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					              Entrepreneurship and the New Venture Capital Paradigm:
                                Trouble in Paradise
                           Dean B. Kiefer, Eastern Washington University
                                    668 N. Riverpoint Blvd 3RPT
                                  Spokane, WA 99202-1660 USA
                            1-509 358 2215 (tele) 1-509 358 2267 (fax)
                           Brian Grinder, Eastern Washington University
                          M. David Gorton, Eastern Washington University
                         Robert G. Schwartz, Eastern Washington University
                                 Lloyd Southern, Mercer University


By the end of 2000 the venture capital bubble had burst with a chilling effect on venture capital
availability world-wide. Since then valuations have plummeted with many firms having ceased
operations, been acquired or merged, or been delisted due to low stock prices. The impact of all this
has been to significantly decrease the amount of funding raised from venture capitalists as well as
overall capital availability, particularly for early-stage firms. Investments as a whole are receiving
far more scrutiny from venture capitalists as the latter attempt to trim their losses and return to
profitable operation.    Overall the lack of capital has resulted in fewer new firms and ultimately
fewer jobs created. In many countries government is stepping into the breach to provide jobs and to
enhance new job development. This takes several forms ranging from direct aid to training in
starting and running a new venture to relaxation of regulation and lessening of tax burdens. This
paper surveys the state of the venture capital industry around the world and examines the issues
concerning the current and future performance of the industry.


The world-wide economic slowdown of the past few years, particularly in the technology sector, has

had a large impact on venture capital activities as well. Fundraising and investment have plunged to

the lowest levels in at least 20 years resulting in serious shortages of capital, particularly for start-up

and early stage firms (Anonymous 1, 2003). This shortage has greatly diminished the number of

start-up firms receiving funding as well as having served to significantly slow the development of

early stage firms. While a few sectors such as health care and software have been fairly successful in

attracting early stage funding, the majority of the funded firms have been in later stage investments

(Learner, N., 2002).

                                           United States


Over the last three years, venture capitalists have experienced large reductions in the amounts of

capital they have been able to raise. In 2002 in the US, 108 funds raised $US6.9 billion compared to

$US40.7 billion raised by 331 funds and $US106.7 billion raised by 653 funds in 2001 and 2000

respectively (Anonymous 2, 2003). These reductions are largely attributable to sharp declines in

valuations with many firms having ceased operations, been acquired or merged, or delisted due to

low stock prices.

Returns on US venture funds have dropped from a three year running average of 26 percent at the

end of June 2002 to 15 percent at the end of September 2002 (Healy, 2003). Average returns have

reportedly declined for the past seven consecutive years. The falling returns, declines in valuation,

lack of suitable investment opportunities and lack of viable exit strategies have all combined to make

fundraising difficult.   Even stable, long-term investors such as university and institutional

endowment funds have decreased their allocations to venture capital from 12.6% of total assets in

2000 to 3.9% in 2002, reportedly to avoid further declines in value and to avoid risk. (Grimes, 2003)

It has been reported that overall investor allocations to venture capital have dropped from an average

of 4% of total assets to 2.9%. Another reason cited for the decline in fundraising was the estimated

$US90 billion overhang of existing funds that some experts felt would stall fundraising efforts for up

to eighteen months (Braunschweig, 2003). The overhang has resulted in about $US5 billion being

returned to investors for lack of attractive investment opportunities (Anonymous 3, 2003). Reasons

for the decline in fund raising and the increase in funds returned are that 1) resources are no longer

available to manage as much money as was available; 2) venture capitalists were spending more time

trying to salvage previous investments, and 3) the technology bust over the past 2-3 years resulted in

unprecedented losses.

Venture Capital Firm Changes

The net result was a “re-sizing” of the US venture capital industry where funds had to consolidate or

downsize to remain viable. The US venture capital industry had contracted. The number of firms

was shrinking, their portfolios were worth less and staff numbers were declining. This same survey

also reported that partners were reportedly going back to their original jobs in banks or consulting

and that venture capital investing was going back to basics (Nelson, 2003). By another estimate, half

the employees in the industry will be eliminated in the contraction (Berthelsen, 2003). Because of

the above cited problems faced by the industry, smaller firms, especially those established within the

past four years , are not expected to survive (Tunkick, 2003). The alternative to shrinking or

liquidating venture funds is the hope that investors will remain patient until market conditions

change (but investors have been waiting for two or three years already). Undaunted by the dearth of

failed and failing venture capital firms, however, one new US venture fund has bucked the trend and

established a new fund to provide capital for start-ups.


