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2006 predicted to be critical transition year in venture capital lifecycle08/03/2006. Source: National Venture Capital Association.
 The evolution of venture capital from a cottage industry to a mature asset class will manifest itself in several critical ways in 2006, says the US National Venture Capital Association. According to NVCA President Mark Heesen, venture capital will witness a fundamental shift in risk taking, investment complexity and participants.
'The venture capital industry has reached an echelon of maturity that brings with it a universal sense of prudence and discipline that will begin to impact decision making in 2006,' said Heesen. 'The coming year will be characterized by less risk, less hype, and more intricacies within investment sectors. This maturity will serve us well as we will face fresh challenges with exit markets, new power players, and competition, both globally and here in the United States.' 'With the maturing of the venture capital industry comes an awareness of responsibility for longer term competitive issues,' said Joe Aragona, NVCA Chairman and General Partner of Austin Ventures. 'We expect the venture capital community to spend more time in 2006 supporting policies that allow the United States to maintain our economic pre-eminence and continue to be the global magnet for innovation.'
More-informed risk taking
Risk taking will remain the cornerstone of venture capital but it will become much more calculated as VCs leverage past experiences when making investment decisions. Entry into new sectors will occur only after a keen understanding of the dynamics associated with the space is achieved. Consequently, we will not see rapid investment increases in new sectors but rather a gradual ramp up over a period of several years. Industries in which venture capitalists have already been climbing the learning curve and are expected to see more investment in 2006 include energy, bioinformatics, and mobile computing. The 'learning curve tenet' will hold true for entry into new geographical regions as well. The pace of visits to China and India may accelerate, but investment dollars will remain low for several more years.
Trading exuberance for stealth
Investment in Internet-based businesses will continue strongly, less the exuberance that characterized the beginning of the decade. There will be healthy competition within hotter sectors, yet VCs will fund far fewer 'me too' companies.
'There will not be another bubble as we simply do not have the liquidity to fund one, the exit market to fuel one, nor the 'tourists' to create one,' said Heesen. 'The venture capitalists investing today are veterans who have a profound sense of responsibility and are making decisions on sound business criteria. We don't expect widespread froth.'
Ironically, the competitive drive may manifest itself in less hype and more stealth investing in 2006. Companies will not be as eager to announce funding rounds unless they have additional traction to complement the investment.
Burgeoning investment complexity
As in other mature industries, participants will continue to operate in the spaces that have been successful including software and life sciences while simultaneously finding new niches to exploit. To wit, venture capital investment will cross industry sectors at an unprecedented rate in 2006 as we see innovation occurring at the intersection of areas such as IT and life sciences, wireless telecom and computing, and media and Internet. Venture capitalists will have to develop expertise in multiple disciplines or, more likely, team with other VCs who posses the required complementary expertise on these cross sector deals.
IPO market angst
The US IPO market is not expected to rebound considerably in the coming year, which has several major implications. Companies will continue to rely on the acquisitions market as an easier, safer exit strategy but will also search for more innovative opportunities. More companies will consider going public on foreign exchanges or soliciting offers from private equity firms. However, the economic and psychological implications of a thin IPO window will begin to make an impact. Venture firms will find themselves in the position of having to support their portfolio companies longer as the proper strategy is selected.
No major blurring among alternative assets
While there is a great deal of talk about the blurring of lines between hedge funds, buyout funds and venture funds, there is not expected to be a major merging of these alternative asset classes in the coming year. It is likely the industry will see multiple types of funds within a firm as a viable strategy. However, it is unlikely that individual hedge fund managers will cross lines into venture capital.
While the entrée of hedge fund managers is not an area of significant concern for the venture industry, there is a growing unease about an excess of liquidity in the buyout and hedge fund spaces. The VC industry would like to see these asset classes exercising the same fundraising discipline that they themselves have been exhibiting in the current cycle which will conclude in 2006 after raising an estimated $65 billion.
New competition likely complementary
Powerful publicly-traded Internet players like Google, Yahoo and EBay will play an increasingly important role in the rhythm of the VC industry. However, that role remains largely uncertain today. These organizations are still in their formative stages which makes them entrepreneurial, but unpredictable. Their role as an acquirer or funding source for young companies, if sustainable, will likely be complementary rather than competitive to the venture capital industry. Many smaller start-ups that are developing features for the Internet are not candidates for venture funding and are best suited to partner with a corporation early in their lifecycle. The innovation pipeline is strong enough that there are plenty of opportunities to go around.
