By some accounts, venture capital investing is in the midst of a revival and perhaps even a bubble. But it is certainly a different story than in the past, based on qualifications of the companies and targets.

By Paul Sweeney

Credit the wild stock market gyrations of August for at least one casualty: it has silenced talk of a bubble in Internet and technology stocks. Concerns over a likely bubble mounted this spring and summer when several hot media and Internet companies — the online social network LinkedIn, Internet radio company Pandora Media and online real estate appraiser Zillow — offered only fractions of their shares in their initial public offerings, and investors snapped them up with gusto.

The demand for LinkedIn’s initial public offering was especially pronounced. LinkedIn went public in mid-May at roughly double its $45 opening price. By July, its stock price cleared $100 and the company’s valuation was said to be a staggering $9 billion, despite reporting second-quarter earnings of just $4.5 million on $121 million in sales revenues.
LinkedIn appeared to be the template for future venture-backed Internet companies going public.

Facebook, of course, remains the 900-pound gorilla. Boasting more than 750 million users worldwide and flush with a $1.5 billion capital infusion from Goldman Sachs, Facebook’s market valuation — based on private trading in the pre-IPO market — is stratospheric, valued at anywhere from $50 billion to $100 billion.

Meanwhile, Twitter, Zynga, HomeAway and Groupon are among a string of Internet companies that have either registered to go public or are waiting in the wings. By all accounts, high-dollar investors and institutions had been chomping at the bit for a piece of the action.

But that was before the August stock market roller coaster played havoc with IPOs. Some 18 IPOs were pulled or canceled in August as a result of the dramatic global market fluctuations.

Even so, the controversial trading of private stock of venture-backed companies in the pre-IPO market, coupled with companies’ practice of releasing only a fraction of their stock to drive up demand — LinkedIn made a mere 15 percent to 20 percent of company ownership available — has propelled valuations skyward.

One recent study by professional services firm BDO USA found that 75 percent of capital markets banking executives believe that pre-IPO valuations ranging into the billions of dollars were “not justified.” In the same study — based on telephone interviews with 100 bankers — 62 percent of respondents reported that chances of a second dot-com bubble similar to the 1990s is at least “somewhat likely.”

Says Lee Duran, a partner in the capital markets and technology practices at BDO: “The good news is that it helps companies understand how much interest investors have in their stock. But if you’re only trading 15 percent of the company publicly, it may be a false sense of optimism.”

James Nolen, a senior lecturer in finance and entrepreneurship at The University of Texas’ McCombs School of Business, says: “For technology as a whole, there hasn’t been a bubble. Prices for selected issues appear to have been overvalued. But I think people are figuring out how to tell good companies from bad.”

Nolen adds that “after the bad news about Greece and the battle in the U.S. over the debt ceiling, it’s hard to create a bubble when there’s that much fear in the markets.”
But venture capitalists like Sandy Miller, an executive at Silicon Valley firm Institutional Venture Partners, argue that, unlike during the dot-com craze that peaked in 2000-01, the current crop of Internet companies are actually showing profits.

At the same time, Miller argues, Internet companies today are riding a tidal wave of “convergence” between high-technology consumer and business products. Tablet personal computers, tablets, smartphones and other mobile devices are reconfiguring the way people work, play and interact.

Not so long ago, Miller notes, computers and telecommunications industries were dominated by companies selling mainframes and big-ticket items to their “enterprise” customers. Technology companies — IBM Corp., Apple Inc., Hewlett-Packard Co., AT&T Inc., Microsoft Corp. — employed large sales forces dealing mainly with the information technology purchasing departments at the company level. Consumer products such as cellphones, laptops or calculators were a technology of a different color and “the division was clear-cut,” Miller says.

No longer. “Consumers have gotten used to having the same devices for both their personal and professional lives,” adds Miller. “Go to any Starbucks and you’ll see more people working off site than you’ll see at a typical office building. People are merging enterprise and social media, and they’re using the best technological products. They’re working 24/7 and they’re not separating their personal and business lives.”

Nick MacShane, senior managing partner at Cambridge, Mass.-based Progress Partners, a boutique investment bank that advises online media companies on both financings and M&A exits, argues that the trends in mobile communications, advertising and social networks will persist no matter what the stock market does or even how the broader economy performs. “The shift of dollars from radio, television and print media to the Internet and iPhones is real,” he says. “This is a very productive and prolific sector.”

The Story is in the Data
All that buzz is reflected by hard data. According to the most recent figures released by the MoneyTree Report, a project of accounting firm PwC and the National Venture Capital Association using data from Thomson Reuters, the level of investments in Internet companies hit a10-year high in the second quarter of 2011. More than $2.3 billion went to 275 “Internet-specific companies,” a quarter-to-quarter increase of 72 percent in dollars and a 46 percent increase in deals.

Venture-backed Internet companies accounted for the two top deals of the quarter — a $165 million, later-stage investment by four venture capital firms in CSN Stores, a Boston-based online retailer of home and office goods, and a $138 million injection of expansion-stage capital from nine VCs (including a venture arm of Goldman Sachs) into Gilt Groupe Inc., a private online shopping community headquartered in New York.
In addition, five of the top 10 VC deals in the quarter were classified as Internet sectors (a “discrete classification” for companies with a business model “fundamentally dependent on the Internet, despite the company’s primary industry category,” MoneyTree notes).
Investments in Internet companies also played a key role in powering the venture capital industry’s most robust quarter in three years. Overall, according to MoneyTree, venture capitalists poured $7.52 billion into 966 deals in the second quarter of 2011. That’s a quarter-to-quarter funding increase of 19 percent over the relatively robust $6.33 billion invested in 814 deals during the first quarter.

