And They Said It Couldn’t Get Any Better…

Tuesday Jul 29, 2014 by Michael Greeley - General Partner, Foundation Medical Partners

And for that reason I am growing more concerned. The 2Q14 VC investment data just released in the MoneyTree Report prepared by the National Venture Capital Association with an assist from PricewaterhouseCoopers and Thomson Reuters details the $13.0 billion invested in 1,114 companies over the last three months. This is the most dollars invested in a quarter since 1Q01 (and we know how that ended). This is almost 34% more than was invested in 1Q14 and a ridiculous 80% more than 2Q13. As you will see, this quarter was bigger and better than recent prior quarters across almost any dimension.

Year-to-date the VC industry has invested $22.7 billion, more than all of 2009 during the depths of the Great Recession. And while the number of deals this quarter was relatively flat, the amount of dollars invested, amount per round, pre-money valuations – all spiked considerably. Quite clearly VC’s focused on more mature, more established companies, and more often than not in software companies in Silicon Valley. Arguably the data probably include non-traditional VC’s such as hedge funds, private equity firms “going down market” and maybe some offshore investors who were out in force this quarter – and who often show up late in a cycle.

So there a few questions I struggle with as I stared at the data this weekend: are some of these deals “venture deals?” That is, when a company like Uber raises a $1.2 billion round should we include that in the analysis (later I strip it out to normalize for the “Uber effect” and yet many of the conclusions still stand). Second, when so many companies espouse the “lean start-up” mantra, why then are round sizes spiking so dramatically. Lastly, as Christopher Mims of the Wall Street Journal so brilliantly pointed out on July 7, 2014, the data suggest that VC’s have continued to forsake industries which do as he states “basic research and development that transforms lives, in fields such as energy, medicine and food safety.” This last issue is profoundly important and merits much greater scrutiny – at another time perhaps – but the data arguably supports the concern.

And the VC industry has shown that it has at times an “absorption” problem – that is, too much capital too quickly more often than not leads to too many look alike companies all beating each other up over small emerging markets, ensuring only few will be successful.

All of this activity reflects increased liquidity in the system with promising IPO activity (see biotech sector) and strong M&A volumes but also at a time of accelerating recovery in jobs creation and overall compelling real economic growth with benign inflation. Increased manufacturing productivity growth of 3.2% this year (according to ISI Group), when it has consistently been well below 2.0% per annum for the past five years, underscores the benefits of a robust tech economy. But I am reminded that the average bull market runs 57 months with the S&P 500 stock index increasing 165%; this current bull market is now 63 months old and stocks have increased 186% – again, how much better could it get?

So what do we see in the 2Q14 data?

  • Software category absolutely killed it – there was $6.1 billion invested in 454 software companies with average round size of $13.3 million. Five of the top deals were software companies and consumed $1.8 billion of that amount (taking those five companies out of the mix – Uber, Lyft, Nanthealth, Anaplan, New Relic) the average round size of the remaining was $10 million. In 2Q13 the average size was $6.2 million – nice step up.
  • Lights, camera, action – media and entertainment captured $1.0 billion of the dollars this quarter which was just below a doubling of the prior year’s second quarter.
  • Consumer Products/Services pulled in $553 million in 58 companies
  • Healthcare held its own – all of healthcare (biotech, devices, services) represented $2.6 billion of the quarter’s total as compared to $1.8 billion in 1Q14 – the difference almost entirely due to an $800 million increase in biotech activity. The average size biotech round in 2Q14 was $15.0 million.
  • Hardware categories like Computers, Electronics, Networking, Semiconductors and Telecom together captured $726 million across 57 companies ($13 million per) which used to be the bread and butter for venture investors last decade.
  • And Energy made a modest recovery scoring $717 million across 68 companies; this is a category that was all but left for dead over the past few years.

The other important theme that was emerging over the last few years was the rotation away from Seed stage investments to Later stage rounds. And while that trend continued, there are some surprising observations buried in the data.

  • Expansion stage dollars invested spiked 53% last quarter and was 44% of all activity; average round size was $18.7 million. In 2Q13 Expansion stage was 31% of the total with average round size of $9.5 million – that is a very big jump.
  • Early stage investing increased 17% on a dollars basis and 9% on a deals basis in the quarter with average round size of $7.3 million. There were 522 Early stage investments or 47% of the total number of deals.
  • Seed stage continued to fade away – while Seed dollars increased 46% and the number of deals increased 20% from the prior quarter, Seed stage was 1.4% of all dollars invested – down from 3.3% in 2Q13. There were only 55 Seed deals recorded in 2Q14 (which actually strikes me as under-reported frankly). Average size Seed round was $3.4 million – which doesn’t even really feel like a seed.
  • Later stage represented $3.2 billion invested in 229 companies, an increase of 25% and 19%, respectively.
  • In aggregate “First Time” investments was $1.9 billion or 14% of all dollars invested; this measures how much capital was invested in companies raising their first VC round. This was a 20% increase over 1Q14 – which may be read as an increase in risk tolerance by VC’s. Worthy of consideration.

The other phenomenon, and not necessarily a good one, is the geographic concentration of the VC industry. Not surprisingly Silicon Valley continues to take market share – accelerated by the “Uber effect” – at the clear expense of secondary and tertiary markets.

  • Silicon Valley rocks – $7.1 billion was invested in Valley-based companies or 55% of the total dollars (this had been 51% in 1Q14 and 42% in 2Q13, respectively). This is 5.7x New England and New York Metro, which were within $49 million of each other this past quarter at around $1.2 billion each. All three regions together captured 74% of all dollars invested.
  • Notwithstanding Silicon Valley’s dominance the region “only” represented 33% of all deals done (vs 55% of dollars invested). Does that suggest a “reverse brain drain” – that is, as my distant relative Horace Greeley may have once said, “Go West, Young Entrepreneur.” Do newly financed executives feel that they need to move to the Valley to scale their companies? Or are Valley companies able to raise more dollars per round? Or VC’s support those companies longer?
  • Coming in at number 4 was LA/Orange County at $538 million or 4.2% while Texas was number 7 with 2.7% share.
  • Funny state facts: 30 states saw less than $50 million invested within its borders in 2Q14; 17 had less than $5 million invested and 6 had $0 million invested. Twenty two states had less than 3 companies raise venture capital in 2Q14.

To the extent innovation represents growth, and VC’s finance that innovation, this concentration risks leaving important geographies behind.

Michael Greeley is a General Partner at Foundation Medical Partners.  You can find this post, as well as additional content on his blog called On the Flying Bridge.

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