Returns pressure
A continued lackluster IPO market will begin to impact venture returns in 2006 as these exits have historically driven the industry's outperformance. The acquisitions market can produce respectable returns of 4- 10x investment but can not alone support the level of cash distributions expected by limited partners. Without these larger IPO driven distributions, the venture industry will not be in a position to achieve the above market returns which limited partners have historically enjoyed.
Minimal growth
We expect to see slight upticks in total VC investment and fundraising in 2006 - but no more than 10%. The number of venture firms may decline slightly as those unable to raise follow on funds choose not to continue. This drop will be offset by veteran venture capitalists spinning out from existing firms to start their own emerging funds.
Optimism abounds
Industry experts agree that, despite the challenges, 2006 will be a positive year for venture capital investment, not only for an industry that has reached maturity but for its stakeholders including entrepreneurs, institutional investors, and the country as a whole.
'It's going to be a great year to start a new company,' said Tracy T. Lefteroff, Global Managing Partner of the Venture Capital Practice at PricewaterhouseCoopers. 'Venture Capitalists had a very active fundraising year in 2005, which means there is plenty of money to invest in 2006. Competition for VC funding has been fierce the last few years, but VCs may start to relax a bit and loosen their purse strings as they broaden their portfolios. Overall, the pendulum is swinging back slightly in favor of the entrepreneurs.'
'In the coming year, the survivors from the post-Bubble meltdown will be nearing that three-to-five- year sweet spot for M&A opportunities. So while overall deal volume will remain stable, the deal values will go up markedly since these companies were the strong performers that had to make do during the lean years with less generous backing. So the potential return on investment for this class of targets should be higher as well,' said Mary Macdonald, Vice President, Thomson Financial.
NVCA members have offered their perspectives in many areas for the coming year as evidenced by the following predictions from leading venture capitalists around the country: Investment and Exit Activity
'The S.E.C. will promulgate a rule exempting small companies from the most onerous requirements of Sarbanes-Oxley; and if they don't, Congress will act and do it for them. Wireless computing and communications will continue to take over the world -- more people will watch TV wirelessly, message, create and share content, surf the web and transact through wireless devices. Security for wireless devices is the next frontier of worry. The IPO market will remain difficult, but large strategics will pick up their activity in trying to acquire growth -- so M&A activity will be robust.'
-Robert Grady, managing director, The Carlyle Group and NVCA Chairman-elect
'I am optimistic about the venture investing environment for 2006. As we come into the new year, there is the best balance between entrepreneurs' interests and the VC interests since the pre-bubble period in the mid-1990s. While valuations are up, exit opportunities are also closer in. Business models and capital spending plans are more realistic. Information Technology continues to increase its share of the economy and there is finally activity again in Communications, which should be the largest investment sector. New technologies are emerging that offer the potential for major paradigm shifts across tech sectors. So in short, I am optimistic that 2006 should be an excellent year for both new investments and successful exits.'
- J. Sanford Miller, managing director, 3i
'Unless the SEC figures out how anti-growth and anti-jobs the impact of SOX is on young growth companies considering an IPO, we will see U.S. venture-backed companies doing what until now has been unthinkable: going public on foreign stock exchanges like the Toronto Exchange or AIM, the small cap exchange affiliated with the London Stock Exchange.'
- Bob Pavey, managing partner, Morgenthaler
'Finally after a period of relative stability and normalcy in 2005 we are once again convinced that we can build important and valuable companies. The Class of 2006 portfolio companies will generate top quartile returns and drive great innovation. While a number of successful companies will be funded, the risk of excess capital which could lead to too many over-capitalized companies still exists. Venture capital is now being exported to some very exciting emerging markets like China which shows great promise.'
- Michael Greeley, general partner, IDG Ventures
'In 2006, the venture industry will see better public capital markets that will facilitate the belief that, once again, venture capital can provide an adequate risk-adjusted return. The pace of both fundraising and investment will trend slightly upward, yet at a rational level that continues to support the fact that we have returned to long-term sustainable levels needed for an even stronger industry.'
- Tom W. Siegel, managing director, Shepherd Ventures
'In 2006, the venture capital industry will fully embrace start-up investing and show a willingness to back truly unique and disruptive technologies. With many new funds closed, venture capitalists will have both the time and the resources to seek out and finance companies that have new, world-changing products.'
- Dennis Dougherty, founding general partner, Intersouth Partners
'While rising energy prices and increasing interest rates may create a slight recessionary trend in 2006, corporate spending is expected to remain robust, helping to maintain economic growth. We see private equity firms and venture firms continuing to benefit from an active equity and M&A market.'
