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Growth in the Valley

The tech bust left Silicon Valley a barren desert. But healthy venture capital numbers are just one sign that the region is ready to bloom again.

Maybe it’s the bright sunshine, the air-conditioned climate and the awesome scenery that makes Silicon Valley execs so sanguine. Or maybe it’s that the region’s history is steeped in heady optimism. Whatever the cause, venture capitalists along Sand Hill Road, the epicenter of the Valley, are again searching for the Next Big Thing, and talking up the upcoming Google IPO, which promises gigantic returns on a valuation expected to be in the $20-billion range.

Just looking at venture capital statistics for the full year 2003, it’s hard to tell whether there’s anything much to celebrate. Venture investments declined 15 percent, to $18.2 billion in 2003, while the number of investments dropped 12 percent, to 2,715, according to a survey by PricewaterhouseCoopers, Thomson Venture Economics and the National Venture Capital Association. Venture-backed IPOs picked up slightly, to 27 last year from 23 the year before, but news of funds was decidedly grim. The number of new venture funds for 2003 was 83, about half of what it was in 2002, while fund sizes were down by more than one-third.

Yet interviews with venture capitalists, entrepreneurs, investment bankers and tech-company CEOs reveal that the numbers, while off from the anomalous peak years of 1999 to 2000, actually represent a return to basics for the Valley. These experts say the current levels of investment are sustainable, with funding and IPO rates that match those of 1995 to 1996, well before the infamous boom and bust (see graphs, page 22). Take out those three bubble years, and it’s just business as usual.

Venture capitalists say the industry has definitely turned the corner. With the markets friendly and the IPO window open a crack, their mood is decidedly up. “There are a lot of interesting companies out there,” says Mitch Kertzman, a partner at Hummer Winblad Venture Partners in San Francisco. “And after listening to the death of innovation and going through the shock and recovery, we are seeing real companies with real technology solving real problems in significant areas.”

Fourth-quarter numbers proved so strong, in fact, they suggest the existence of a “mini-bubble” in Silicon Valley, says Kertzman, with venture capitalists rushing to pour money into new and expanding companies. Venture investments rose 11 percent, to $4.9 billion over the preceding quarter and represented the most capital invested in a three-month period since the second quarter of 2002. It’s a marked contrast from 2002, when “Sand Hill Road was closed and everyone was on the golf course,” Kertzman adds.

At the top of the VC prospecting list are emerging companies in life sciences, possibly one with a cure for some dreaded disease. Last year, life sciences attracted $4.89 billion in financing, or 27 percent of total venture capital. It was followed by software, which drew $3.6 billion, or 20 percent of all funding last year.

What’s Hot
Ask venture capitalists what sectors are “in,” and there is no shortage of responses. “The second coming of life sciences is what we will see,” says Sriram Viswanathan, managing director at Intel Capital, explaining that one trend is the application of information technology to life sciences. He adds that when “Jobs, Gates and Buffett were asked recently what investment area they were most interested in, they all listed life sciences.”

Viswanathan adds that software development is being fed by “the digitization of our lives” and adds that cyber-security is hot as well, thanks to an air of paranoia that began with Y2K-related fears and escalated with 9/11. “Now we are looking at what technology can do to make you feel more secure-cyber-security,” he says.

Wireless also gets Viswanathan’s blood flowing, although he calls the current lack of geographic coverage “unacceptable” and says that it’s reach, range and rate that are most important. Intel recently invested in Tokyo-based Japan Communications with the idea of pre-installing the firm’s wireless technology on Intel Centrino-powered notebook computers for Internet access anytime, anywhere.

Jeff Loomans, a partner at Sierra Ventures in Menlo Park, singles out anti-spam startups as a space so hot that it’s “frothing.” Four companies in this market have nabbed multimillion-dollar funding over the past year: MailFrontier, Brightmail, Frontbridge Technologies, Postini and MessageGate. Their staying power has yet to be determined.

Nanotechnology, which arrived in 2001, is also piquing investor interest. Erik Straser, general partner at Mohr Davidow Ventures in Menlo Park, points to fundamental breakthroughs in this complex area, which is essentially manufacturing technology on a molecule-size scale that could lead to faster and cheaper silicon chips or even a cure for cancer.

Startups outside the usual 50-mile radius of Silicon Valley interest also have caught the imagination of venture capitalists. “The impact of international is just starting to hit the VC business,” says Gary Rieschel, executive managing director of Palo Alto-based Mobius Venture Capital. Doing software development in India and China is emerging as “a killing zone” in Silicon Valley, he says, adding that Mobius will “not do a software investment unless they have an India or China software strategy.”

The spurt of startup investment activity has elicited the usual grumbling about too much money chasing an overinvested area-another sign that things are back to normal in the Valley. In describing the highs and lows of the Bay Area’s economic cycles, Straser notes that “the VC world has a tendency to get carbonated, with too many people and money chasing ideas.”

But eager VCs may also be responding to another sign of life: the trickle of new public offerings. “There is an IPO window,” says Lawrence Calcano, a managing director at Goldman Sachs in New York, but he adds that for the moment it’s only for “selective companies.” On the list of what’s required to make it: “A proven business model, profitability, strong barriers to entry, products supplying immediate returns, expanding gross and operating margins and a strong strategy and management team.” Calcano predicts only a slight increase for IPOs next year, nowhere near the overall 300 to 400 levels of recent years. “There is a slower period of maturation and the gestation period is stretched out,” he says, advising companies not to rush “but to cook a little longer.”

Not all VCs are so conservative. Thomas Weisel, chairman and CEO of San Francisco-based investment banking firm Thomas Weisel Partners, is predicting “an explosion of IPOs in 2004,” even as he acknowledges that “the IPO market is still dormant.” He says his firm did 50 IPOs in 2003 and expects to see 250 or 300 marketwide this year.

The Giants Awake
In addition to the upturn in IPO activity and VC investment, there is another piece of evidence of a comeback in the Valley: The established tech players in the region are healthier. Sales and earnings of software firms located along Highway 101 are improving. And the downturn forced software-company CEOs to hone their survival skills and to get lean and mean; as a result, they are better positioned to reap the rewards of a bull market.

“We decided after the turmoil of the past years that we would only go after businesses that we are best at, that are sustainable and that drive our economic engine,” says Stratton Sclavos, chairman and CEO of VeriSign in Mountain View. The company, which provides infrastructure services for Internet and telecom customers, is focusing on recurring business rather than one-shot deals.

CEO confidence is also up and rising, notes Calcano, and those leading the technology companies that keep the industry humming are investing again. The information technology market grew by 8 percent in 2003, after declines the two previous years, and Weisel forecasts roughly the same growth in 2004.

“There is a beginning of a recovery and while it is not a miraculous recovery, it is a very measured recovery,” says Gary Bloom, chairman and CEO of Veritas Software in Mountain View. “The cycles are longer and it’s more back to basics.” Veritas, which provides security solutions for companies, expanded its staff to 4,800 during the downturn, a bet that has paid off as the firm reported an 18 percent revenue increase, to $1.8 billion for 2003.

Many pundits have been burned over the years making predictions about Silicon Valley. But all signs seem to point to recovery. Backups on Highway 101 during rush hour are common again. Housing prices remain sky high, and open houses are packed with young couples making first-time purchases. Conferences for techie types and entrepreneurs are once again drawing record numbers. It may be a far cry from the overheated bubble era, but at least the Valley’s CEOs have something to smile about again.

About Rebecca A. Fannin

Rebecca A. Fannin is the author of Startup Asia and Silicon Dragon.