Venture capital investors send out mixed signals

07 May 2001

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The current investment climate is precipitating mixed reactions amongst the venture capital community, with many of the big-hitters remaining bullish, while others are afflicted with growing uncertainty. One of the prevailing sentiments is that bearish stock market valuations of quoted technology companies have forced the highly exaggerated valuations of unquoted companies down to much more realistic levels, creating a more attractive investment environment. However, Initiative Europeâ€™s preliminary results seem to suggest that investment activity has dropped off quite significantly, with the volume of technology investments in Q1 2001 down 40% from the previous quarter (from 403 deals to 241), with the largest fall recorded in the seed and early-stage categories. In comparison to Q1 2000, the volume of technology deals in Q1 2001 was down 20%, with a 44% decrease in the number of seed and early-stage deals. This decline in activity can be explained by widespread uncertainty as to whether we have reached the bottom of the cycle. Investors are proceeding with caution as valuations could potentially drop even further than their current level. In addition, many investors have been channelling their resources into the maintenance of their existing portfolios, rather than seeking new investment opportunities.

While the market correction has been credited with bringing valuations down to a more realistic level, it has also highlighted the problems associated with valuing unquoted businesses, particularly amongst seed and early-stage businesses, which have yet to post significant revenues. While quoted market prices have fallen, entrepreneurs have proved unwilling to accept the parallel decrease in the value of their unquoted companies. Similarly, existing investors have resisted â€˜down roundsâ€™, where new financial backers come in at a much lower price than a companyâ€™s existing investors. However, in the current climate, entrepreneurs and investors are under increasing pressure to downgrade their expectations, as the quest for funding becomes increasingly difficult.

The waning interest in cash-hungry early-stage businesses has led to an increase in activity in the later-stage investment category. Initiative Europeâ€™s preliminary figures indicate that expansion stage investments in Q1 2001 increased by 24 deals compared to the same period last year, from 139 deals to 162. As well as the obvious benefits of having established technologies and market positions, later stage companies are also less of a minefield to value, as investors can refer to revenue multiples. This vogue for expansion capital is demonstrated by the increasing appetite for later stage investment opportunities amongst traditional early-stage investors such as Atlas Venture.

The strong returns generated by technology investments during the previous 18 months attracted many new players to the market and led to the creation of a large pool of capital focused on the technology sector. The current investment climate has left many players struggling to deploy capital at a rate commensurate with the size of their funds and the distribution expectations of their limited partners. In light of this, a number of venture capital groups have returned money to their limited partners. Amongst these are Geocapital Partners, epartners and Azeo Ventures. Despite this gloomy outlook, many of the more established players have remained confident in their ability to put their capital to work, with Atlas Venture and Apax Partners both closing large funds in Q1. Despite the mixed messages coming from the venture capital community, the true test will be in three to five years time, when institutions begin to realize their portfolios.