On the investment side, the US picture is equally bleak. Start-up and early stage growth firms are

finding it very difficult to locate capital. Deals are reportedly off by 50% as venture capital firms

attempt to “right-size” the industry while investing more in firms with proven business models and

revenue streams rather than more risky start-ups (Grimes, 2003).         US venture finds invested

$US21.1 billion in 2002, the lowest levels in four years, with 3,208 deals and an average size per

deal of $US7 million. This compares to investment of $US41.1 billion in 4,691 deal for an average

of $US8.76 million per deal in 2001 and investment of $US106.4 billion in 8,202 deals with an

average size of $US12.96 million. In 2002, 756 early stage firms received about $US 4.3 billion

compared to 1178 firms receiving about 18% of the total investment in 2001 (National Venture

Capital Association, February 15, 2003, www.nvca.org). The pessimism is not uniform throughout

the US, though. A recent poll found that investors in the Northwest were most optimistic while those

in New York were the most pessimistic regarding the current outlook. Investors in the Northwest

generally felt that the problems in their portfolios had been resolved and that there was capital
available. They also felt that the general improvement in the quality of business plans has helped

companies acquire funding (Anonymous 4, 2003).

In general, venture capitalists were still willing to fund companies with rising revenues that were

within 12-18 months of profitability, had proven products and an established customer base and were

generating a strong cash flow (Cole, 2003). While later stage financing was available for companies

that were already successful, the start-ups and early stage forms were experiencing the venture

capital drought in the US.

A negative, but typical, example follows: one firm based in the Northwestern US had considerable

difficulty locating additional funding in 2002 after previously securing $US8 million in capital in

2001. This firm has an important new technology related to wireless tagging of shipped materials.

The firm‟s current strategy is to form strategic alliances with partners who are interested in using the

technology in their businesses (Edwards, 2002).

Such strategic alliances were becoming more common in the US as large firms are investing heavily

in start-ups and early stage companies developed technology important to the larger partner. Actual

and potential customers are also becoming an important source of capital.            As noted above,

entrepreneurs were also cautious because of low valuations and about giving up creative and

operating control venture capitalists presently require (Anonymous 4a, 2003).

Angel Investors

Angel investors were another important US source of capital, one which has not slowed in their

investing as much as has the venture capital industry. The University of New Hampshire Center for

Venture Research reported that in the US, angels invested $US30 billion in 2002 versus $US21

billion for venture investing. The 2002 level was about two-thirds of the amount angel investors

provided in 2000. With the exception of 1999 and 2000, angel investing in the US has outpaced

venture capital investing every year for the past decade.    They were investing smaller amounts per
deal on average. Angels were also seeking firms with strong business plans and the same types of

returns as venture capitalists. This is a natural consequence of greater risk seeking greater reward.

(Friedman, 2003)

Exit Strategies

In the US, the IPO as an exit or harvest strategy has been severely limited by the poor market

conditions and economy. There were total of 22 venture offerings US IPOs for a total of $US1.9

billion in 2002 compared to 35 venture backed US IPOs totaling $US2.8 billion in 2001. However,

the average size of the deals was larger in 2002 than in 2001, $US86.8 million and $US82.6 million

respectively. The distribution across industry segments followed the recent trends in investments.

Software, medical devices and healthcare services accounted for 47% of venture backed offering size

(Metzger and Radler, 2003). With continuing problems in the public equity markets, exit strategies

will continue to be problematic for 2003.


Other sources of capital are federal and state governments. In the past when times became difficult

the US federal and state governments stepped up. It is not clear whether this will occur to the same

extent in 2003. Thirty-five of fifty states are reporting large budget deficits with the result that many

states are cutting budgets and reducing or eliminating funding for economic and job development


Some government help is available, however. Federal Small Business Innovation Research grants

have been available for about twenty years. These funds are available to assist firms in developing

innovative technologies that meet government needs. Such grants are peer-reviewed and begin at

$US50,000 at the first stage while second stage financing can be as much as $US750,000 and up

(www.sba.gov/sbir). These grants are difficult to win and only about one in ten firms receive awards

at the first stage. They represent a major step up for early firms with innovative solutions to major

technology challenges.

US Small Business Administration guaranteed loans are yet another form of federal government-

backed financing. The Bush Administration was proposing an appropriation of $US800 million in

2003, the same amount as last year. With this budget, the SBA could commit to $US20.8 billion in

loan guarantees. (Kaiser, 2003).

States are also assisting with venture capital despite the economic downturn and budget problems.

