Venture Funding Showing Signs of Returning to Life

By KATE BERRY
Staff Reporter

The deep freeze in venture capital funding is starting to thaw.

Local venture investing in Los Angeles, never a leader in capital-raising to begin with, jumped in the second quarter compared with the paltry levels of the first three months of the year. But the recent pickup still lags behind investment levels of a year ago.

Just 14 companies in Los Angeles County attracted a total of $147 million in venture funding in the three months ended June 30, according to consulting firm Growthink Research of Venice.

Funding in the second quarter rose five-fold compared with a measly $22.8 million invested in the first quarter, when the sour economy and the war in Iraq sent investors into hiding.

But funding still fell short of the $180.7 million raised in the second quarter of last year.

"This is by far the most challenging venture environment I've seen," said Steve O'Connor, president and chief executive of Pasadena-based Nanostream, a maker of tiny pharmaceutical devices used by lab researchers that raised $22 million in the period.

O'Connor, who has started four biotech companies since 1992, believes the hangover from the free spending days is still in evidence.

"The reality is, there are an awful lot of companies out there right now that should not be in business. They just have a dumb idea or poor management and they were well financed in 1998 or 2000," O'Connor said.

Overall, Southern California ranked fourth in total funding received in the second quarter, at $517 million, behind the Bay area, New England and the Northeast. A total of 54 companies received an average of $9.6 million each during the second quarter. In Los Angeles, the average investment was $10.5 million.

Holding steady

Nationally, $4.2 billion in venture capital was raised in the second quarter, almost identical with the previous quarter's $4.3 billion, but nearly 50 percent below the $6.3 billion raised for the like period a year ago.

Los Angeles has always lagged behind San Diego, the Bay Area and Boston in attracting venture capital, primarily because more venture firms are based in the Bay Area and Boston, while San Diego has carved out its own niche in the biotech industry.

Still, Los Angeles showed some resilience by receiving investments in all fields, from biotechnology to software to telecommunications.

"Los Angeles experienced a very good second quarter in light of the declining economy," said Corey Lavinsky, president of Growthink. "Holding steady from one year to the next isn't bad."

Three of the investments in Los Angeles companies were follow-ups in optical networking companies, which were hot in 2002. Unlike other fads, investors appear to be sticking with the sector, Lavinsky said.

The biggest local winner was TelePacific, a telecommunications company based in downtown Los Angeles that offers local, long distance and web hosting services.

TelePacific received $30 million in private equity funding in the quarter and expects to be cash-flow positive by the end of the year. Its major investors include Investcorp of New York, and GE Capital, among others.

Dick Jalkut, the company's president and chief executive, said the company is more reflective of the types of companies getting financed.

TelePacific has been around for five years, has 540 employees and expects to have $100 million in revenues by year-end. It received $40 million in funding last year.

"This round of capital has enabled us to fund our growth," said Jalkut, a former president of Nynex Corp.'s New York telephone unit. "We'll all breathe a lot easier when we're cash-flow positive."

Hot and cold

Nanostream is another indicator of a bifurcated venture capital market with a small number of hotly competitive deals and the remaining startups having a tough time raising capital.

Nanostream had previously raised $11 million from the same group of private equity investors, including Lilly BioVentures, the venture capital arm of Eli Lilly & Co., and AEA Investors Inc. of New York, the venture arm for the Rockefeller, Harriman and Mellon industrial families.

With just 50 employees and an anticipated $2 million in revenues, the company expects to become cash-flow positive with the latest round of funding, O'Connor said.

Another sought-after company is Intersperse Inc. of Pasadena, a provider of management software for business applications, which received $9.3 million in a third round of venture financing.

A set of four venture firms Palomar Ventures, Kleiner Perkins Caulfield & Byers, Clearstone Venture Partners and Rustic Canyon Group put up the recent round and have raised $28.3 million for Intersperse since it was founded in 2000.

"Money is coming back off the sidelines but it's not coming back in a smooth fashion," said Jim Gauer, a general partner at Palomar in Santa Monica. "But if you rewind the tape six months ago, venture funding was a total disaster."

Despite the limited number of attractive options, pressure appeared to be building in the second quarter for venture firms to put their money to work. Limited partners who are paying high management fees have been pushing for money to get off the sidelines.

At the same time, venture firms are starting to think twice about pouring more money into companies that have already raised upwards of $50 million but need more. Some venture capitalists said the trend is to invest only if a chief executive has a proven track record or a product has gained traction.

For those companies still languishing, venture firms are consolidating operations by merging technologies or management teams. That's one way for venture capitalists to avoid taking write-offs and potentially damaging their reputations.

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