Chapter 6: Industry, Technology, and the Global Marketplace - Venture Capital and High-Technology Enterprise

Venture capitalists typically make investments in small, young companies that may not have access to public or credit-oriented institutional funding. Such investments can be long term and high risk and, in the United States, almost always include hands-on involvement in the firm by the venture capitalist. This money can aid the growth and development of small companies and new products and technologies, and it is often an important source of funds used in the formation and expansion of small high-technology companies. This is of special interest to the S&E field, as small businesses play a vital role in the U.S. economy and have become important employers of recent S&E graduates (National Venture Capital Association 2002).

For most of the 1990s, computer technology businesses engaged in hardware or software production and related services and medical and health care companies were the leading recipients of venture capital in the United States. This pattern changed significantly in 1999, when Internet-specific businesses emerged in the marketplace.

This section examines venture capital investment patterns in the United States since 1980, with special emphasis given to a comparison of trends in 1999 and 2000 (hereafter called the bubble years) with trends in 2001 and 2002 (hereafter called the postbubble period). It discusses changes in the overall level of investment, the technology areas U.S. venture capitalists find attractive, and the types of investments made.[31]

U.S. Venture Capital Resources

Several years of high returns on venture capital investments during the early 1990s led to a sharp increase in investor interest. The latest data show that new commitments rose vigorously each year from 1996 through 2000, with the largest 1-year increase in 1999 (table 6-6

). Investor commitments to venture capital funds jumped to $62.8 billion that year, a 111 percent gain from 1998. By 2000, new commitments reached $105.8 billion, more than 10 times that recorded in 1995. Quickly, venture capital emerged as a key source of financing for small innovative firms. Evidence of a slowdown emerged in 2001 when new commitments declined for the first time in 10 years.[32] Commitments fell by more than 64 percent that year, to $37.9 billion. Still, this sharply reduced total was quite large when compared with capital investments during the prebubble years. Another sharp drop in 2002 reduced the amount of new money coming into venture capital funds to only $7.7 billion, a level not seen since 1994.

The pool of money managed by venture capital firms grew dramatically over the past 20 years as pension funds became active investors following the U.S. Department of Labor's clarification of the "prudent man" rule in 1979.[33] In fact, pension funds became the single largest supplier of new funds. During the entire 1990–2002 period, pension funds supplied about 44 percent of all new capital. Endowments and foundations were the second-largest source, supplying 17 percent of committed capital, followed closely by financial and insurance companies at 16 percent (table 6-7

). California, New York, and Massachusetts together account for about 65 percent of venture capital resources, as venture capital firms tend to cluster around locales considered to be hotbeds of technological activity, as well as in states where large amounts of R&D are performed (Thomson Financial Venture Economics 2002).

Boom and Bust in New Venture Capital Commitments

High returns on venture capital investments during the 1990s made the funds attractive for risk-tolerant investors. Starting in 1994, the amount of new capital raised exceeded that disbursed by the industry, leading to a large pool of money available for investments in new or expanding firms. As early as 1990, firms producing computer software or providing computer-related services began receiving large amounts of venture capital (appendix table 6-15

). Software companies received 17 percent of all new venture capital disbursements in 1990, more than any other technology area. This figure fluctuated between 12 and 21 percent thereafter. Communication companies also attracted large amounts of venture capital during the 1990s, receiving from 12 to 21 percent of total disbursements. Medical and health care-related companies received a high of almost 21 percent of venture capital in 1992 before dropping to just 5 percent in 1999.

In the late 1990s, the Internet emerged as a business tool, and companies developing Internet-related technologies drew venture capital investments in record amounts. Beginning in 1999, investment dollars disbursed to Internet companies were classified separately, whereas before 1999, some of these funds were classified as going to companies involved in computer hardware, computer software, or communication technologies. Internet-specific businesses involved primarily in online commerce were the leading recipients of venture capital in the United States during the bubble years. They collected more than 40 percent of all venture capital funds invested in each of those years. Software and software services companies received 15–17 percent of disbursed venture capital funds. Communication companies (including telephone, data, and wireless communication) were a close third with 14–15 percent.

The U.S. stock market suffered a dramatic downturn after its peak in early 2000, with the sharpest drops in the technology sector. Led by a dot.com meltdown, technology stock valuations generally plummeted and many Internet stocks were sold at just a fraction of their initial price. Venture capital investments, however, continued to favor Internet-specific companies over other industries in the postbubble period. In 2001 and 2002, Internet companies received far less venture capital, 28 and 21 percent, respectively, of the total dollars disbursed. This was a sharp drop from the previous 2 years but still more than the amount received by any other industry area. Companies involved primarily in computer software, communication, and medical and health care also continued to attract venture capital-backed investments during this period (figure 6-25

The decline in enthusiasm for Internet companies seems to have benefited other technology areas, because their shares of total venture capital disbursements increased during a time when venture capitalists were sharply curbing their activity. A comparison of venture capital disbursements in 1999 and 2000 with those in the 2001 and 2002 shows that medical and health care-related and biotechnology companies attracted much higher percentages in the latter period. Medical and health care-related companies received 11 percent of total investments in 2001 and 2002, nearly triple their share of 4 percent received in 1999 and 2000. Biotechnology companies doubled their share, from 3 to about 6 percent. Other industries attracting larger shares of the smaller pool of investment funds in 2001 and 2002 were software companies, semiconductor and other electronics companies, and industrial and energy companies.