For example, the State of Washington awarded $US23 million in 1997 and the amount grew to

$US29 million in 2001 (Cook, 2002). In other examples, the State of Florida recently announced a

$US130 million venture capital fund and in 2002, the State of Indiana, the State of Illinois and one

California County provided $US1 billion in venture capital (Braunschweig, C., 2002). Rhode Island

recently doubled the annual budget of the state-supported technology fund from $US2.5 million to

$US5 million. The fund makes investments in local technology firms and over the past five years

has invested in 59 companies employing 250 people. The state-run Rhode Island Economic

Development Corporation works closely with the technology fund to attract fast-growth, emerging

technology firms. (Anonymous 5, 2003).



Internationally, fund raising conditions appear to be slightly better than in the US. European Venture

Capital Association reported that both funding and investment were in decline although the decline

was not as dramatic as in the US. One fund has been reduced from €250 million or $US235.6

million to €158 million of $US148.9 million (Anonymous 6, 2002). Another firm reduced the size

of its European fund from $US250 million to $US500 million (Anonymous 7, 2002). While some

European and US venture capitalists were reducing their European funding, a few were raising new

funds. One firm recently closed a €140 million ($US131.9 million) fund to invest mostly in early

and growth stage technology firms in Ireland (Goncharoff, 2002).


Internationally, the investment picture was also slightly more optimistic than in the US. Venture

capitalists in Europe also showed a preference for investments in later-stage firms rather than

startups and early-stage financings as were their counterparts in the US.) follow-on investment was

64% of the total in 2002 compared to 54% in 2001. The same study reported that new investment

was 36% of the total in 2002 compared to 46% in 2001. Total investment in 2002 was €27.2 billion

($US25.6 billion), up from about €24.4 billion ($US21.9 billion) in 2001. For the past five years, the

2002 investment level is exceeded on by the €35 billion ($US32.3 billion) investment in 2000

(Preliminary Survey of Pan-European Private Equity and Venture Capital Activity, European Private

Equity and Venture Capital Association, 2002).

Also like the US, larger European firms are investing in new companies that have promising

technology related to their business. In Denmark and Sweden, a large number of bio-technology

firms have resulted from spin-offs from larger companies. This tactic reduces R&D expense as well

as risk. In Sweden, one venture capital firm increased its stake in a supplier of business support

systems to 7.8% of share capital (and voting rights) from 4.8% (Anonymous 8, 2002). Another firm

recently closed a €140 million ($US131.9 million) technical investments fund to invest in early and

growth-stage firms in Ireland. The fund already has invested €30 million ($US28.3 million) in seven

different companies (Meyer, 2002).

Like their counterparts in the US however, some European venture funds were also writing down

portfolio values. One firm in Germany took a 40% write-down of their portfolio in the second

quarter of 2002 (Goncharoff, K., 2002). Preliminary figures for 2002 indicate that write-offs in that

year were 28.5% of the €8.1 billion ($US7.6 billion) in total divestments “Preliminary annual survey

figures indicated difficult fundraising, but also steady investment in 2002” (EVCA Annual Survey of

Pan-European Private Equity and Venture Capital Activity, European Private Equity and Venture

Capital Association, March 12, 2002).
Governments and institutions in Europe have helped improve the atmosphere for entrepreneurship

and venture investing. Germany, France and the Netherlands have all cut personal income taxes

within the past three years. State-run companies have been privatized and forced to compete with

start-ups (Drozdiak, 2001). European universities have been teaming with industry to establish

clusters in various industries life sciences and biotech (Drozdiak, 2001). The growth in biotech has

been particularly strong in Germany which has taken over the lead in terms of new companies

formed. German lawmakers accomplished this by offering to match every €1 ($US1) of venture

capital with €3 ($US3) of state financing (Abate, 2001).

Exit Strategies

Europe venture capitalists have experienced a similar slowdown in the IPO markets. New listings on

the major European exchanges fell 44% from 309 in 2001 to 174 in 2002. The total amount of

capital raised fell 66% from €33.4 billion ($US29.9 billion) in 2001 to €11.5 billion ($US10.8

billion) in 2002. Difficult conditions are expected to prevail for most of 2003 (IPO Watch Europe,


European venture capitalists divested €8.1 billion ($US7.6 billion) in 2002 compared to €12.5 billion

($US11.2 billion) in 2001. With IPO markets weak, the most popular exit strategy was via trade sale

which accounted for 29.8% of the funds divested, followed closely by write-offs at 28.5%. IPOs

accounted for only 1.1% of the divestments in 2002 (European Venture Capital Association 2, 2002).


In Europe, subsidies and market reform (Germany), changing legal constraints (France), streamlining

methods for distributing government funding (United Kingdom), and changing the tax structure

(several countries) have made and continue to make the environment more friendly to entrepreneurs

and job creation. France and Germany, in particular, have been trying to create large, liquid, risk-

tolerant stock markets similar to the US to make exit via IPO easier and less risky.