At the same time there are numerous moving parts complicating the venture capital story — so much so that no single narrative easily explains current trends. Warns Seth Gilbert, an independent Silicon Valley analyst based in Woodside, Calif.: “It’s always hard to characterize the venture cycle.”

Consider, for example, the clean technology sector, which comprises alternative energy, pollution and recycling, power supplies and conservation. This sector experienced a 23 percent decrease in dollars to $942 million from $1.2 billion, even while the numbers of deals completed increased by 11 percent to 81. Thus, while the money invested sank, it was the most active quarter for clean technology deals ever recorded by MoneyTree.
The state of biotechnology investments is also hard to characterize. VC investments in the sector rose 46 percent to $1.2 billion from the previous quarter. But Mark Cannice, a professor of entrepreneurship and innovation at the University of San Francisco, found in a July report that investors were worried about both a potential bubble and regulatory overkill. His Silicon Valley Venture Capital Confidence Index ticked down in the second quarter to 3.66 from 3.91 (on a five-point scale with five indicating “high confidence”).  The USF professor declared that downturn “significant.”

“Most investors in the life sciences are stating concerns about FDA approval,” Cannice says, referring to the U.S. Food and Drug Administration. “It’s not a big enough sample to be scientific, but the guys I spoke to (for the survey) were very negative.”
The two biggest biotech deals of the second quarter were both later-stage investments — a period in a start-up company’s life cycle when success is most likely, if not assured. Deals making MoneyTree’s “top 10” list included $100 million raised by Intrexon Corp., a Blacksburg, Va.-based synthetic biology company, and $77 million invested in Merrimack Pharmaceuticals, a Cambridge, Mass.-based developer of therapies for autoimmune disease and cancer.

Joe Cunningham, a physician and managing director at Sante Ventures, an Austin, Texas-based firm specializing in early-stage health care investments, says: “Trials [for drug approval] are lengthy and expensive. We look at 100 deals for every one that we choose.”
Cunningham says of exiting deals: “Obviously we pay attention to M&A and IPO markets. But we’re not deal guys; we’re company builders. We like to do projects from start to finish. That takes years and years, so we never know what the exit environment will be like.”

BDO’s Duran reports that corporate strategic buyers sitting on piles of cash reserves —“I hear numbers of $1 trillion and above” — are poised to purchase software, technology and health care companies. “Companies such as Intel Corp., Qualcomm Inc. and Google Inc. that have their own venture arms are also looking for opportunities,” he says. In acquiring companies with promising technology, Duran adds, “They’ve effectively outsourced research and development.”

Now, the Caveat
But one big worry for the venture capital industry has been the change in attitude by its limited partners. VCs are bank­rolled by institutional investors that include pension funds, college endowments and insurance companies. In expectation of superior returns to the stock exchanges, the funders patiently park their money for five to seven years — if not longer — before an IPO or M&A “liquidity event.”

Now, it turns out, those limited partners are becoming increasingly choosy. Venture capitalists are raising more money but the dollars are flowing to fewer firms.
For the first half of 2011, fundraising by 76 venture capitalists totaled $10.2 billion. That’s a 67 percent increase in the dollar amount of funding, compared with the first half of 2010. But it was a 15 percent decrease in the number of funds garnering commitments, reports NVCA and Thomson Reuters.

It was, moreover, the fewest number of VC funds receiving commitments since the first half of 1995, more than a decade and a half ago.

As a case in point, two funds operated by Palo Alto-based Accel Partners raised $1.35 billion in the second quarter of 2011, accounting for half the total dollars raised in the quarter. “The rich get richer,” says Silicon Valley analyst Gilbert. “Venture firms at the top tier continually have access to the best clients and the best deals.”

This trend has resulted in shrinkage in the VC industry. Today, there are some 450 active VCs, “about 25 to 35 percent of the peak in the year 2000 when there were probably 1,200 firms,” says Catherine Crockett, co-founder and managing partner at Grove Street Advisors in Wellesley, Mass. The firm, which invests in private equity and venture capital, among other engagements, oversees $6.4 billion in assets under management for 10 clients.

“With many fewer active venture funds,” Crockett says, “you end up with much less money and fewer companies competing in the same sector and tripping over each other. “The exception, she adds, “is the proliferation of seed stage capital around social media.” In general, though, she adds that, “venture capital is a very sane industry to be in today.”
But that sanity worries Mark Heeson, NVCA president. He warns that institutional money flowing into fewer firms is resulting in the “ongoing contraction” of the VC industry and is depriving the country of entrepreneurship. “It is critical,” he says, “that the mix of funds remain geographically diverse and cover a broad base of industries if we expect to contribute to economic growth and innovation.”

For those VCs in the midst of the current revival, though, the mood continues to be one of cautious optimism.

Igor Sill, managing director at San Francisco-based Geneva Venture Partners, says that venture capital is emerging as a safe haven in hard times. “The Federal Reserve Bank announced that they have no intention of increasing interest rates for the next two years,” he says. “That’s the first time in my lifetime that I’ve ever heard that. It bodes well. It means that there’s no better place to put your money where you can find alpha. I’m enthusiastic.”

Paul Sweeney (easysween@aol.com) is a freelance writer in Austin, Texas, who frequently writes for Financial Executive on business and finance.