounds.

Steve Baloff, a partner at Advanced Technology Ventures in Palo Alto, Calif., said: "With areas like security - areas that are hot - you have to scratch your head when you see the level of activity there. Why does the world need another 100 security companies when we've already got 800, or something like that?" He described as "very good news" this past quarter's steep decline in investing.

Venture capitalists, of course, do not care if their rivals lose money, but they do worry that the tendency to invest in 10 start-ups in a market that can handle no more than one or two companies harms everybody.

"Too many companies in one space diffuses the message and increases the cost of business," said Ted Schlein, a venture capitalist at Kleiner Perkins Caufield & Byers in Menlo Park, Calif. "It used to be you had to spend as much money as your dumbest competitor. We certainly don't want to go back to those days."

The numbers released last week help quell concerns about a return to those bad old days. But the third quarter is often, though not always, an off quarter for venture investing, because of summer vacations and other distractions.

"I'd caution against drawing any conclusions on a single quarter," Mr. Kertzman said. According to VentureOne, venture capitalists have invested $15.4 billion in 1,536 deals this year, versus $13.6 billion in 1,492 companies through the first nine months last year.

"We're going to see these numbers keep going up and down as everybody tries to figure out if it's safe to get out from beneath their beds and tinfoil hats and invest again," said Paul S. Kedrosky, a academic director of the Von Liebig Center for Entrepreneurism and Technology Advancement at the University of California at San Diego. So far, venture capitalists are acting with appropriate caution, added Mr. Kedrosky, who teaches venture capital courses in both the business and engineering schools. "A bunch of undisciplined people are so far acting with amazing discipline," he said.

THAT caution is evident in data that show that a larger portion of venture money went into first-round deals last quarter than at any time over the last two years. "To me this says we're seeing a return to fundamental, early-stage, new company starts," said Jonathan Feiber, the managing partner at Mohr, Davidow Ventures in Menlo Park, Calif. "At the same time, we're seeing a fall-off of later-stage funding rounds supporting the myriad of companies created during the bubble."

Still, some people worry that evidence of bubble behavior remains. Mr. Koontz of Foundation Capital says that for each company his partnership has financed, another 49 that he and his partners rejected have received financing from rival firms.

"Every day sees more companies that don't deserve it getting funding," he said. "In many ways the discipline that was lost during the crazy bubble days hasn't returned to the venture industry to the degree people think it has."

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