VENTURE CAPITAL INVESTMENTS DECLINE IN DOLLARS AND DEAL VOLUME IN Q1 2013

Increases in Software and Media Investing Temper Declines in Clean Technology and Life Sciences

Venture capitalists invested $5.9 billion in 863 deals in the first quarter of 2013, according to the MoneyTree™ Report from PricewaterhouseCoopers LLP (PwC) and the National Venture Capital Association (NVCA), based on data provided by Thomson Reuters. Quarterly venture capital (VC) investment activity fell 12 percent in terms of dollars and 15 percent in the number of deals compared to the fourth quarter of 2012 when $6.7 billion was invested in 1,013 deals.

The Life Sciences (biotechnology and medical device industries combined) and Clean Technology sectors both saw marked decreases in both dollars and number of deals in the first quarter. However, there was a notable percentage increases in dollars invested in the Media & Entertainment industry while the Software industry accounted for 40 percent of the dollars invested in the quarter.

“The bright spot in the first quarter was Software,” remarked Tracy T. Lefteroff, global managing partner of the venture capital practice at PwC US. "These capital-efficient companies that have shorter time frames to a liquidity event – whether that is M&A or IPO – continue to be attractive to an ever-shrinking pool of VC funds. Activity in both the IPO and M&A markets for Software companies is likely an encouraging factor for VCs and this dynamic could be spurring the greater focus, accordingly. The exact opposite is true for the Clean Technology sector. This capital-intensive sector is showing signs of reaching its limit in how much VCs can continue to support these companies without additional equity coming from outside sources.”

“Lower investment levels in the first quarter were driven by a number of factors, none of which were unexpected," said John Taylor, head of research for NVCA. "The venture industry has been raising less capital than it has been investing now for several years, and ultimately this dynamic flows through and manifests itself in lower investment levels overall. Additionally, we are seeing less money going into traditionally capital-intensive sectors such as clean tech and life sciences, especially in first-time deals. Lastly, the majority of deals are being done in the capital-efficient IT sector where rounds’ amounts are lower. We expect these overall trends to continue until exits and subsequent fundraising activities pick up, and dollars start to flow back into more venture funds.”

Industry Analysis

The Software industry received the highest level of funding for all industries, rising 8 percent from the prior quarter to $2.3 billion invested during the first quarter of 2013, marking the fourth consecutive quarter of more than $2 billion invested in the sector. The Software industry also counted the most deals in Q1 at 329; however, this represented an 18 percent decrease from the 399 rounds completed in the fourth quarter of 2012.

The Biotechnology industry was the second largest sector for dollars invested with $875 million going into 96 deals, falling 33 percent in dollars and 30 percent in deals from the prior quarter.

The Medical Devices and Equipment industry also experienced a decline, dropping 20 percent in Q1 to $509 million, while the number of deals dropped 10 percent to 71 deals.

Overall, investments in the Life Sciences sector (Biotechnology and Medical Devices) fell 28 percent in dollars and 23 percent in deals, which was the fewest number of deals since the first quarter of 2009.

Venture capitalists invested $1.4 billion into 231 Internet-specific companies during the first quarter of 2013. This investment level is 11 percent lower in dollars and 5 percent lower in deals than the fourth quarter of 2012 when $1.5 billion went into 243 deals. Two of the top ten deals for the quarter were in the Internet-specific category. ‘Internet-Specific’ is a discrete classification assigned to a company with a business model that is fundamentally dependent on the Internet, regardless of the company’s primary industry category.

The Clean Technology sector, which crosses traditional MoneyTree industries and comprises alternative energy, pollution and recycling, power supplies and conservation, declined 35 percent in dollars and 13 percent in deals from the prior quarter to $368 million going into 61 deals. The investment total is the lowest since the first quarter of 2006 when Clean Technology companies received $355 million. The relative decrease in Clean Technology investments was driven by the lack of any large deals in the sector during Q1.

Eleven of the 17 MoneyTree sectors experienced decreases in dollars invested in the first quarter, including Industrial/Energy (63 percent decrease), IT Services (41 percent decrease), and Semiconductors (39 percent decrease). The Media & Entertainment sector experienced a 37 percent increase during the quarter, which was primarily due to a single large deal, the third largest in Q1.

Stage of Development

Seed stage investments rose 11 percent in dollars but fell 22 percent in deals with $178 million invested into 52 deals in the first quarter. Early stage investments fell 28 percent in dollars and 17 percent in deals with $1.5 billion going into 393 deals. Seed/Early stage deals accounted for 52 percent of total deal volume in Q1, compared to 54 percent in the fourth quarter of 2012.

The average Seed deal in the first quarter was $3.4 million, up from $2.4 million in the fourth quarter.

The average Early stage deal was $3.7 million in Q1, down from $4.2 million in the prior quarter.

Expansion stage dollars decreased 13 percent in the first quarter, with $2.0 billion going into 217 deals. Overall, Expansion stage deals accounted for 25 percent of venture deals in the first quarter, approximately the same as was seen in the fourth quarter of 2012. The average Expansion stage deal was $9.2 million, nearly identical to the prior quarter.

