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By Justin Hibbard In the history of venture capital, 2004 will go down as the year VCs recovered from the bursting of the Internet bubble. Will 2005 be remembered as the year venture-capital investing reached equilibrium -- or the year the next bubble began inflating?
Industry watchers are pondering that question after two venture-capital surveys released on Jan. 21 and Jan. 24. Both studies found that the amount of venture capital invested in the U.S. last year increased from the previous year for the first time since 2001. Total investments in 2004 reached $20.9 billion, up 11% from 2003, according to the MoneyTree Survey by PricewaterhouseCoopers, Thomson Venture Economics, and the National Venture Capital Association. A similar survey by Ernst & Young LLP and VentureOne tallied total investments at $20.4 billion, an 8% annual rise.
UPWARD TREND. With fresh data in hand, venture capitalists are asking the Goldilocks question: Is $20.9 billion a year too much, too little, or just right? The money VCs invest today creates private companies that go public or get acquired tomorrow. Invest too much, and more companies will be funded than public-market investors and acquirers demand. Invest too little, and opportunities will be lost. The former happened in 2000, when venture capitalists plowed an all-time high of $103 billion into startups, many of which shuttered before going public or being bought.
For the moment, the answer appears to be "just right." Based on current conditions, researchers for the MoneyTree survey believe $20 billion a year is a healthy level. "It feels like the right size for the industry," John Taylor, vice-president of research at the National Venture Capital Assn., said in a call with reporters on Friday. "We don't see a lot out there that would suggest the numbers will increase in the coming quarters."
However, Taylor expressed concern about the large amounts of money that investors are eager to pump into venture-capital funds. If venture capitalists raise too much money, they may fund too many companies or drive valuations skyward.
The upward trend in raising money is likely to keep going this year, says a study released last week by Private Equity Intelligence (PEI). After raising $29 billion worldwide in 2004, VCs are looking to raise an estimated $33.6 billion in 2005. Moreover, that figure could double by year's end, PEI found. The capital is coming from institutional investors such as pension funds and endowments, two-thirds of which currently have less of their money invested in venture capital and buyout funds than they would like.
DUBIOUS RETURNS. Some VCs are wary of the ever-growing supply of capital. "I think it's hard for the VC industry to make money if it's deploying more than $10 billion a year," says Steve Domenik, a general partner at Sevin Rosen Funds in Palo Alto, Calif. His estimate is based on the returns venture capitalists promise to their investors, which can range from 3 times to 10 times their money.
Domenick doubts the initial public offering and mergers & acquisitions (M&As) markets can generate those kinds of returns on more than $10 billion a year. "If you look at the size of IPOs, the system only seems to support so many," he says.
There are signs that valuations of venture-backed companies are rising, particularly among outfits at middle stages of development. In the 12 months ended Sept. 30, 2004, the average valuation for expansion-stage companies rose 60% from a year earlier, according to the MoneyTree Survey -- even as the amount invested in such companies fell 8%.
LIFE-SCIENCES SEEDLINGS. Competition for expansion-stage investments has intensified as IPOs and M&As have increased in the past 18 months. Such companies have often overcome the risks of early stage startups and are well on their way to being sold or public-market debuts.
Drilling further into the numbers reveals that life sciences was the sector attracting the most venture funding last year. In 2004, venture capitalists sank $5.6 billion into the industry -- the second-largest amount in MoneyTree survey history. Over the last four years, venture capitalists have funded 600 life-sciences companies, and at least 12 are currently in registration to go public. That's more than any other industry segment.
Still, it will take a lot of IPOs and acquisitions to absorb all of those startups. Hibbard is a correspondent in BusinessWeek's Silicon Valley bureau