Private Equity’s Rise, And Fall, And Rise Again: Causes And Trends

Wednesday, October 22, 2003

Prof. Jeffrey Sohl, Abstracted from: The Private Equity Market In The USA: Lessons From Volatility, http://

Better Business Management & Planning Practices

By: Prof. Jeffrey Sohl University of New HampshireVenture Capital: International Journal of Entrepreneurial Finance - Vol. 5, No. 1, Pgs. 29-46

Riding the upswing.
Entrepreneurs, angel investors, and venture capitalists can all learn from the enormous changes in the private equity markets over the last decade, Jeffrey Sohl believes. After suffering a severe financing drought during the early 1990s, entrepreneurs began to see a rapid rise in interest among angel and venture capital investors in the latter half of the decade. Interest intensified after Amazon.com’s 1997 initial public offering indicated how profitable providing startup funding can be. Between 1995 and 2000, venture capital funding expanded from $6.3 billion to $90 billion, a five-fold increase, while angel investments rose to about $40 billion annually. The money invested as venture capital exceeded the dollar amount of angel investments, although the latter funded more deals. Both investor groups were rewarded with hefty returns.

Weathering the fall.
The inevitable market contraction occurred swiftly. By 2002, Silicon Valley’s unemployment rate had risen to 6.6%, up from 1.3% the previous year. Venture capital returns declined by nearly 28% in 2001, the first time the industry had recorded a 12-month negative return. In this cautious climate, many VC funds prefer to devote resources to companies already in their portfolios, rather than take a risk on new ventures, suggests the author’s research. VC investment fell from a high of $26.2 billion in the first quarter of 2000 to $5.7 billion in the second quarter of 2002. Angel investors also chose to retrench. Several reasons underlie the severity and swiftness of the fall. Inexperienced investors who had never witnessed a market downturn were ill-equipped to handle the rigors of the private equity market. As funds became bloated with investors’ dollars, they lost their nimbleness and became unfocused. Companies lunged for VC financing, losing the benefit of the valuable experience and advice that angel investors provide. Even for those with angels, the abbreviated timeframe for developing new companies extinguished the opportunity for angel investors to nurture the business gradually.

Return to basic black.
A back-to-basics philosophy of more measured growth marks the recent private equity market, observes the author. This includes a return to the angel model of investing in which a group of five to seven angels provide both seed capital and valued guidance. Before angels enter the picture, entrepreneurs may try to grow the business on their own or use money provided by family members or friends. At some point in the seed or startup phase, private investors enter the picture. Some 300,000 to 350,000 angels invest about $30 billion a year in nearly 50,000 ventures, according to conservative estimates. A typical early-stage angel round provides between $100,000 and $2 million in capital. Institutional VC funds focus on larger deals, and invest approximately $30 billion to $35 billion in under 3,000 companies each year. The typical later-stage deal usually involves $10 to $15 million in financing.

Bridging the gap.
A critical funding gap exists for startup and early-stage companies, and an information gap means that many promising new technologies remain overlooked or forgotten. Entrepreneurs seeking $100,000 to $2 milliontypical needed amounts after funding from family and friends runs outsuffer most. Another funding gap has emerged among companies in the early stages of equity financing. Requiring between $2 million and $5 million, these companies need more than most angels can provide but fall short of the growing financing requirements of the VC industry. The author sounds a positive note: more realistic deal valuations and the return of angels as a potent force in the private equity market bodes well for the future. Investors and entrepreneurs will strive for sustainable growth, rather than a quick exit strategy, while several US government initiatives promise to enhance further development of businesses in the technology sector.

Abstracted from Venture Capital: International Journal of Entrepreneurial Finance
published by Taylor & Francis Ltd., 4 Park Square, Milton Park, Abingdon, Oxon OX14 4RN, England.

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