THE VENTURE FINANCE ECOSYSTEM

Michael Danaher

Wilson Sonsini Goodrich & Rosati

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1. Venture Funding Activity

2. Demand Side Dynamics

3. Supply Side Dynamics

4. Dealing with Deflation

5. Other Trends and Fashions

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1. Venture Funding Activity

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The View From on High:Investment Rises Slightly in 2Q’03

Am

ou

nt

Investe

d

($B

)N

um

ber o

f Deals$4.4

$5.7$5.8$7.6

$4.4 $3.5

$7.6$9.3$11.0

$19.2

$23.0$24.8

$26.9

$4.0

442

1786 1713

1427

1239

878801

723 710

563 594530

469 424

$0

$10

$20

$30

$40

2Q00 4Q00 2Q01 4Q01 2Q02 4Q02 2Q03

0

300

600

900

1,200

1,500

1,800

Amount Invested ($B) Number of Deals

Underlying data available in VentureSource

Source: VentureOne/Ernst & Young

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The View From the Ground

Consumer confidence in the venture industry moved strongly up in the Spring

Multiple term sheets – what a concept!

Some instances of valuation giddiness

Overall activity is sharply up

First round deals are up

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2. Demand Side Dynamics

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Confidence is Up

The Market has awakened

1200

1300

1400

1500

1600

1700

1800

1900

2000

J anuary-03 April-03 J uly-03 October-03

Nasdaq Composite Index

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Confidence is Up

0

10

20

30

40

50

60

2001 2002 2003* 2004*

S&P 500 EarningsPer Share

The economy has awakened

Source: Bloomberg & Zachs Investment Research

* Estimated Earnings

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Confidence is Up

The world is adjusting to life after 9/11

The Iraq war ended quickly

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Venture Fund Dynamics:The Clean-up is Mostly Done

In 2001 & 2002 VCs were preoccupied with the care of their existing portfolio

Now that most of the the triage is complete, VCs can focus on investing again

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$2.4

$13.2

$48.8

$83.8

$55.7

$25.7

$16.6$13.2

$6.7$5.6$6.6$3.1

$0

$20

$40

$60

$80

$100

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 IH03

Fu

nd

s R

ais

ed

($

B)

Commitments to Venture Capital Funds

Underlying data available in VentureSource

Source: VentureOne/Ernst & Young

Venture Fund Dynamics

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Nu

mb

er o

f Deals

Source: VentureOne/Ernst & Young

$7.5

$20.3

$35.4

$93.9

$49.2

$17.8$13.1$9.9

19012198

2520

4502

6165

3112

2156

866

$0

$25

$50

$75

$100

1996 1997 1998 1999 2000 2001 2002 1H03

0

1,000

2,000

3,000

4,000

5,000

6,000

Amount Invested ($B) Number of Deals

Underlying data available in VentureSource

Venture Fund Inflow and Outflow

$2.4

$13.2

$48.8

$83.8

$55.7

$25.7

$16.6$13.2

$6.7$5.6$6.6$3.1

$0

$20

$40

$60

$80

$100

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 IH03

Fu

nd

s R

ais

ed

($

B)

Am

ou

nt

Investe

d

($B

)

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Source: VentureOne/Ernst & Young

Underlying data available in VentureSource

Venture Fund Inflows and the Nasdaq

$2.4

$13.2

$48.8

$83.8

$55.7

$25.7

$16.6$13.2

$6.7$5.6$6.6$3.1

$0

$20

$40

$60

$80

$100

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 IH03

Fu

nd

s R

ais

ed

($

B)

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Negative Dynamics

A number of “fair weather funds” are drying up

Many top funds have downsized

Corporate investors are mostly gone

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Corporate Investment is Mostly GoneA

mou

nt

Investe

d

($M

)

