Tech valuations continue dizzying spiral

Some venture capitalists dispute Fenwick & West report, which predicts VC pricing will slide this year

A controversial new report by a major Silicon Valley law firm signals that entrepreneurs are giving up more equity to venture capitalists, while those investors are earning less on their venture investments.

The report by Fenwick & West LLP of Palo Alto is disputed by some venture capitalists.

Tracking 81 venture-backed technology companies, the Fenwick & West report says second-round venture capital pricing declined throughout last year and is expected to continue to track downward this quarter.

Fenwick & West partner Barry Kramer says the twin trends could be a warning sign that post dot-com companies are in worse shape than generally predicted.

The report shows 20 percent of fourth-quarter fundings were second-round infusions (also called “B” rounds), and half of those financings were down rounds, meaning the companies were valued less than they were in the previous round. In the third quarter last year, only 33 percent were down rounds.

“The dot-com era was a pricing party and you should expect a pullback,” says Kramer. “But companies in round B now were in A rounds a year ago. They got their initial funding in the post dot-com.”

He says companies funded after the dot-com bubble burst were thought to be funded at more reasonable levels, which means second-round funding should have gone up.

Venture capitalists see the numbers differently.

“We’ve seen stabilization in pricing,” says Jeanne Metzger, a vice president with the National Venture Capital Association (NVCA) in Arlington, Va.

Metzger says she doesn’t know about the 81 companies in the report, but the nationwide trend her organization has seen in technology is an emergence from the bloodbath of 2001 with a more realistic industry.

“It’s complicated out there,” says Kate Mitchell, managing partner at BA Venture Partners in Foster City. Unlike Kramer, she thinks the down rounds in 2002 were expected.

“Even in 2001 and part of 2002, we were still seeing pricing that was inflated,” Mitchell says. “But things aren’t getting any worse. I think we’re skirting the bottom.”

NVCA’s Metzger agrees.

“VCs don’t expect any quick turn around. Most recognize it will get better over the next couple of years,” she says.

She says part of the reason 2002 saw a drop in funding for new companies is that existing venture capital firms were busy propping up troubled companies already in their portfolio.

“VCs have two jobs: to find new investment opportunities and to work with portfolio companies to help build sustainable business models,” Metzger says.

Many venture capitalists were too busy doing triage and providing intensive care services to existing portfolio investments to spare time on scouting new investments in recent months.

Saying the “triage process is almost complete,” Metzger believes venture capitalists have learned to take the time to do adequate due diligence on prospective investments.

Fenwick & West’s Kramer admits his numbers could be skewed by the threats of war and terrorism and their dampening effect on the market in 2002, but
that trend doesn’t seem to be getting any better.

“Sure, the numbers are a few months old,” he says. “But the stock market isn’t doing any better, so I wouldn’t think these funding rounds would be better either.”

To gauge whether the downward trend is continuing, Fenwick & West expects to release venture capital funding results from this year’s first quarter by mid-May.