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Venture capital market in 2002 marked a return to the old fundamentals Back  
In reviewing the venture capital sector Jimmy Maher writes that we have moved on from the halcyon days back to the ‘old paradigm’ of business fundamentals and he says that the old adage of the three keys to venture capital of ‘management’, ‘management’, and ‘management’ has made a comeback.
The current investment climate has been the subject of many column inches over the past number of months. Some of the articles make for depressing reading so much so that one wonders whether people are talking themselves into a self-fulfilling prophecy. At the end of 1999, the key feature of venture capital (VC) activity was the significant uplift in investment activity during that year. What was fuelling investments was the quick turn from ‘idea’ to ‘initial public offering (IPO)’ that was being experienced at that time. IPO successes, especially in the US, for firms without any near term profitability potential had altered the risk relationship between investors and start-ups, in particular, and created the ‘new paradigm’.

At that time the success of a small number of Irish technology companies in global markets helped change the investment climate for technology start-ups in Ireland given the ‘heady potential returns’. Venture capital firms found themselves competing to get involved in start-ups.

Clearly we have moved from these halcyon days back to the ‘old paradigm’ of business fundamentals. The old adage of the three keys to venture capital of ‘management’, ‘management’, ‘management’ has made a comeback.
The overall picture for 2002 is one of decreasing investment. Various reports to date on venture capital investment in Europe indicate a decline of between 30 - 40 per cent in investment in the nine months to 30 September 2002. There is a paucity of investment statistics for VC investment in Irish companies during 2002; however, intuitively the level of investment is down but probably by not as much as the European figure of 40 per cent. In addition, reports on VC investment in Ireland vary significantly, especially as to the amount invested, for example some reports appear to include investments from all sources i.e. private individuals, corporates, government agencies and VCs.

Another feature in 2002 was the continuing trend of VCs focusing their attention on portfolio companies to ensure they successfully navigate their way through these lean times. This in turn has lead to an emphasis on later stage deals. 2002 also saw a noticeable decrease in investment in seed and early stage companies continuing a trend that became evident in 2001.

From discussions with a number of VCs and other investors, considerable effort has been made over the last 18 months or so in focusing and helping certain investee companies reorganise and restructure. In assisting their portfolio companies many VCs have been active in 2002 in seeking to drive consolidation in certain technology sectors. Irish VCs are considering each other’s portfolios with a view to identifying suitable merger/acquisition candidates and are looking at opportunities in the UK and other territories for complementary type businesses.

Interestingly, VCs have found this year that ‘ego’ has become less of an issue as management have (of necessity or otherwise) become more realistic and pragmatic. ‘Perseverance’ and ‘tenacity’ have become the prime qualities sought by VCs in a management team, reflecting an ability to ride with the tough times.

As with their European counterparts, Irish technology companies are not finding things significantly easier, they face the same market fundamentals. They all experienced the splurge by the major corporates on technology and software spending for Y2K. The market expected a short-term dip in spending on software post-2000 to last no more than six months. The dip has continued for two years and consequently entrepreneurs have been forced to become pragmatic in assessing their own business fundamentals with an emphasis on burn rates and customer traction.

This pragmatism has also extended in many cases to an assessment of whether to merge, acquire or sell. Certain VCs have concluded that there are too many small companies chasing the same customer base and are not sustainable in their own right. In the current climate, ‘credibility’ and ‘financial strength’ are important to corporates issuing requests for proposals, as they need to be confident about a continuing source of supply.

Conditions for investment have very much returned to the more sound and sustainable basis that prevailed before the ‘irrational exuberance’ that dominated the capital markets in recent years. VCs are taking more time to conduct extensive due diligence and are seeking out companies with proven management, existing seed capital, and a ready market for their products. If the value equation is not right, the VCs are not prepared to invest. The key points on VC investment arising from 2002 were:

Caution: Greater caution prevailed because of the uncertainty in the market and sectors giving rise to greater scrutiny especially in the area of commercial due diligence.

Timing: Deals took longer, six months plus, against the background of greater scrutiny.

Sustainable models: There has been a greater focus on the viability of the business and security of supply.

Lower valuations: Valuations became more realistic, driven by market forces.

Sophisticated financial structures: Investors have been burned in the downturn, giving rise to more aggressive structures in exit and anti-dilution preferences in trying to minimise their risks.

Smaller rounds: Given the downturn in investment and valuations, companies have been going for smaller rounds to avoid punitive dilution until they reorganise and refocus their efforts.

More reliance on existing investors: their ability to follow their money is important to their development. The overall slowing of the market has had a number of positive features:
• There are fewer plans, of better quality
• Stronger management teams
• Greater levels of syndication in 2002
• Companies are focusing on their core proposition
• Valuations are more realistic
• Rationalisation in the market has seen a return to business fundamentals
• Increased presence of international VCs in Ireland - large international VCs investing in Ireland for the first time during 2002 included Siemens, Viventures, IDG Ventures and B-Business partners.

Notwithstanding the challenges, in our experience money is still available for sound companies with experienced management teams and realistic value expectations.

Over the past three years the Irish VC community has gone through a huge learning experience in the ICT sector. From discussions with VCs they are conscious they need to collectively ensure there are some successes out of their existing portfolios over the next two to three years. Investment decisions require greater scrutiny than before and the timing and likely manner of exit is a crucial feature of the investment decision. Another key question for the VCs is whether there is sufficient capital available over the venture period and the ability to attract international capital.

VCs have gone through a challenging year in 2002 but challenges bring opportunities. Subject to no significant downturn in the global economy, the outlook for 2003 can be summed up as ‘more of the same’ with perhaps a greater level of M&A activity on VCs portfolios given the hard work that has been carried out in 2002.

The funding environment is significantly different to the mid nineties with significantly more funds available for investment. Unofficial industry estimates note that •300-•400 million is currently available for investment. Customer-solution orientated software companies will continue to attract investment and there is a greater focus by companies on the needs and payback opportunities for the customer. Companies here have been working on their sales strategy during 2002 focusing on what solution is required today as a ‘must have’ so that they have a better sales proposition for 2003. VCs also see domain knowledge and good technology as other important issues for 2003.

As 2003 is upon us it is important to remember to learn from the harsh lessons of the past and focus on sound business fundamentals. An experienced and proven management team with a quality business proposition will attract interest. There is likely to be consolidation within technology sectors and I expect to see a greater level of M&A activity this year among VC portfolio companies.

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