Underlying data available in VentureSource

Source: VentureOne/Ernst & Young

$130$142$129$106$242$253

$1,491$1,618

$1,928

$60 $104 $206 $49 $22

70

48

100

41

2429

120

135

2516 15 14 13 7

$0

$500

$1,000

$1,500

$2,000

1Q00 2Q00 3Q00 4Q00 1Q01 2Q01 3Q01 4Q01 1Q02 2Q02 3Q02 4Q02 1Q03 2Q03

0

25

50

75

100

125

Amount Invested ($M) Number of Deals

(except Intel and Cisco)

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First Round Financings

0

500

1000

1500

2000

2500

3000

3500

1997 1998 1999 2000 2001 2002

Series A Deals

Data extrapolated from VentureSource

Source: VentureOne/Ernst & Young

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Negative Dynamics

The Ex-Smoker Syndrome: the Reformed VC

• Excessively risk averse

• Excessively slow

• Excessively LP conscious

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3. Supply Side Dynamics

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“The older but wiser girl is the girl for me.”

-- The Music Man

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The Entrepreneurs

More realistic about valuations

More patient about building a company, and building a career

More down-to-earth

More plentiful

More hard core technology plans

More thrifty

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4. Dealing With Deflation

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The Old Days of the New Economy

The market rewarded

•First to market

•Scale (e.g. engineer head count)

•Revenue prospects

Earnings didn’t matter

•The rational response: go fast, spend big, never mind the losses

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Earnings Really Didn’t Matter

Year OfferingsPercent profitable

in IPO year

1999 47 49%

2000 66 9%

2001 13 31%

The WSGR IPO Universe*

(Company and Underwriter Side)

* An unofficial compilation

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Exit Valuations Are Now Earnings Driven

IPO’s Require Profits

Acquirers want accretive acquisitions

•No big premiums for “time to market”

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The Venture Industry Responds:Valuations Remain Down

Med

ian

Am

ou

nt

Investe

d (

$M

)

Underlying data available in VentureSource

Source: VentureOne/Ernst & Young

$6.7$6.2

$4.3$0.8

$0

$5

$10

$15

$20

$25

2Q00 3Q00 4Q00 1Q01 2Q01 3Q01 4Q01 1Q02 2Q02 3Q02 4Q02 1Q03 2Q03

Later Round Second Round First Round Seed Round

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The Venture Industry Responds:Deal Size Remains Down

Med

ian

Am

ou

nt

Investe

d (

$M

)

Underlying data available in VentureSource

Source: VentureOne/Ernst & Young

$100

$17

$39

$14

$5

$13

$3$5$0

$20

$40

$60

$80

$100

1Q00 2Q00 3Q00 4Q00 1Q01 2Q01 3Q01 4Q01 1Q02 2Q02 3Q02 4Q02 1Q03 2Q03

Later Rounds

Second Round

First Round

Seed

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The Entrepreneurs Respond:Run Silent, Run Cheap

Smaller budget business plans

Lower headcount, smaller salaries, cheaper facilities, leased equipment, smaller marketing budgets…

Focus, do less, outsource

Aim right—sell, design, build

Overseas Design Centers

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The Entrepreneurs Respond:Run Silent, Run Cheap

Some great businesses are being built on $200k to $300k per month

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5) Other Trends and Fashions

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Proceed With Caution

Show me the customers

Almost every deal is syndicated

More first round deals are traunched

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Other Deal Terms

Often smaller shares for founders (especially outside Silicon Valley)

Investors prefer plain vanilla deals when possible

•No cumulative dividends, weighted average anti-dilution

•Liquidation preferences: usually 1x participating preferred, often without caps

•Redemption rights (but why bother?)

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Market Dislocations

Fewer dislocations (un-served sectors) than years past

•Most will consider first round, second round and mezzanine

•Seed rounds are still a problem – the angel market is still decimated

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Market Dislocations

Out of fashion

•Optics

•Telecom services

In fashion

• Network security, homeland security (government sales!), wireless, consumer electronics, biotech