Chapter 6: Industry, Technology, and the Global Marketplace

Venture Capital and High-Technology Enterprise

Venture capitalists typically invest 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. The funds and management expertise venture capitalists provide can aid the growth and development of small companies and new products and technologies. In fact, venture capital is often an important source of funds used in the formation and expansion of small high-technology companies. These new high-technology companies play a vital role in the U.S. economy and have become important employers of recent S&E graduates (National Venture Capital Association 2002). Tracking venture capital investments also provides indicators of technology areas that venture capitalists consider the most economically promising.

This section examines venture capital investment patterns in the United States since 1980, with special emphasis on a comparison of trends in 1999 and 2000 (hereafter called the bubble years ) with trends in 2001 and 2002 (the postbubble years ) and most recently in 2003 and 2004. It discusses changes in the overall level of investment, those technology areas U.S. venture capitalists find attractive, and the types of investments made.[45]

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 new commitments rising vigorously each year from 1996 through 2000, with the largest increase in 1999 (table 6-9 table.). Investor commitments to venture capital funds jumped to $62.8 billion that year, a 111% gain from 1998. By 2000, new commitments reached $105.8 billion, more than 10 times the level of commitments recorded in 1995. Evidence of a slowdown emerged in 2001, when new commitments declined for the first time in 10 years.[46] Commitments fell by more than 64% that year, to $37.9 billion. Still, this sharply reduced total was quite large compared with capital investments before the bubble 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.[47] In fact, pension funds became the single largest supplier of new funds. During the entire 1990–2002 period, pension funds supplied about 44% of all new capital. Endowments and foundations were the second-largest source, supplying 17% of committed capital, followed closely by financial and insurance companies at 16% (table 6-10 table.). California, New York, and Massachusetts together account for about 65% of venture capital resources, because 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).

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U.S. Venture Capital Disbursements

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, creating a large pool of money available for investments in new or expanding firms and leading to a period of large year-to-year jumps in venture capital disbursements. In 1994, money disbursed by venture capital funds totaled to $4.1 billion and increased to $11.6 billion in 1996 and $21.4 billion in 1998, before peaking at $106.3 billion in 2000 (figure 6-31 figure.).

As early as 1990, firms producing computer software or providing computer-related services began receiving large amounts of venture capital (appendix table 6-18 Excel table.). Software companies received 17% of all new venture capital disbursements in 1990, more than any other technology area. This figure fluctuated between 12% and 21% thereafter. Communication companies also attracted large amounts of venture capital during the 1990s, receiving 12%–21% of total disbursements. Medical and health care-related companies received a high of almost 21% of venture capital in 1992 before dropping almost each year thereafter to just 5% in 1999 and to 4% in 2000.

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, collecting more than 40% of all venture capital funds invested each year. Software and software services companies received 15%–17% of disbursed venture capital funds. Communication companies (including telephone, data, and wireless communication) were a close third with 14%–15%.

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 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. During this period (2001–02), Internet companies received 28% and 21%, respectively, of the total venture capital dollars disbursed. Although a sharp drop from the previous 2 years, this still exceeded the amount received by any other industry area.

In 2003 and 2004, however, venture capital funds preferred other technology areas for investment, in particular software and medical/health companies, over Internet-specific companies. Software companies attracted the most venture capital in 2003 and 2004, receiving about 21% of the total invested each year. Companies in the medical/health field received 16% in 2003 and 18% in 2004. Internet-specific companies received about 13% of all money disbursed by venture capital funds in the latest 2 years (figure 6-32 figure.).

The decline in enthusiasm for Internet companies seems to have benefited other technology areas as well. Biotechnology companies were only attracting about 3% of total venture capital when Internet-specific companies were hot. Since 2000, however, biotechnology companies have gained steadily to receive 11% of total venture capital investments in 2003 and 2004, more than triple their share of 4% received in 1999 and 2000. Medical/health companies also have received higher shares, rising from a level of about 4% in 1999 and 2000 to an average of 11% in 2001 and 2002, and to 17% during 2003–04. Other industries attracting larger shares of the smaller pool of investment funds in the postbubble period are semiconductor and other electronics companies, and, to a lesser extent, industrial and energy companies.

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Venture Capital Investments by Stage of Financing

Investments made by venture capital firms can be categorized by the stage at which the financing is provided (Venture Economics Information Services 1999):

  • Seed financing usually involves a small amount of capital provided to an inventor or entrepreneur to prove a concept. It may support product development but is rarely used for marketing.