Venture Capital Investments by Stage of Financing

For this report, the first three types of funds are referred to as early-stage financing and the remaining three as later-stage financing.

Two patterns stand out in an examination of venture capital disbursements by financing stage: (1) most of the funds' investment dollars are directed to later-stage investments, and (2) during the postbubble period, venture capital funds directed more money to later-stage investments than ever before. (See appendix table 6-16

and sidebar, "U.S. Government Support for Small Technology Businesses.")

Later-stage investments ranged from 60 to 79 percent of total venture capital disbursements, with both the highest and lowest points reached in the 1990s. In 1999 and 2000, later-stage investments made up 72 percent of total disbursements, rising to 77 percent in the postbubble period. Although early-stage, venture-backed investments as a share of total disbursements have gradually declined over time, during the 2001–02 period they fell to their lowest level ever (figure 6-26

The postbubble trend toward later-stage investing is also evident when analyzing the three early-stage categories. Most of the postbubble venture capital that previously went to early-stage investments shifted to the most mature of the early-stage companies-those companies that had exhausted their initial capital and were in need of funds to initiate commercial manufacturing and sales. During a period when venture capital became increasingly scarce, the more high-risk early-stage projects suffered.

Expansion financing has typically been favored by venture capital funds, with this stage alone accounting for more than half of all venture capital disbursements since 1997. In 2000, the amount of venture capital invested to finance company expansions reached 57 percent of total disbursements. This upward trend continued into the postbubble period, with the share rising to 62 percent in 2002. About one-quarter of the $36.3 billion disbursed to finance expansions of existing businesses during 2001 and 2002 went to Internet companies.

Venture Capital as Seed Money

Contrary to popular perception, only a relatively small amount of dollars invested by venture capital funds ends up as seed money to support research or early product development. Seed-stage financing never accounted for more than 8 percent of all disbursements over the past 23 years and most often represented between 2 and 5 percent of the annual totals. The latest data show that seed financing represented just 1 percent of all venture capital in 2001 and 2002, falling from just 2 percent in 1999 and 2000. Over the past 23 years, the amount invested in a seed-stage financing has averaged about $1.8 million per disbursement. The average peaked at $4.3 million per disbursement in 2000 before falling in 2001 and 2002 (figure 6-27

). In 2002, the average seed-stage investment was about $1.9 million.

The same three technologies, Internet, communication, and computer software, attracted the bulk of seed financing during the past 4 years. They were the largest recipients of venture capital seed financing during the 1999 and 2000 bubble years, with Internet companies the preferred investment destination. Internet companies received 58 percent of all disbursements in 1999 and 43 percent in 2000 (appendix table 6-17

). In 2001 and 2002, seed investments going to Internet companies fell off considerably but still represented 21 percent of all such investments in 2001 and 7 percent in 2002.

As dot.com panic replaced dot.com mania, other technology areas attracted more attention. Medical and health care-related companies received 10 percent of seed money in 2001 and 20 percent in 2002, up from 4 and 5 percent during the bubble years. The share going to biotechnology companies rose to 5 percent in 2001 and to 15 percent in 2002. Semiconductor companies received 8 percent in 2001 and 15 percent in 2002, up from 4 percent in 1999.

Over the past 23 years, venture capital investment showed consistent support for technology-oriented businesses, particularly companies and industries that develop and rely on information technologies. And, despite the recent reduction in new money invested in venture capital funds, information technologies continue to attract the largest shares of total U.S. venture capital.

During the late 1990s, venture capitalists increasingly favored later-stage investments over early-stage investments that are more likely to support exploratory R&D and product development. That trend continued in the postbubble years of 2001 and 2002. If this trend continues, U.S. Government programs like the Small Business Innovation Research program and Advanced Technology Program may become more important sources of early-stage funds for new technology-oriented businesses.

Footnotes

[31] Data presented here are compiled by Thomson Venture Economics for the National Venture Capital Association. These data are obtained from a quarterly survey of venture capital practitioners that include independent venture capital firms, institutional venture capital groups, and recognized corporate venture capital groups. Information is at times augmented by data from other public and private sources.

[32] According to recent reports from the National Venture Capital Association, new money coming into venture capital funds slowed down during the last quarter of 2000, following several quarters of lackluster returns to investors in venture capital funds. See "Venture Capital Fundraising Slows in Fourth Quarter, But Hits New Record for the Year," NVCA February 22, 2001.

[33] Under the Department of Labor "Prudent Person"standard, "A fiduciary must discharge his or her duties in a prudent fashion." For pension fund managers, the standard emphasizes how prudent men balance both income and safety as they choose investments. The web site www.investorwords.com describes the Prudent Man Rule as the fundamental principle for professional money mangement stated by Judge Samuel Putnam in 1830 (Supreme Court of Massachusetts in Harvard College v. Armory): "Those with responsibility to invest money for others should act with prudence, discretion, intelligence, and regard for safety of capital as well as income."