THE VENTURE FINANCE ECOSYSTEM Michael Danaher Wilson Sonsini Goodrich & Rosati

Venture Funding Activity 2. Demand Side Dynamics 3. Supply Side Dynamics 4. Dealing with Deflation 5. Other Trends and Fashions

Venture Funding Activity

The View From on High: Investment Rises Slightly in 2Q’03 Amount Invested ($B) Number of Deals Underlying data available in VentureSource Source: VentureOne/Ernst & Young

The View From the Ground  Consumer confidence in the venture industry moved strongly up in the Spring  Multiple term sheets – what a concept!  Some instances of valuation giddiness  Overall activity is sharply up  First round deals are up

Demand Side Dynamics

Confidence is Up The Market has awakened Nasdaq Composite Index

Confidence is Up The economy has awakened Source: Bloomberg & Zachs Investment Research * Estimated Earnings

Confidence is Up  The world is adjusting to life after 9/11  The Iraq war ended quickly

Venture Fund Dynamics: The Clean-up is Mostly Done  In 2001 & 2002 VCs were preoccupied with the care of their existing portfolio  Now that most of the the triage is complete, VCs can focus on investing again

Funds Raised ($B) Commitments to Venture Capital Funds Underlying data available in VentureSource Source: VentureOne/Ernst & Young Venture Fund Dynamics

Number of Deals Source: VentureOne/Ernst & Young Underlying data available in VentureSource Venture Fund Inflow and Outflow Funds Raised ($B) Amount Invested ($B)

Source: VentureOne/Ernst & Young Underlying data available in VentureSource Venture Fund Inflows and the Nasdaq Funds Raised ($B)

Negative Dynamics  A number of “fair weather funds” are drying up  Many top funds have downsized  Corporate investors are mostly gone

Corporate Investment is Mostly Gone Amount Invested ($M) Underlying data available in VentureSource Source: VentureOne/Ernst & Young (except Intel and Cisco)

First Round Financings Data extrapolated from VentureSource Source: VentureOne/Ernst & Young

Negative Dynamics The Ex-Smoker Syndrome: the Reformed VC Excessively risk averse Excessively slow Excessively LP conscious

Supply Side Dynamics

“The older but wiser girl is the girl for me.” -- The Music Man

The Entrepreneurs  More realistic about valuations  More patient about building a company, and building a career  More down-to-earth  More plentiful  More hard core technology plans  More thrifty

Dealing With Deflation

The Old Days of the New Economy  The market rewarded First to market Scale (e.g. engineer head count) Revenue prospects  Earnings didn’t matter The rational response: go fast, spend big, never mind the losses

Earnings Really Didn’t Matter YearOfferings Percent profitable in IPO year % % % The WSGR IPO Universe* (Company and Underwriter Side) * An unofficial compilation

Exit Valuations Are Now Earnings Driven  IPO’s Require Profits  Acquirers want accretive acquisitions No big premiums for “time to market”

The Venture Industry Responds: Valuations Remain Down Median Amount Invested ($M) Underlying data available in VentureSource Source: VentureOne/Ernst & Young

The Venture Industry Responds: Deal Size Remains Down Median Amount Invested ($M) Underlying data available in VentureSource Source: VentureOne/Ernst & Young

The Entrepreneurs Respond: Run Silent, Run Cheap  Smaller budget business plans  Lower headcount, smaller salaries, cheaper facilities, leased equipment, smaller marketing budgets…  Focus, do less, outsource  Aim right—sell, design, build  Overseas Design Centers

The Entrepreneurs Respond: Run Silent, Run Cheap  Some great businesses are being built on $200k to $300k per month

) Other Trends and Fashions

Proceed With Caution  Show me the customers  Almost every deal is syndicated  More first round deals are traunched

Other Deal Terms  Often smaller shares for founders (especially outside Silicon Valley)  Investors prefer plain vanilla deals when possible No cumulative dividends, weighted average anti- dilution Liquidation preferences: usually 1x participating preferred, often without caps Redemption rights (but why bother?)

Market Dislocations  Fewer dislocations (un-served sectors) than years past Most will consider first round, second round and mezzanine Seed rounds are still a problem – the angel market is still decimated

Market Dislocations  Out of fashion Optics Telecom services  In fashion Network security, homeland security (government sales!), wireless, consumer electronics, biotech