  • Start-up financing provides funds to companies for product development and initial marketing. This type of financing usually is provided to companies that have just organized or that have been in business just a short time and have not yet sold their products in the marketplace. Generally, such firms already have assembled key management, prepared a business plan, and completed market studies.

  • First-stage financing provides funds to companies that have exhausted their initial capital and need funds to initiate commercial manufacturing and sales.

  • Expansion financing includes working capital for the initial expansion of a company, funds for major growth expansion (involving plant expansion, marketing, or development of an improved product), and financing for a company expecting to go public within 6–12 months.

  • Acquisition financing provides funds to finance the purchase of another company.

  • Management and leveraged buyout provides funds to enable operating management to acquire a product line or business from either a public or private company. Often these companies are closely held or family owned.

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 when venture capital disbursements are examined by financing stage: (1) most 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.

Later-stage investments ranged from 50% to 80% of total venture capital disbursements, with the highest point reached in 2003 and the lowest point back in 1980. In 1999 and 2000, later-stage investments made up 72% of total disbursements, rising to 79%–80% in the postbubble period. Although early-stage, venture-backed investments as a share of total disbursements have gradually declined over time, during 2003–04 they fell to their lowest level ever (figure 6-33 figure.; appendix table 6-19 Excel table.).

The postbubble trend toward later-stage investing is also evident when analyzing the three early-stage categories. In 2001 and 2002, seed and start-up financing were the hardest hit among the three early stages. During a period when venture capital became increasingly scarce, the highest-risk, early-stage projects suffered the most.

Expansion financing has typically been favored by venture capital funds. This stage alone accounts for more than half of all venture capital disbursements from 1997 through 2003. In 2000, the amount of venture capital invested to finance company expansions reached 57% of total disbursements. This upward trend continued into the postbubble period, with the share rising to 62% in 2002.

The latest data show two seemingly contrary trends. In 2003 and 2004, among the three early stages, venture capital is shifting to riskier start-up investments. Start-up financings jumped to 13% of total venture capital investments in both years. Conversely, later-stage financing investments are moving away from company expansions and toward even later-stage investments that involve acquisitions of existing companies (appendix table 6-19 Excel table.). These contrary trends may simply reflect companies' efforts to mitigate risk by rebalancing the stage diversification in their investment portfolio.

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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 has never accounted for more than 8% of all venture capital disbursements over the past 23 years and most often has represented 1%–5% of the annual totals. The latest data show that seed financing represented just 1.3% in 2003 and less than 1% in 2004.

Over the past 25 years, the average amount invested in a seed-stage financing (per company) increased from a low of $700,000 in 1980 to a high of $4.3 million per disbursement in 2000. Since then, the average level of seed-stage investment has fallen steadily, providing just $1.8 million in 2003 and only $1.4 million in 2004 (figure 6-34 figure.).

Internet, communication, and computer software companies were the largest recipients of venture capital seed financing during the 1999 and 2000 bubble years. Internet companies were the preferred investment, receiving 58% of all disbursements in 1999 and 43% in 2000 (appendix table 6-20 Excel table.). In 2001 and 2002, seed investments going to Internet companies fell off considerably but still represented 21% of all such investments in 2001 and 7% in 2002. Most recently, Internet companies received 8% in 2003 and 13% in 2004.

As panic replaced mania, other technology areas attracted more attention. Medical and health care-related companies received 10% of seed money in 2001 and 20% in 2002, up from 4% and 5% during the bubble years. In 2003 and 2004, medical and health-related companies received more seed money than any other technology area. The share going to biotechnology companies rose to 5% in 2001 and 15% in 2002 and 2003. Semiconductor companies received 8% in 2001 and 15% in 2002, up from 4% in 1999. In 2004, semiconductor companies and software companies each received about 22% of venture capital seed money.

In sum, over the past 25 years, venture capital investment has consistently supported technology-oriented businesses, particularly companies and industries that develop and rely on information technologies. Although information technologies continue to attract the largest shares of total U.S. venture capital and seed money, life sciences (including medical, health, and biotechnology companies) have gained favor in the past few years.

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[45] Data presented here are compiled by Thomson Financial Services 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.

[46] Recent reports from the National Venture Capital Association show that 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 National Venture Capital Association, "Venture capital fundraising slows in fourth quarter, but hits new record for the year," press release, February 23, 2001.

[47] 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 investors balance both income and safety as they choose investments. The website describes the Prudent Man Rule as the fundamental principle for professional money management 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."

National Science Board.