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).
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
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 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.
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
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).
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.
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.
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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