Venture capital's good news, but only when it pays off

The shakeout in the hi-tech sector has been every bit as dramatic as I (and many others) predicted at the start of the year. Most internet start-up companies are trading at a fraction of their earlier market prices, and the fallout has spread far enough to reach the likes of Autonomy and Bookham, outstandingly innovative companies which have genuinely valuable products and rosy (though by no means guaranteed) futures.

The shakeout in the hi-tech sector has been every bit as dramatic as I (and many others) predicted at the start of the year. Most internet start-up companies are trading at a fraction of their earlier market prices, and the fallout has spread far enough to reach the likes of Autonomy and Bookham, outstandingly innovative companies which have genuinely valuable products and rosy (though by no means guaranteed) futures.

These companies, which have old-fashioned things like revenues, are miles removed from the typical internet incubator funds of last year, which raised money on the strength of their intention to invest in dot.com start-ups and which for a while traded at absurd multiples.

When piles of cash are trading at multiples of three or four times merely because they have declared an intention to invest in a fashionable area, you can be fairly certain you are close to the peak of a market fad. I remember Jim Slater telling me in early March that the emergence of this modern form of alchemy (where cash trades at several times par value) was what had convinced him that it was time to bow out of the market for a while.

The more interesting question to my mind is where this leaves the venture capital business, which has prospered mightily on the back of the stock market's love affair with hi- tech companies, but which now I sense has reached something of a crossroads in this country.

For years, pundits of all kinds have bemoaned the fact that Britain has such a poor track record at backing start-up technology companies. Compared with the US, at least, the criticism has been that we have neither the infrastructure nor the institutions to create our own equivalent of Silicon Valley.

Earlier this year the pension funds in Britain were again lambasted for not doing more to invest in technology start-up companies. The Williams report last year urged the Government to do more to foster an entrepreneurial culture in this country, by giving further tax breaks to venture-capital investors and extra incentives for experienced managers to abandon their cosy corporate lifestyles for the uncertain charms of life in a start-up business.

By and large, the Government has acceded to almost all these demands. The upshot is there has never been a better environment for venture capital. And thanks to the strength of the economy and the stock market, the money and the managerial talent has indeed been pouring into venture-capital funds.

As the chart shows, the amount of money flowing into UK hi-techfirms has been growing steadily since the early 1990s. Last year it topped £1bn for the first time. The typical deal size is still only a third of that in the United States, but the trend is clearly improving. All this is by and large good news for UK plc.

But for those who are doing the investing, the outlook is less certain. The shakeout in the tech sector is not just confined to the UK market. Nasdaq, the US technology market, is down by around 40 per cent since its peak in February this year. While IPOs are still finding their way to the market, the rate of new issues has slowed, and the screening process is proving a tougher hurdle than earlier this year.

Amadeus Capital, which runs one of the best UK venture-capital operations and has a number of blue-chip investors, as well as close links to the best technology coming out of Cambridge University, succeeded in closing its second venture-capital fund a few days ago. It showed that the best-quality funds can still attract capital, and those that do are not short of projects to choose from.

According to Herman Hauser, one of Amadeus Capital's leading lights and the nearest thing to a guru for the UK venture-capital business that we have, the fund has been receiving business plans from wannabe entrepreneurs at the rate of five a day for some months. He recalls how everyone he knew laughed five years ago when hepredicted that within 10 years Cambridge would produce a company with a market value of $1bn. In fact, it has already produced three companies - ARM Holdings, Virata and Autonomy - that have already comfortably passed the $1bn threshold (though how long they stay there remains to be seen).

As far as he is concerned, the key changes that have assisted this development are the willingness of managers to move across from established industries to run promising start-up businesses (where the tax changes and share options undoubtedly help) and the fact that we now have a generation of successful entrepreneurs, who have shown themselves willing to plough back some of their money and some of their experience into backing potential new successors.

He attributes the success of Amadeus to the fact that most of its founders have come down this route themselves, having both technical backgrounds and the experience of running companies. This has allowed them to avoid the worst of the internet hype; although they backed lastminute.com, only around a third of the companies Amadeus has invested in are dot.com businesses.

Hauser thinks the end of "the internet frenzy" is a necessary and positive development, since it has helped to bring investor expectations down to earth. It is clear to me that we are still going through a phase when the fabulous-looking returns achieved by some venture-capital funds in the past two to three years (70 per cent per annum in some cases) has created a market in which demand is suddenly running well ahead of supply.

While investors are suddenly two a penny, there is by definition only a finite number of really solid new-technology projects that have the makings of a potential future winner. It is easy to forget that, just because a sky-high stock market has enabled some investors in venture capital to realise handsome returns, the fundamental characteristics of venture-capital investment remain high risk and periodic illiquidity.

While a healthy venture-capital business is undoubtedly a good thing for Britain, it does not follow that those who put their money into it are always going to achieve the spectacular returns of the past. It must be highly likely that we have already passed the high-water mark of this particular cycle, which remains ultimately driven by the stock market. As Charley Ellis has pointed out: "Most of the money that has gone into venture capital has gone in after there have been some great years of returns, and before some years of rather poor returns."

davisbiz@aol.com