Post peak

Venture outlays for private emerging companies have resembled a roller-coaster ride for the past decade. Funding rocketed from $1.7 billion nationally in the first quarter of 1995 to a peak of $28.6 billion in the first quarter of 2000, before stumbling for a dozen consecutive quarters to just over $4 billion in the first three months of this year. Investments ticked up to $4.5 billion in the second quarter, breaking the three-year free fall, but slipped back to $4.2 billion for the July-to-September period, according to the Boston Globe Money Tree survey.

Looking at the numbers for the first nine months of 2003, venture industry watchers see a trend: Funding appears to be stabilizing in a quarterly range of $4 billion to $4.5 billion. "We've had three straight quarters of relatively stable activity," said Matthew Littlewood, a partner in the Boston office of PricewaterhouseCoopers, which compiles the quarterly surveys with Venture Economics and the National Venture Capital Association. "It looks like we've stopped the slide."

Contributing to the long-sought leveling off is renewed interest in earlier-stage companies, along with the continued rise of biotechnology and other life sciences fields as a magnet for venture investing. Some regions are demonstrating particular strength, with New England, the second-largest recipient of venture investments, bucking the national trend and taking in $692.2 million in the three months ending Sept. 30, up from $556.7 million the previous quarter.

Many in the venture business find these trends encouraging, though no one expects investments to rebound to 2001 heights any time soon. But a larger question with which some are just starting to grapple is whether even the current levels of funding are justifiable.

"The industry is on a pace to do between $17 billion and $18 billion of funding this year," said Tom Crotty, general partner of Battery Ventures in Wellesley, which reported seven venture investments in the third quarter. "What's missing from the discussion is whether this is an appropriate level or not. That's where I get off the bus. I think it's two times higher than it should be in the current environment."

Crotty cited several factors that might give pause to venture capitalists and their limited partners. Even with the pickup in business spending, growth rates are declining, especially in the information technology sector that has long been a favorite of venture firms. There is no big new technology wave, such as the PC or the Internet, creating opportunity for large numbers of start-ups. And he said there are too many "look-alike companies" in markets that are promising but limited.

Forty to 70 companies are being funded worldwide, for example, to provide chips for WiFi wireless Internet service, Crotty estimated. "No more than five will be needed."

Similarly, about 30 venture-backed companies are working on e-mail spam solutions, and several hundred on computer security applications, he said.

"Most of them are going to die," Crotty predicted. "The world can't support that number of companies. It's an absolutely fundamental problem for our industry. And it's going to lead to poor returns for a very long time."

Citing that tougher environment, Battery sent a letter to its investors Friday asking for permission to cut its $1 billion venture fund by 15 percent. It also said that, with less money to invest, two of its senior partners would be stepping down.

Stephen O. Meredith, a partner at the Edwards & Angell law firm in Boston who represents venture clients, put it this way: "What's going on now is too much money chasing too few deals."

But Meredith said he expected the level of investing to climb in the fourth quarter, based on his advance look at term sheets for venture deals, equivalent to letters of intent outlining the terms of investments that have yet to close.

"There is more than a mild uptick, and it may not be showing up in the numbers yet," Meredith said. "There's been a lot of activity the past few months. The machine is getting ginned up again."

Nationally, there were 667 companies funded in the third quarter, a 5 percent dip from the previous three months. Silicon Valley remained the top-funded region, though investments there dropped 7 percent to $1.38 billion. Second was New England, for which quarterly funding rose 24 percent, to $692.2 million.

Among business sectors, biotechnology and medical devices were the hottest, with third-quarter outlays totaling $1.24 billion nationally, about 30 percent of all dollars invested. Next was software, which took in $819 million in the quarter.

Littlewood said interest in life sciences has grown partly because companies in that sector have proved relatively immune to the malaise gripping information technology the last couple of years. He said venture firms, buoyed by the prospects of a stronger economy, also are showing more willingness to fund early-stage and seed-stage companies than they have in the recent past, especially in New England.

"It may be that we're slightly more optimistic," Littlewood said. But he conceded that another explanation was simply that "the VCs have got money set aside that they can put to work."

The improving economy, plus pressure to invest money before they are compelled to return it to their limited partners, may be leading to a relaxing of the onerous terms venture firms were able to command from young companies in recent years.

Last quarter, in contrast to even a year ago, some companies found themselves on the receiving end of competing offers from multiple venture firms. In such cases, the terms typically didn't include "liquidation preferences" giving VCs the rights to be paid off first in the event a company is shut down, a provision that had become common the past few years.

When start-up Netezza Corp. of Framingham went looking for money, four venture firms vied to proffer term sheets. California-based Sequoia Capital wound up leading the $20 million later-stage funding round.

"We were very fortunate," said Patrick Scannell, chief financial officer of Netezza, which sells server, storage, and database packages for business intelligence applications. "The venture people want you to show that you have a good value proposition, customer traction, a large market opportunity, and a strong management team."

Even if companies meet those criteria, those perceived to be in a competitive field, such as WiFi chips, have to convince venture investors that they have a superior technology or are targeting a more lucrative segment of the market.

Engim Inc. of Acton, which closed an $18.5 million expansion round in the third quarter, fielded intense questions from VCs about the chipsets it sells to infrastructure companies for gear that businesses use to offer wireless Internet access.

Company leaders stressed that they were not selling WiFi chips for laptop computers, phones, or PDAs, a more crowded space.

"I would describe the environment as having moved back to basics," said Engim's president and chief executive, Nick Finamore. "During the tech bubble and even as we were sliding into the crash, I saw a lot of companies whose strategy was to create a technology and get acquired. Now you really have to put yourself on a trajectory to have a sustainable and profitable business in a short time."

How venture backers fare will hinge on such companies becoming sustainable businesses.

"The challenge is to deploy large amounts of money very quickly without chipping a tooth," Meredith said. "Some of them can do it; some of them can't."

Robert Weisman can be reached at weisman@globe.com.