VCs dole out $5.49 billion during the third quarter, but invest less money in each company. Investments in IT startups accounted for $3.11 billion, a 10.6 percent increase from a year ago.

October 24, 2005

Venture capitalists invested 9.4 percent more in high-tech startups during the third quarter than they did a year earlier, according to a study released Monday, but the typical deal was smaller.

The total investment rose to $5.49 billion from $5.02 billion in Q3 2004, according to the study by VentureOne. The median amount invested in each startup that received financing during the quarter fell 4.6 percent to $6.7 million from $7 million during the same period last year.

Investment in information technology startups increased 10.6 percent to $3.11 billion, up from $2.81 billion in the third quarter of 2004.

Venture capital interest in healthcare cooled as VCs put 2.8 percent less money into biotechnology, pharmaceuticals, and medical devices. Investment fell to $1.66 billion, down from $1.71 billion during last year’s third quarter.

Consumer product startups saw the biggest uptick in venture backing. Investment increased 443.3 percent, closing the quarter at $36.4 million, up from $6.7 million.

Biopharmaceuticals posted the biggest loss, losing 19.7 percent of their funding to close the third quarter at $907 million, down from $1.13 billion.

Early-Stage Anxiety

Seed and first-round investment fell 7.3 percent to $1.18 billion during the third quarter, down from $1.28 billion during the same period last year.

Yet the deal flow edged up slightly. Early-stage deals accounted for 35 percent of all VC investments, up from 34 percent in 2004. “This is a clear sign that investors still support early-stage innovative growth companies,” said John Gabbert, vice president of VentureOne.

But many deals may not be counted, say investors. “For early-stage investing, the numbers may not accurately reflect what’s going on,” said Wes Raffel, a venture capitalist with Advanced Technology Ventures. “We’re seeing more early-stage opportunities. Our calendars are fuller now.”

But along with better deal opportunities comes less disclosure about investment activity, especially in the early stages. When one VC hears about an interesting company, he or she may bid up the company’s valuation.

“It’s getting very competitive and expensive,” said early-stage investor Venky Ganesan, managing director of Globespan Capital Partners.

Increased competition is keeping some VCs from saying anything about their investments, even to reporting agencies such as VentureOne.

“Ten percent of our portfolio has not given any information about what they are doing,” said Mr. Raffel.

Mr. Ganesan said his firm keeps all of its seed and first-round investments secret.

Although early-stage venture firms may be keeping their cards close to their chests, angel investors have been more active. Innovators who meet with angels are twice as likely to receive funding this year compared to two years ago, according to one study.

In 2005, angel investors backed 21.8 percent of the companies they investigated, up from 10.3 percent in 2003, according to a study by the Center for Venture Research (see Angels Fund More Deals in ’05).

Restarts Rebound

Venture capitalists are putting more money into “restart” companies they backed during the boom and that required additional financing before the investments could pay off.

Money flowing into restart companies increased 43 percent to close the third quarter at $518.4 million, up from $333.8 million during the same period last year.

Restarts may be gaining traction as a result of increasing IT spending.

Take NetContinuum. The company recently closed a $15-million recapitalization round for its web-application firewall, a type of software that blocks hackers from breaking into databases through the Internet.

Founded in 1999, NetContinuum had taken substantial venture funding during the boom (see Web Firewall Gets $15M).

“I saw the market opportunity as one that is finally here,” said CEO Varun Nagaraj. “I saw that the notion of protecting your web applications was moving from ‘nice to have’ to ‘need to have.’ The tide was definitely rising in this particular segment.”

Venture capitalists who backed companies such as NetContinuum may be hoping to ride an improving exit market.

The median paid to venture-backed companies increased 148 percent to $59.5 million in the third quarter, up from $24 million during the same period last year.

Later-Stage Strength

Third-quarter IPOs were down from 2004 levels but topped the rest of 2005’s performance. Some 16 companies went public in the third quarter, raising $942 million. That bested the five companies that raised $231.7 million during the second quarter.

The improving exit market has also attracted more later-stage investments. Venture firms have put 19 percent more money into their more mature companies, closing the quarter with $2.64 billion invested, up from $2.18 billion in 2004.

The biggest deal of the quarter was a $150-million fourth round of financing that went to communications company FiberTower (see FiberTower Raises $150M).

But early-stage VCs say the up-tick in late-stage funding is the product of a poor understanding of upcoming trends. “The one thing you can’t deal with is the market timing,” said Mr. Raffel. “That’s why you’re seeing the market valuations increasing at the upper end. There’s no market timing risk.”

Hot Spots

Venture capitalists doubled their investment around the Research Triangle in North Carolina, the biggest increase in any region. The area picked up $147.4 million this quarter, up from $73.4 million during the same period in 2004.

New York lost 30 percent of its venture capital investment, falling to $303.4 million in the third quarter, down from $435.2 million during the same period last year.

The San Francisco Bay Area, by far the world’s most active hub of venture investment, upped its funding by 10 percent, closing the quarter at $2.03 billion, up from $1.83 billion.

Israel, in comparison, closed $311 million in venture capital for the third quarter, while Europe raised $890 million.