Despite a difficult final quarter for both fledgling and well-established technology companies, UK venture capitalists (VCs) are undeterred - but more cautious.
It has long been recognised that emerging markets overshoot on their way to equilibrium. This brings little comfort to technology investors who watched their portfolio companies weather the volatility of 2000 as markets around the world followed the classic J Curve Effect.
UK VCs are continuing to invest, and the average deal size is following an upward trend, regardless of the reality check on company valuations.
Better-quality UK investments, particularly in the software sector, will continue to increase and are predicted to remain on an upward trend through the first half of 2001.
So what did we learn from investment activity in 2000? After dominating the first half of last year, incubators ceded ground to VCs in start-up technology investment. Figures for Q4 showed a sharp fall in incubator deals and a corresponding increase in VC investments.
Incubators, having invested even earlier in fledgling dotcoms, were hit by the severe market corrections which quashed any hope of realising their often ill-starred investments in an unfriendly initial public offering environment. Q3 showed a marked slowdown in incubator spending, reflecting market scepticism for less robust dotcom propositions.
Incubators, originally associated with university-funded projects, did not appear in the mainstream private-equity market until late 1999. A good deal of consolidation has already occurred, and the number that are predicted to survive and flourish in 2001 is hotly debated.
Is the love affair over?
Do pure-play Internet retailers remain an attractive investment opportunity for funders? It is the well-known and trusted high street or catalogue retailer, rather than traditional funder, that seems best placed to realise the opportunities in this area. The acquisition of the UK operations of Buy.com by John Lewis once again demonstrates the appetite of bricks- and-mortar companies to bolster their multichannel strategy with a pure-play.
So what is in store for 2001? Some analysts predict doom and gloom. Yet despite the hangover suffered by some after their speculative ventures in 2000, cheques are still being written for robust business ideas with technologies that have a clear commercial application.
Research conducted by Deloitte & Touche into private-equity confidence among VCs shows that although less than half of the 770 VCs interviewed expect overall deal numbers to rise, technology deals are expected to grow. This focus on quality rather than quantity is also a reason why the average deal size is predicted to be on an upward trend throughout 2001. This rise was already evident in 2000. An analysis of 400 technology deals showed the average deal size increasing from £6.4m to £8.1m in Q1.
This year has already seen significant investment in wireless and communications software, with business support services following closely in terms of overall value and number. Wireless alone is estimated to make up 34% of deals struck already this year, totalling more than £100m. The only deal reported in the business-to-consumer (B2C) space has been the second round funding of £7m raised by travelstore.com.
Sectors to watch
With Europe recognised as the most developed market globally for mobile communications (55% penetration, compared with 30% in US), wireless and telecoms deals are expected to increase over the coming year.
Technologies that allow various devices to transfer data across a wide spectrum of devices, using wireless, land-based and Internet telephony, also look set for growth.
A simple comparison of retail B2C deals and deals in the wireless sector over the last two years highlights the shifting trends. Deals for retail were buoyant from October 1999 to October 2000, while wireless really began to hit its stride at the end of Q1 2000.
We don't expect the pattern to be mirrored, however, as devices and services need to be created for each wave of mobile technology - GSM, general packet radio switching (GPRS) and third-generation mobile.
Some of the needed technology is still embryonic, or non-existent. This industry should show strong growth and solid interest from VCs throughout 2001.
In many ways, the tech shake-out has been a blessing for the technology sector. The hype will gradually subside, and strong contenders will be left in a more robust and credible sector.
Syndicated deals continue to rise, with many funders preferring to co-invest with a trade investor who is close to the ground. The technology learning curve has been steep. Five years ago, many didn't invest in technology at all, and that's the biggest change that has taken place.
Despite enthusiasm for companies that produce technology products, European investment is likely to remain strong in IT services. VCs, while bolstering their tech knowledge with new hires with industry experience, still find merging the tech culture with that of financiers problematic. In Europe, VCs still are keener to invest in services over product because they "get it".
Back to Basics
While their coffers are still relatively full, a more sober mood has prevailed with an inevitable attendant flight to quality. Rationalising portfolios is a priority for the year, either through concentration on later-round funding for existing companies or increased specialisation. A return to the spatter-gun approach to investment is unlikely.
Any VC who has had its fingers burned by taking their eyes off the ball when making investment decisions will appreciate the benefit of sticking to the fundamentals of any business. More companies will be judged on the importance of the technology they provide rather than on an all-singing, all-dancing business plan.
VCs are now weary of plans with a fuzzy route to market but with a huge marketing spend, and instead will expect companies to focus on alliances and strategic partnerships.
In the public markets, some equilibrium should be achieved from July onwards and there should be demonstrable performances from companies that will strengthen the case for more realistic evaluations.
More bullish investing is expected in late Q3 and Q4. Don't expect another technology free-for-all, though - that's now history. B2C and high-profile consumer Internet businesses took a public beating in 2000. But that's disproportionate to the activity in the sector in other areas and in the (B2B) activity that continues in technology for the leisure, travel and retail sectors. VCs and incubators are focused on getting their companies to profitability and rationalising their portfolios. But VCs continue to fund technology companies and there is still plenty of money to go round for robust ideas in high-growth sectors.
Is it the end of the Web rush?
The Internet explosion of dotcoms is often likened to the California Gold Rush: another period of history in which wealth seemed to be there for the taking. So, what do we remember about the Gold Rush apart from the frenzy? That Levi Strauss was the only enduring brand to emerge.
John Gilligan is a corporate finance partner at Deloitte & Touche. He heads D&T's capital raising business for emerging technologies
Deal derby: hot sectors
The last quarter saw a flurry of deals in the following areas:
Watch companies developing enabling technologies in areas such as data warehousing and CRM. There will be opportunities for games makers to develop multi-platform software for mobile phones and consoles. Key telcos are working with NTT DoCoMo, a Japanese mobile operator, to link mobile phones to Sony PlayStation video consoles. They will build an interface that allows connectivity between mobile Internet services and PlayStation.
Shoot out: J Curve Effect
Rudiger Dornbusch of the Massachusetts Institute of Technology, the spiritual home of the Web, identified the J Curve Effect in foreign exchange markets: first the market overshoots, then it tries to correct and undershoots. The technology market will do the same, but the underlying trend is for increased investment in digital technologies, creating significant wealth.