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By Michael Greeley

MICHAEL GREELEY July 15, 2003 | RECENTLY RELEASED INVESTMENT data from Ernst & Young and VentureOne for Q1 2003 in the venture capital industry lead to some interesting, perhaps subtle, conclusions. Encouraging signs indicate that we have probably touched bottom and that the venture market is no longer in a free fall. As Bryan Pearce at E&Y observes, "We have moved from a period of self-preservation through a period of company preservation and now to a period of company growth."

A total of 404 companies were funded in Q1 2003, raising $3.4 billion. The bio/pharma, medical device, and bio-IT categories accounted for 74 of those companies, raising nearly $700 million; bio-IT was the smallest category, with 10 companies and $40 million raised.

Activity during Q1 2003 is reminiscent of that in 1994-95 and clearly below the peak of the venture financing frenzy of early 2000, when more than 1,700 companies reaped nearly $27 billion in funding. Of the 404 companies funded in Q1 2003, 107 raised either seed money or first-round capital of about $500 million.

Bio-IT Funding 
In the bio-IT sector, the rate of company formation tracks the larger software funding pattern over the past five years, except for the exuberance the bio-IT sector experienced this time last year, which saw 38 VC transactions raising almost $250 million. But the subsequent nine months witnessed only 36 financings and $155 million (less than $4.5 million each). The 10 bio-IT investments in Q1 2003 is the lowest level of activity in the past five years for this sector.

How should we interpret this? This forced rationalization is good news for entrepreneurs who have already raised capital. One of the problems with the venture industry is that compelling new technology sectors can become "overinvested" too quickly — emerging categories are overwhelmed by too many new entrants dividing up a small pie.

So just how attractive is this category for the venture community? Has pharma already bought all the solutions it requires? Probably not. Indeed, the flood of genomic and proteomic data points to ever-expanding needs. The issues may be more fundamental and reflect the problems that other new software verticals experienced as they introduced solutions into the marketplace. Undoubtedly, the shortcomings of previous bio-IT solutions have burned many bioinformaticians within pharma. More troublesome, however, is the notion that enough bio-IT vendors exist that already address pharmas' needs.

The E&Y/VentureOne data also track activity upon liquidity or exit. Investors face three principal outcomes: a merger and acquisition (M&A), an initial public offering, or company closure. When considering the robustness of the exit environment, investors monitor three critical metrics: the amount of capital required to reach liquidity, the multiple of invested capital (known as the "exit ratio") realized upon liquidity, and the time to liquidity.

Ten years ago, companies required approximately $10 million-$15 million of capital before a liquidity event (either M&A or IPO). From 1997 to 2000, the amounts required ballooned, often to $35 million-$40 million. Interestingly, the multiple of invested capital for M&A exits consistently averaged between 4x and 7x, peaking at 10x in 1998. Ominously, companies that raised capital in 2000 and have been sold realized a 2.4x multiple. (If one includes the unsuccessful outcomes, this figure falls below 1x.)

Company closure has become so prevalent that Ernst & Young now tracks it as carefully as it tracks IPOs and venture financings. Even as 107 new companies were created across all sectors in Q1 2003, another 96 companies closed (despite having raised $3.1 billion in funding).

E&Y also tracks how many private companies exist in venture funds portfolios. As of the end of Q1 2003, there were 5,638 private companies, of which 1,005 were bio/pharma, medical device, and bio-IT companies. Of these, 447 were financed in or before 1999, which means they may be getting a little ripe. Specifically, there are 208 private bio-IT companies, 106 of which were financed four or more years ago. A total of $3.9 billion is invested in these 208 companies, of which $1.8 billion is four years old or older. These latter investors must be getting nervous, and many will be looking for liquidity. While many of these companies are performing at or above plan, some of them may be functionally obsolete. Those companies will continue to put downward pricing pressure on competitive products and on M&A multiples.

These dynamics have powerful implications for the entrepreneur. VCs are obsessed with capital-efficient business models in today's environment. Given that there's the lack of an IPO window, multiples of invested capital for successful M&A outcomes have collapsed to 2.5x, venture investors are suffering losses elsewhere in their portfolios, and rounds are at $5 million, entrepreneurs must deploy capital even more carefully.

As we enter a period of consolidation, successful bio-IT companies will be those that moderate their burn rates, don't overengineer products or develop multiple products in parallel, and build those deeper relationships. As E&Y's Pearce says, "Now that you have your foot in the door with some customers, it is time to get the whole leg in."

Michael A. Greeley is the managing general partner of IDG Ventures, a global family of venture capital funds operating in North America, Europe, and Asia, with approximately $600 million under management. He can be reached at 

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