Investments in Later stage deals increased 2 percent in dollars but declined 9 percent in deals to $2.2 billion going into 201 rounds in the first quarter. Later stage deals accounted for 23 percent of total deal volume in Q1, compared to 22 percent in Q4 when $2.2 billion went into 220 deals.

The average Later stage deal in the first quarter was $11.1 million, which decreased slightly from $10.0 million in the prior quarter.

First-Time Financings

First-time financing (companies receiving venture capital for the first time) dollars decreased 20 percent to $903 million in Q1, the lowest level since the third quarter of 2009, while the number of companies fell 21 percent from the prior quarter to 263. First-time financings accounted for 15 percent of all dollars and 30 percent of all deals in the first quarter, compared to 17 percent of all dollars and 33 percent of all deals in the fourth quarter of 2012.

Companies in the Software industry received a major portion of first-time rounds in the first quarter, accounting for 63 percent of the dollars and 45 percent of the companies receiving funding in Q1.

The Life Sciences sector experienced a dramatic drop, falling 52 percent in dollars to $98 million from the prior quarter, which is the lowest quarterly amount since the third quarter of 1996 and only the fourth time in survey history that the total has fallen below $100 million in a single quarter. Only 20 Life Sciences companies received venture capital funding for the first time in Q1 of 2013, which is the fewest seen since Q2 of 1995.

The average first-time deal in the first quarter was $3.4 million, approximately the same as the prior quarter.

Seed/Early stage companies received the bulk of first-time investments, garnering 51 percent of the dollars and 79 percent of the deals in the first quarter of 2013.

Middle-Market Mergers & Acquisitions Holding Steady In 2013

The middle-market for Mergers & Acquisitions has significantly improved in the past two years according to The Babson College Middle-Market/Small Business Mergers & Acquisitions Survey conducted by the business school’s MBA students in the first quarter of 2013.
Yet according to the report, growth in 2013 will be flat versus 2012 because of a stalled economy, challenges in Washington around tax and estate issues, hesitation by business owners to relinquish, and the gradual recovery in the debt market.

The Babson Survey directed by Babson College Professor Kevin J. Mulvaney in collaboration with members of the Association for Corporate Growth (ACG) and Exit Planning Exchange (XPX), assesses and defines current trends that impact buyers and sellers of businesses. The survey population included leading national middle-market investment banks, large business brokerage firms, advisory professionals, and commercial bankers.

“The M&A environment for both small and mid-sized business exits or recapitalizations is stable and may improve in the coming years,” commented Mulvaney, “ It is a very good time for entrepreneur owners to begin planning for their capital event.”

Among the survey’s key findings:

Middle-market volume is strong; but small business M&A activity grows more slowly.

• The volume of middle-market deals is steady and a majority of respondents project a continuation of the current level through the rest of the year. Only 20% of respondents foresee volume increases as the year unfolds.
• Services industry sector remains the strongest with increased activity reported in e-commerce, health and medical services, and aerospace and related industries.
• The small business arena is growing more slowly (an average of 0.5 times increase in EBITDA valuation over 2012) with no expected rise this year in valuations.
• The environment for M&A activity is about the same as a year ago. Babson authors project an increase in the number of private equity buyers in the next eighteen months because of increased debt availability on more acceptable terms.
• Underperforming or weak companies are not viable deals and receive lowball offers and very little interest from financial buyers. The market is willing to pay a premium for revenue growth potential and predictable EBITDA performance.

Buyers demand high ‘seller assistance’ for smaller companies

• The percentage of seller assistance (earn outs, deferred money, etc.) continues to be high. The smaller the company (on a $1-100MM survey scale) the higher the demands for seller assistance from the buyer.
• Good news for sellers – the deferred component of the purchase price has dropped from an average of 30% to 20%. The survey also found that sellers are beginning to dig in their heals demanding a larger component of cash up front.
Timeframe to complete deals lengthens
• Due diligence by buyers who have concerns about a sluggish economy and perceived challenges to building revenue will increase deal-making timeframes by a month (formerly 6-9 months). Strategic buyers are also organizing more outside expertise than ever before to prepare their due diligence reports.
• Sellers need patience and must be prepared with information and the ability to respond quickly to buyer requests to increase chances of closing deals within six months. Like buyers, seller success is dependent on acquiring the right legal and deal-making expertise.
• It is still a seller’s market for quality companies. Whether selling or restructuring capital, sellers must develop a knowledgeable game plan to evaluate options and potential deal partners.

Financing for Buyers continues to grow and terms are more acceptable

• More financial lenders are making loans with terms that represent a fair balance between what the lender and borrower feel is acceptable.
• The Babson survey projects an increase in the number of opportunities for every type of middle-market financing. This is good news for private equity buyers when balancing leverage versus equity contributions for new M&A deals.
• For smaller deals, there has been a strong rebound in SBA loans especially from community banks, that will help contribute to the growth of small business deals moving forward.
• Surprisingly, the survey found an increase in the percentage of equity needed by qualified buyers of small businesses. This had been a minimum of 20% but some experts see an increase to a minimum of 25%. The increased equity demands from lenders may have contributed to the slow growth of small business sales.
• Middle-market stability is reflected in increased pressure on pricing for financial institutions involved in M&A deals. Yields on mezzanine debt dropped to 12-14% from historical averages of 15-20% and financing costs declined as the volume of financial buyer deals increased.