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Private Markets

March 1, 2005

The collapse of Internet and telecommunications stocks in mid-2000 closed the IPO markets for all technology companies, damping the enthusiasm of venture capitalists, who frequently look to IPOs to repay them for their efforts. But with the revival of the IPO markets in 2004, venture capital financing is slowly returning, at least for more mature startups. Venture capital and private equity investments in 2004 were roughly $20 billion, a slight increase from $18.7 billion in 2003, according to estimates based on the annual end-of-the-year survey by PricewaterhouseCoopers, Thomson Venture Economics, and the National Venture Capital Association. And the prices of deals—especially deals with later-stage companies—are creeping back up. “We’re seeing deals that wouldn’t have gotten funded one or two years ago,” says Allan Ferguson of 3i, a leading venture capital firm.

There are even encouraging, albeit tentative, signs of a renewed interest in early-stage startups. The valuations for companies receiving their first few rounds of venture investment remained flat from 2003 to 2004 and are still below 2000 and 2001 levels. But according to VentureOne, a venture capital research firm, early rounds of venture funding represented 33 percent of all rounds in the United States in 2004, reversing a downward trend that started in 2001, after early-stage venture investments peaked at 54 percent of the total in 2000.

In addition to the improved prospects for exit strategies, another reason for the rising prices of venture deals (at least four startups, Jazz Pharmaceuticals, RiskMetrics Group,, and Vonage, each raised more than $100 million in 2004) is that limited partners—the pension funds, endowments, and others that provide the capital to venture funds—are putting their money to work again, investing it in venture capital funds. At the same time, billions of dollars committed to venture capital funds since 2000 remain unspent. Venture capitalists are coming under pressure to invest this money soon; the consequence is that more companies are getting funded, and later-stage deals are getting bigger.

But for the most part, companies just starting up are still struggling. And venture funding for one of technology’s most speculative, albeit promising, fields has been one of the biggest casualties. Venture funding for nanotechnology dropped from $386 million in 2002 to $200 million in 2004, according to New York City–based nanotech market research firm Lux Research. That means nanotech startups are finding it harder to do research in areas that could have tremendous long-range impact: new nanomaterials for optics and chip-cooling systems; biological diagnostics based on ultrasensitive nanosensors; and smart, automated delivery systems for protein drugs. “Over the years, the financial community has pushed for shorter-term results,” says Peter Garcia, chief financial officer of Nanosys, a nanotech startup based in Palo Alto, CA. “There are projects that are more long term technically that have the greatest potential to change how products are made, but the funding is not there.”

By contrast, areas of technology that require much less time in development are continuing to gain attention. One area that is attracting interest these days is RFID technology, which uses radio frequency identification tags that work like bar codes to track merchandise more precisely. The technology is hardly cutting edge; it has been ready for market for several years. But an international consortium has now established standards for RFID systems and is working with more than 30 companies to roll them out for large supply-chain management applications in the next year, creating lucrative opportunities for startups such as ThingMagic in Cambridge, MA, and Rockville, MD–based Matrics, which was acquired by Symbol Technologies for $230 million.

Other technology sectors finding favor with venture capitalists:

Mobile applications: entrepreneurs and venture capitalists are creating and funding companies that are developing new applications and services for cell phones, MP3 players, and other mobile devices; recent startups have concentrated on games, video, photo and music sharing, and location-based services. One example is AudioFeast, which offers portable Internet radio service for MP3 players and mobile devices and raised $10 million in a recent round of financing.

Business on the Internet: the growing number of computers online and higher broadband penetration into households is helping business on the Internet to finally begin to fulfill its promise. And with Internet powerhouses like Google, Amazon, and Yahoo doing well, venture capitalists are feeling confident in Internet companies again. “Twenty-four months ago, they couldn’t get any love from venture guys. Now they’re beating down their door,” says Tim Connors of U.S. Venture Partners. LinkedIn, a social-networking company in Mountain View, CA, secured $10 million in second-round financing in October; and Snocap, an online music copyright management company in San Francisco founded by the creator of Napster, got $10 million in December.

Anything having to do with IT security: though chief information officers are still on tight budgets, what money they are spending often goes to security. Viruses, worms, and spyware are on the rise, and entrepreneurs have leaped at the chance to make a buck off the fears they inspire. “It’s an area that’s been funded like crazy, but it’s a problem that hasn’t been solved,” says Jeff Andrews of Atlas Ventures. Lending even more urgency to the development of security-related technology is the increase in government accounting regulations. Companies are under growing pressure to keep better track and control of all their documents, and they need new software and systems to do it. CIOs have no choice but to buy new technologies that enable them to comply with new government regulations.

Biotech startups: people will always get sick. Health-care costs continue to soar, and the drug pipeline remains constricted. So investors are turning to biotech, and especially to drugs for cancer, inflammation, and neurological and infectious diseases. Jazz Pharmaceuticals of Palo Alto secured last year’s biggest venture capital financing round, $250 million, to commercialize drugs for neurological and psychiatric disorders. PharmAthene of Annapolis, MD, received $50 million in financing in October to develop therapeutics for bioterrorism agents.

Technology Review editors Gregory T. Huang, Corie Lok, and David Rotman contributed to this report.

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