If nothing is changed, then nothing will be ventured

The recent drop in activity in the sector illustrates that for successful venture capital activity, the key factor is not the quantity of venture capital available but the returns generated

Mon, Apr 29, 2013, 06:00

Venture capital investment in the US has just had its worst quarter in the last two and half years, according to a report this month from Dow Jones VentureSource (available online at http://bit.ly/17rVECF).

Between January and March, 752 venture capital investments were made across the US, with approximately $6 billion invested. This represents an 11 per cent decrease in the number of deals, and a 12 per cent decrease in the total invested in the same quarter in 2012.

A start-up company is often funded in its early days by its founders, and their friends and family. Sometimes “angel” investors will join as further shareholders, relatively wealthy individuals, who have been successful in particular industry sectors and have money to re-invest.

Usually, the total amount raised in this early stag will be less than $2 million. For 2012 in the US, the recent Halo report by Silicon Valley Bank, CB Insights and the Angel Resource Institute (available online at http://bit.ly/11vf9cL) showed median angel financing was about $600,000, and the total amount of early stage financing at about $1.5 million.

The first financing usually allows the founders to build a working prototype of their innovation, and perhaps undertake early testing in the market. At this point, the company may raise venture capital by selling further shares in the company, perhaps over several financing rounds.

The first round provides capital to develop the prototype into a real and commercially acceptable product. The second and subsequent rounds aim to increase the company’s customer base and market share, frequently worldwide.

Series of rounds
The financing provided by each round usually lasts for a year or two, and the amounts raised over series of rounds usually increase. The total amount raised may run from a few millions to hundreds of millions of dollars.

Once a company has consistent market growth, venture investments are usually recouped either by selling the company to an established multinational, or by floating the company on a stock exchange.

Venture capitalists naturally expect a return on their investment. Two or three times the total investment is usually considered a reasonable return.

Elevation Partners, in which U2’s Bono is in investor, reportedly made approximately $160 million for shares sold at the Facebook flotation last year, for which it had originally paid about $22 million.

If venture capital investment decreases, it becomes more challenging for start-up companies to raise risk capital. Perhaps the most significant indicator in the Dow Jones VentureSource report was the dramatic fall in company valuations.

At each investment round, a value for the company is negotiated between the parties involved before the new money is invested – the “pre-money” valuation.

VentureSource reported the median pre-money valuations fell to just $6 million during January to March, down from $29 million in the prior quarter – the first time to fall below $10 million in several years. If venture investment is falling; if the number of companies successfully raising funds is falling, and if the values placed on these companies are falling, then clearly the venture capital industry is being much more cautious.

Pension funds
The finance venture capitalists invest typically originates from pension funds and other large investment funds. They raise money from these funds, invest in high-risk but potentially high-return companies, and ultimately share the profits back to their own investors. VentureSource reported US venture funds raised $4.2 billion in the last quarter, a 65 per cent increase on the prior quarter, and with a median raise of $140 million per fund. Thus it would appear that although the venture industry is being more cautious it is managing to raise new funds for investments.

What of the situation in Ireland ? The UK-based Unquote analysts report venture activity in the UK and Ireland reached its lowest point in five years during January to March. The Irish Venture Capital Association has yet to publish quarterly industry results for January to March, but for the full year 2012 reported the total amount invested in Ireland was about €270 million, about the same as the previous year. However, the number of companies that raised funds in 2012 was up 18 per cent to 159, on 2011. Thus the average amount raised by any single company has fallen.

Our Government clearly views a healthy venture capital sector as an important pillar of its Action Plan for Jobs. It has announced a €175 million exchequer catalysis for seed and venture funding. Nevertheless, the recent drop in activity in the sector illustrates that for successful venture capital activity, the key factor is not the quantity of venture capital available but rather the returns generated when that capital is deployed.

If venture capitalists do not believe that they can generate reasonable returns, they will not necessarily invest. A healthy pool of risk capital and of start-ups in which to invest are thus insufficient. There must also be opportunities to recoup investments, through acquisitions of companies and stock market flotations.

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