Technology

The 2008 Venture Capital Outlook


VCs want to ride the momentum from NetSuite's Dec. 20 IPO into the New Year and cash out of companies they've held in their portfolios for years

Things are finally looking up for venture capital investors. The initial-public-offering market, which provides the biggest opportunity for VCs to cash out, continues to recover from its mid-decade doldrums. It got a big boost on Dec. 20 when software maker NetSuite (N) raised $161 million in its highly anticipated IPO. And the median buyout price of venture-backed companies continues to rise.

Riding that momentum, VCs expect 2008 to be the year that they finally start to unload companies in their portfolios that have been absorbing cash for years. A survey of 170 VCs released by the National Venture Capital Assn. on Dec. 17 showed that 59% of venture investors expect the market for IPOs to strengthen in 2008. Nearly three-quarters expect merger-and-acquisition transaction values—already nearly double 2005 levels—to either increase or remain the same in 2007.

But optimism is a relative concept for the folks who have been pumping millions of dollars into Internet, clean technology, and life sciences companies. "If you want to put money into a sector that's going to do well next year, tech is looking more and more attractive," says Duncan Davidson, a venture partner at VantagePoint Venture Partners. But that's partly because everything else looks so bad. Real estate, commodities, oil, and China have all hit their peaks, he says.

Financial Sector Woes Could Hurt Online Ads

And the truth is, despite a few hot IPOs, VCs will continue to find it challenging to generate the kind of home-run returns they count on to turn a profit, which is typically at least 10 times their initial investment. Their portfolios are filled with companies that survived the dropoff in technology spending earlier this decade. Today those companies are generating steadily growing sales.

But truly blockbuster Web companies, such as Facebook and LinkedIn, may wait until 2009 to go public. And the spreading woes of the financial sector could throttle the rapidly expanding market for online advertising, a key revenue source for Web startups. "The ride won't be smooth. It will probably be bumpy," says Deborah Farrington, a general partner at StarVest Partners in New York, which invested in NetSuite and backs other software companies.

VCs will have sunk more than $40 billion worldwide into startups in 2007, up from $37.3 billion in 2006, according to market researcher Dow Jones VentureOne (NWS). That's still well short of the $56 billion VCs plowed into startups in 2001, but up by more than a third compared with the Death Valley days of 2003 and 2004. Among the hot investment areas in 2008, VCs surveyed by the NVCA pointed to clean technology, media and Internet companies, and biotechnology outfits.

A Far Cry from the Dot-Com Boom

On the return side, 80 venture-backed companies went public in 2007, up from 57 in 2006, according to an NVCA estimate. That includes standouts like NetSuite—which ended its first day of trading up 36% (BusinessWeek.com, 12/19/07) after doubling its offering price in an auction—and software company VMware, whose shares are up about 60% since their Aug. 14 debut.

But 2007's IPO count is a fraction of the 260 such companies that went public during the dot-com boom in 1999 and the 264 that did so in 2000, according to data from the NVCA and Thomson Financial (TOC). And the median time from a startup's founding to its IPO stretched to nearly eight years during the first three quarters of 2007, up from about six in 2005 and four in 1999. That means VCs will need to crack the whip on underperforming investments. "You've got to force them to make a move or get rid of them," says NVCA President Mark Heesen.

A tepid IPO market makes it harder to reap the kind of returns that VCs count on to offset the bad bets in their portfolio. They made at least 10 times their initial investment on just 27 of 135, or 20%, of their portfolio companies that were sold for disclosed amounts through Dec. 21, according to the NVCA and Thomson Financial.That's slightly higher than in 2006 but well short of the 45% of deals in 2000 that yielded a tenfold or higher return.

Reining in Rollups

That sluggish IPO environment has another effect as well: It reduces VCs' leverage to get the best prices for their companies out of big corporate acquirers like Microsoft (MSFT) and Cisco Systems (CSCO). "It's the IPO exuberance that drives up the value on the M&A side," says Davidson at VantagePoint.

True, tech vendors are still paying top dollar for startups that specialize in hotly contested areas such as online advertising and virtual-machine software, which can reduce the number of servers companies need to maintain. Yahoo's (YHOO) $680 million acquisition of Internet advertising startup Right Media netted its backers 45 times their initial investment, and Microsoft, Google (GOOG), AOL (TWX), and IAC/InteractiveCorp (IACI) have been heavy acquirers in the sector. On Nov. 5, Dell (DELL) paid $1.4 billion in cash for storage company EqualLogic. Standard & Poor's, which, like BusinessWeek.com, is owned by McGraw-Hill (MHP), predicts technology companies' 2008 operating earnings per share will rise by 24% (BusinessWeek.com, 12/14/07) compared with a 15% gain for the S&P 500.

However, tighter credit has curtailed "rollup" buyouts in which private equity firms purchase a tech company that's strong in a given area, then buy smaller startups that complement it to create a new company. That has closed down one avenue for VCs to cash out of their positions. "There's certainly going to be less leverage available," says Farrington. "Money won't be as easy in the future, and that usually hits the M&A market at some point."

Working Out the Business Model

As VCs try to sell or take public their best-performing Web companies, and foster new ones for the future, they'll need to keep a close eye on how the performance of the U.S. economy affects online spending. If consumer sentiment keeps eroding and business confidence slips, investors could discount Web startups on lower expectations for growth. "When you're buying a startup, you're buying the future," says Will Price, a managing director at Hummer Winblad Venture Partners. "If there's a fall in business or consumer sentiment, there could be a falloff in the online ad market. The difference between a company growing at 50% and 15% is huge."

Here's something else to consider about those hot Web companies: Some still haven't settled on a business model. Social networking site Facebook's rough start with its Beacon purchase-tracking ad system, (BusinessWeek.com, 11/30/07) for instance, may dampen enthusiasm for companies that are banking on selling ads on the networks. "People are going to have to be extremely careful about how they monetize these Internet communities," says StarVest's Farrington. "People are going to have to be careful about killing the goose that laid the golden egg."


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