Ready, Set, Flow

Oliver Curme sums up the current venture capital climate-and the outlook for 2004-in five long-awaited words: "Happy days are here again," says the general partner of Battery Ventures, a VC firm in Wellesley, Massachusetts.

You wouldn't necessarily know it was time to celebrate just by looking at the numbers. VC investments in 2003, at $18 billion, declined by 15 percent over the previous year, according to the most recent "MoneyTree Survey" from PricewaterhouseCoopers (PwC), Thomson Venture Economics and the National Venture Capital Association (NVCA). First-time funding was also down in 2003: 624 companies got $3.4 billion, compared with 2002's 792 companies that got $4.3 billion.

But the survey results also show evidence of a turning tide. Investment levels in the fourth quarter of 2003, at $4.9 billion, were at their highest since the second quarter of 2002. Moreover, external economic and market conditions have changed the VC mood from despondent to enthusiastic again. Healthier equity markets have opened the IPO window; according to Greenwich, Connecticut-based Renaissance Capital, more IPOs were completed by the second week of February 2004 than in the entire first half of 2002. And there has also been a thawing in M&A activity, thanks in part to larger companies having more currency with which to do deals.

Given that better exit opportunities inspire VCs to invest more money, it's not surprising that most experts see good news ahead. As further proof, an uptick in VC fund-raising in the fourth quarter of 2003 suggests funds are looking toward future investments. "There's just a whole lot of optimism out there," says Curme, whose firm is talking to investment bankers about two companies it plans to take public this quarter or next. "The valuations are ranging from half a billion to $2 billion," he says. "When you've been wandering the desert without a drink of water for a couple of years, and you start experiencing things like that, it restores the soul."

Funds continue to sink money into existing portfolio companies that have moved into later stages, and investment in early-stage companies consequently declined from third to fourth quarter 2003. But John Taylor, NVCA's vice president of research, says while the numbers may not have shown it this past quarter, "we know from what practitioners have been telling us that there is renewed interest [in] seed and early-stage companies."

Software attracted the most first-time capital, taking 20 percent of the total, followed by biotechnology and medical devices. Jesse Reyes, vice president of Thomson Venture Economics, notes that VCs are still taking a rational, risk-averse approach to investing-going after more-established, cash-generating, proven businesses that are either likely to go public or will be ripe for a buyout in the next year. Those later-stage companies "are getting better valuations primarily because they're more mature and their valuations are more certain, so the cash-flow stream is more certain," says Reyes.

"Better" is still a relative term, adds Tracy Lefteroff, global managing partner of PwC's venture capital and private equity practice, who notes that terms are still tough all over. "VCs are still hedging their bets with tough terms to get the downside protection they need," he explains. "It's improving, but it's probably not where it should be."

But even as portfolio companies exit and VCs invest in new ventures again, all agree there definitely will not be a return to the unsustainable levels of the bubble years. Rather, investing levels per quarter should hover around the $4 billion to $5 billion level. Says Tom Siegel, a managing director and co-founder of San Diego-based Shepherd Ventures: "The current pace of investing is a prudent, rational level that could and should continue at similar levels in the future."

C.J. Prince is executive editor of CEO Magazine.