- Walter G. Kortschak, managing partner, Summit Partners
'In 2006, the rewards will come for the more adventurous venture firms. Silicon Valley and US markets still have good opportunities but don't promise the kind of excitement and rapid market expansion that places like India, China, Europe and Israel do. The US venture industry will accelerate its advance towards world-wide penetration for it to get better returns. Herzliya Pituach, Bangalore and Shanghai beckon with lots of risk but higher returns.'
- Deepak Kamra, general partner, Canaan Partners
'More venture-backed companies will finally go public in 2006.'
- Promod Haque, Managing Partner, Norwest Venture Partners Sectors of Focus
'The first usable home multimedia wireless distribution system will hit the market. This will start a new wave of wireless adoption and media will become non-device centric i.e. truly distributed.'
- Chad Waite, general partner, OVP Venture Partners
'In 2006 we will see increased activity in funding interdisciplinary startups as markets converge and customers demand innovative products. One area in particular is the interface between Life Sciences and Information Technology. Advances in computing, materials science and nanotechnology are enabling life changing breakthroughs in the healthcare industry.'
- Patrick Ennis, managing director, ARCH Venture Partners
'The next big thing is still the last big thing. The Internet is 10 years old, not even a toddler by any measure. Traffic is up, users are up, Internet businesses are growing exponentially as communities are lighted up worldwide. True Internet Mobility is here to stay and Hotspot/VOIP/Wimax technologies will complement as well as compete against carrier cellular networks. For all these reasons, the venture capital industry will continue to play a major role in global innovation for the next phase of the Internet Age.'
- Greg Galanos, managing director, Mobius Venture Capital
'Next year we will see valuations for media related deals will come back to earth, nanotechnology will still be on the verge of a breakthrough, and alternative energy deals will be en vogue. On the regulatory front, congress will continue battling SOX issues faced by small companies and 2006 will be the low water mark for taxes. '
- Roger Novak, partner, Novak Biddle Venture Partners
'Medical device investing will remain strong, with valuations for late stage deals continuing to heat up, mainly due to positive liquidity events. The life science side will be more mixed with investments funneling into two main categories: licensing/roll-up plays where the VC acts more like a buyout firm and platform-to-product plays where the VC invests early and the company goes from IP to product.'
- Mike Carusi, general partner Advanced Technology Ventures
'As the personal computer was to an earlier generation of technology entrepreneurs, mobile phones now present one of the most lucrative platforms for development. A host of novel mobile phone services and applications promise to dramatically change how people work, communicate and recreate just as PCs did twenty years ago.'
- Sam Jadallah, general partner, Mohr Davidow Ventures
'The wireless industry is going through an inflection point that will create massive opportunity for start ups in 2006 and revolutionize global communications. Moving forward, the majority of the world's population - particularly factoring in China and India - will access the Internet via a mobile phone prior to even encountering their first PC.'
- Eric Buatois, managing director, Sofinnova Ventures
'As the regulatory landscape evolves, the costs of non-compliance grow dramatically, in some cases leading to severe legal repercussions. Enterprises are making significant investments in ensuring corporate compliance, and corporate funds are increasingly being allocated to external vendors and service providers to better manage the process. This was validated at a recent gathering of more than 50 Chief Compliance Officers and CIOs hosted by Fidelity Ventures, where we heard loud and clear that compliance is here to stay. So for 2006, all indications are that compliance will represent an increasingly attractive investment sector.'
-Rob Ketterson, managing partner, Fidelity Ventures
'Global investigative reporting will be permanently transformed by the interactivity and relevance of blogs, enabled by the introduction of new content-based analytical technologies applied to blogging. Many traditional metropolitan newspapers will die and be replaced by a renaissance of local community newspapers. Blog 1.0 is cumbersome; Blog 2.0 is going to happen fast.'
-Pascal Levensohn, managing director, Levensohn Venture Partners
'The Center for Medicare and Medicaid Services will step up efforts in 2006 to more uniformly recognize telemedicine solutions to better manage the millions of chronically ill patients in their own homes. This should open the market for companies with medical devices and technology serving this segment to see both venture capital investment and exit opportunities rise in the coming year.'
-Alexander Spiro, Jr., senior managing director, Beringea.
The National Venture Capital Association (NVCA) is the trade association that represents the venture capital industry. It is a member-based organisation. Its membership consists of venture capital firms and organizations who manage pools of risk equity capital designated to be invested in young, emerging companies. Currently, the NVCA represents 400-plus member firms, representing the majority of venture capital invested in US based companies. For more information, visit www.nvca.org
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