                                             Pacific Rim


The trends in fundraising and investing in the Far East were also similar to those in the United States.

Asian venture funds raised less than $US10 billion in 2001 compared to $US18 billion in 2000

(Gillmor, 2002). Conditions varied across countries, however. The climate in Korea appeared more

favorable since the government has now allowed foreign investors to restructure troubled companies.

In Japan, however, the banking sector was approaching insolvency as the banks were overburdened

with bad loans. Mainland China was viewed as having major potential and was attracting increased

attention. Developing technical capabilities as well as a growing middle class were expected to

generate opportunities in technology such as software, communications, biochemicals, and financial

services. At the recent 2002 World Capital Forum in Nanjing, China, venture capital firms were

expected to come with a reported $US2 billion to look for projects in China (Anonymous 9, 2002).


In Asia and the Pacific Rim, investment also slowed somewhat. The International Finance

Corporation, the private equity lending arm of the World Bank, committed $US 10 million to a

California-based venture capital firm for investments in information technology in India (Ramat-

Gan, 2002). A New York-based venture fund has also set up a private consultant in India to take on

clients for the fund (Anonymous 10, 2002). In Thailand, the country‟s first venture capital fund

planed to launch a private equity fund, spurred by the Thai SEC‟s new policy that will waive

dividend taxes and offer other incentives. The fund plans to invest Bt20 million, or about $US461,

700. Also in Thailand, a Thai venture fund, had been severely criticized and may be penalized. They

apparently failed to comply with the Thai government policy of providing liquidity to small and

medium sized enterprises by failing to make effective deals with such companies (Praiwan, Y.,

2002). In Malaysia, a government sponsored fund was evaluating deals and running seminars as a

part of the Entrepreneurship Development Programme for Malaysians. The fund would assist

entrepreneurs in starting and running and information technology and communication ventures.


In other parts of the globe, an Israeli startup raised $US10 million in a second round of financing.

This was considered a rarity due to the now harsh climate for startups in Israel , a climate that used to

be quite excellent, as late as early 2000. The company has a software product designed to fight

money laundering and credit card fraud, a market potentially worth $US550 to $US600 million.

(Sandler, 2002).


In other parts of the globe, government efforts have been varied. The Zambian government is

emphasizing job creation through the development of small enterprises by supporting efforts to train

Zambians on how to start and profitable manage new businesses (Anonymous 11, 2003).

The Kenyan government has received a grant from the European Union to support poverty

alleviation and job creation initiatives by developing and promoting tourism. (Anonymous 12, 2003).

The government of the Philippines planned to create five million emergency jobs to clean up and

beautify Manila and the surrounding areas to reduce unemployment, particularly among youth.

(Anonymous 13, 2003).

In Thailand the Thai Securities Exchange Commission changed its policy to waive dividend taxes

and offer other incentives to attract entrepreneurs and spur job creation. (Tenorio, 2002).

Australia‟s government recently eliminated the 24.5% capital gains tax for venture capital entering

the country in an attempt to attract venture capital funding and job growth. (Tunick, B., 2003).

The Chinese government has, for the first time, included new job creation as a specific objective in

its state planning. (Anonymous 14, 2003).

                                     Summary and Conclusions

The recent state of the venture capital industry throughout the world has been one of caution, risk-

reduction and pessimism. Venture capitalists were more interested in financing established firms

with an established customer base, growing sales and an increasing cash flow. As a result, finding

seed capital and funding for startups and early stage firms had become considerably more difficult.

Venture capitalists had reverted to the old paradigm of intensive due diligence with a greater

emphasis on management and business planning.

Investors in venture capital funds had likewise become considerably more cautious. As a direct

result of the huge losses of the past few years coupled with the lack of suitable exit strategies,

investors had greatly reduced their funding of venture capital funds. While the caution appeared to

be greater in the US than in other parts of the globe, the lack of attractive investments, reduced

funding and limited exit strategies remained a problem worldwide.

As the funding and development of entrepreneurial businesses slows, governments around the world

stepped in to spur growth. Their major reason for doing so was job creation. In many cases, the

support of venture capital activity had been in the form of relaxed regulation, mitigated tax impacts

and direct subsidies. Despite these efforts, however, conditions in the venture capital industry

generally are not expected by the authors to improve for the next one to three five years. What

investors in venture capital funds and the public can expect is a higher quality investment portfolio

and a return to profitability for the industry as a whole with new IPOs that have value.


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______, __, 2003, “Deals and Dealmakers: Darwin was Right: Venture Deals are Off 50% in a
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US Small Business Administration, www.sba.gov/sbir.


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