Venture capitalists emerge from a tough two years
After a rough two years, venture capitalists are being choosy about investments.
- April 28, 2010
Robert Patzig calls Synchrony Inc. “a great company.” It’s not an idle compliment because he’s betting big on this hi-tech enterprise’s future.
Patzig is chief investment officer for Third Security, a Radford-based venture capital firm. In January, it provided $10 million to Synchrony. That follows investments of $5 million in 2006 and $10 million in 2007.
Synchrony makes magnetic bearings in Salem. Compared with conventional bearings, these are faster, quieter, “greener,” more efficient and more reliable. “We’re excited about Synchrony’s revenue staying in Virginia and the company staying in Virginia. In the past, we have seen companies leave the state to get money,” Patzig says.
Not only is Third Security’s $10 million investment good news for the commonwealth, it also is good news for the state’s venture capital industry, which plays an important role in business growth. Using money raised from investors, venture capitalists fund young companies. In exchange for financing, investors become part owners and get a full return on their investments when a firm goes public or is sold.
Arlington-based language-learning software company Rosetta Stone offers an example of the type of homerun investors are after, although the National Venture Capital Association classifies its financing as debt-related private equity rather than venture capital. Founded in Harrisonburg in 1992 as Fairfield Language Technologies, the company was sold for $62 million to Baltimore-based ABS Capital Partners and Minneapolis-based Norwest Equity Partners. Under its new owners, Rosetta Stone’s revenue soared 335 percent in three years. In the company’s initial public offering last year, the stock price rose 40 percent in one day. Rosetta Stone now has a market cap of nearly $500 million.
But that kind of success is rare. Since 2008, Virginia-based venture capital firms have endured a rough ride. “Make no mistake about it, 2009 was a very, very tough year,” says Michael Drzal, a lawyer specializing in venture capital issues at LeClairRyan’s Blacksburg office.
A few statistics support Drzal’s statement. The National Venture Capital Association (NVCA) reports that venture capitalists invested $17.7 billion in 2,802 deals last year. That compares with $27.9 billion invested in 3,984 deals during 2008. The 2009 figure represents the lowest level of dollar investments since 1997.
The situation was similar in Virginia. Investments in the state totaled $219 million in 43 deals last year, down from $464 million in 86 deals during 2008.
Notwithstanding last year’s performance, many observers believe that this year may see an uptick in the industry’s fortunes. Surveys by the NVCA show that most venture capital firms expect to get more money to invest than they did last year. Plus, they foresee mild improvement in initial public offerings and merger-and-acquisition activities. In the first quarter, NVCA and Thomson Reuters reported nine venture-backed IPOs and 111 merger-and-acquisition transactions, the best results since the fourth quarter of 2007.
“We have helped clients close several venture capital financings recently, with both institutional and angel investors,” says Ben English, a lawyer with the firm Hirschler Fleischer in Richmond. “The deals that get done tend to be growth financing for companies with a proven business model. Some investors are focusing on opportunistic turnaround situations, where a company is sound in many respects but has run into problems which can be fixed with capital and the right expertise.”
Despite the industry’s improvement, venture capitalists remain cautious. They’re carefully reviewing every deal in detail, Patzig says. Due diligence now takes about four to six months. That’s well above the two- to four-month timeframe common before the recession.
Another sign of caution? The sectors in which venture capital firms are willing to invest. They remain deeply interested in high-technology enterprises. Yet, they’re focused firmly on companies using fully developed, practical ideas. “Venture capital firms are less interested in science-enabled ideas,” says Jonathan Wallace, with WWC Capital Group, a venture capital firm in Reston. “They’re more interested in technology-enabled ones. They are not looking at cutting-edge concepts.” That means the most attractive investment targets are in clean energy, biotechnology, pharmaceuticals, social networking and software, especially with military intelligence and cyberwarfare applications.
Another sign of conservatism is a tendency to avoid putting cash into startups or extremely young companies, Wallace says. Far more attractive are mature enterprises with proven performance, ideas and leadership.
Because venture capitalists have cut back on funding young companies, they’ve been seeking support from angel investors. These are wealthy individuals who invest their money in new companies. Typically, they invest less than $1 million in any one firm.
Unfortunately, many “angels” are sitting on the sidelines, having taken a beating in real estate and stocks. “Angel investing is hurt more than I’ve ever seen before,” says Gary LeClair, the co-founder and chairman of LeClairRyan in Richmond, who has more than 20 years experience with angel investors and venture capital firms. There just aren’t that many good startups available because would-be entrepreneurs are sitting tight, he says. “I’ve heard it over and over from people: ‘My Number One asset is my job and my health insurance. I just can’t risk it.’”
Some Virginia angels are cautious but still interested in finding solid investment opportunities, says Letitia Green with the Charlottesville-based Virginia Active Angel Network. As a result, potential investors are reviewing deals carefully, asking more questions and readily walking away if the fit isn’t perfect. Investors also are following the progress of a financial reform bill in the U.S. Senate that could restrict angel investing and boost government oversight. Opponents argue the measure is unnecessary and would stifle economic expansion and job growth.
Looking ahead, observers agree that the current economic climate will change the venture capital industry. For instance, Patzig believes some firms will close. He isn’t alone.
“It is readily understood by the venture capital community that our industry is going to contract in size going forward,” says Mark Heesen, president of the national group, NVCA. ”That will mean fewer firms, for sure, but not necessarily fewer companies funded. There is a great deal of innovation taking place, and venture capitalists who have the track record to raise funds will be well positioned to build companies. Most venture capitals will agree that a smaller industry is a better one.” In fact, a recent study by the Kansas City, Mo.-based Kaufman Foundation says that the industry must shrink by half to remain viable.
Odds are good that the survivors may re-embrace an old set of values, says Fred Russell, chairman of Richmond-based Virginia Capital Partners, whose portfolio of investments includes Virginia Business magazine. These venture capital firms may totally reject the get-rich ethos that characterized the sector in the go-go years at the start of this century. “The attitude was about ‘getting out,’ not about building a great company,” he says. Instead, Russell foresees venture capitalists returning to their roots as advisers and partners who assist in facilitating a growing company’s success.
Nobody is sure when venture capital firms will reach a point where robust growth begins again. Estimates run from several years to an entire decade. “I think it’s a process,” LeClair says. “The industry will come back. It’s just there’s a lot of shock in the system that has to be worked out.”
That said, some people argue that well-run, prudent venture capitalists may do extremely well as the economy improves. These firms chose carefully in making their investments and now are tied to strong companies that will be well positioned for a stock offering or sale when good times return.
“I’m confident that we’ll have our day in the sun,” Wallace says.