Last Friday the Washington Business Journal gave a first look at venture capital activity for the third quarter of 2006 (see "The Nation's Capital -- Venture Capital Report")  According to the report 29 companies obtained $267 million in venture capital funding during the quarter. This report, which was compiled through the hard work of Ben Hammer, their venture capital reporter (and a good guy, by the way), probably doesn’t include every financing that occurred during the quarter (they missed the financing of Zenoss, one of our third quarter investments, for example) but still gives a window into the market’s current condition. 

Certainly the numbers compare favorably to the third quarter of 2001, which as you might recall was towards the end of the “Internet bubble” – or as I affectionately call it “the aneurism.”  They also compare favorably to the mid 1990s.  And, anecdotally, there seems to be ample venture capital available for suitable companies based upon our own portfolio and my conversations with other professional investors.   Meanwhile, some of the most respected venture capital firms in the region have raised new multi hundred million funds this quarter, and a number of others will be going out to market next year.  So, all in all, it would appear that this should be a great time to be an entrepreneur looking for venture capital and the investor looking to invest in a venture capital fund.

But, as is always the case, there are details behind the trends that are worth paying attention to.  The most important of which are the following: 

• Venture capital funds are historically large – they need to put more money to work in each deal. 
  
  • This has driven up valuations for mid and later stage financings, by creating a competitive market for portfolio companies that can utilize larger amounts of capital. 
    
  • Nationally, at least one well regarded venture captial organization has chosen not to raise a multi-hundred million venture captial fund in the current competitive environment.
    
  • Smaller professionally managed funds such as Amplifier, which are structured to provide smaller amounts of start up capital, are benefiting significantly from these trends.
    
• The average technology business sale is in the $50 million range and with the exception of a new media deal such as a Google/YouTube, valuations are tending to be tied to traditional business metrics.
  
  • The post-Enron regulatory environment continues to make a public offering and being a public company an expensive and frightening undertaking.
    
• Technology development can often be undertaken overseas at lower unit costs. 
  
  •  This does not necessarily have an effect on reducing subsequent costs of business expansion (business development, customer service, etc.), but can reduce the amount of capital required to prove a technology concept.

So, while the overall venture capital market is apparently healthy, the larger trends should be respected by both entrepreneur and venture capital fund investor.  For the entrepreneur looking for venture capital in the DC region you should particularly consider:

• Capital efficiency in the earliest stages.  You should be efficient in the use of capital in the earliest stages – the market will expect this of you.  If you are not using off shore development resources be prepared to explain why.  
  
• If you want to raise a large amount of venture capital understand how to trigger competition for your deal.  Target growth inflection points in your business that will support an up tick in valuation, and look for your first large round of venture capital when you have an established business. This is more likely to be attractive to larger funds.
  
• For most businesses a large public offering (or high value business sale) is simply not achievable – if you are going to take venture capital figure out why you are an exception, or if you can provide a high return for your investors in a $50 to $100 million business sale.
  
• Chose your investors carefully.  If you are doing well, they will probably want to finance later rounds also.  And, if you are doing badly – well, it won’t matter….

 For the individual technology investor:

• Understand a venture capital fund’s competitive position.   Arguably today there is more than enough money available for desirable technology companies in the mid and later stages of development.  Therefore, gravitate towards funds that have established a market position to see deals early on, or on a proprietary basis.
  
• Pay attention to fund size.  If you want to have exposure to seed and early stage investing, look at investing in smaller venture capital funds or making individual angel investments.  All things being equal, the larger a fund gets the harder it is to make $500,000 investments in early stage businesses.  And, often, that is the most investment an early stage business can or should properly deploy before revenue. 
  
• Understand that returns from venture capital vary by stage of investment, and at a time of scarcity early stage capital can demand higher returns (i.e., invest at favorable valuations).
  
• Don’t be afraid of the “next bubble” and understand the current trends by looking forward and not backward.  Venture capital is not “back” – it never left, but the dynamics of the market change constantly.  Select funds that are ahead of capital deployment trends, rather than part of them.