The latest PWC Money Tree data highlights a few trends we have been seeing over the last year or two. To cover a couple of the most salient:

Larger and Later
VC's are steadily moving to larger and later stage deals and doing fewer small, early deals. In 2005, 76% of investment dollars went to expansion or later stage deals, while that number grew to 82% in 2006 (see charts below).

This seems to me a predictable result of funds getting larger. 2006 saw a number of VC funds go back to raising $1-2 billion funds. While a few did this pre-bubble, this is the first year since then that VC fundraising (yes, VCs raise money too) tilted dramatically toward a small number of mega-funds.

Following through on that trend, these mega funds have a hard time doing true seed/early deals which should only need $1-2 million to get started. They all will do some, but as you can imagine, it is hard to deploy $1 billion in 4 years in chunks of $2 million. Thus the temptation is to do expansion/later deals that can take $10 mil or more.

Look at the average "Startup/Seed" round size in the PWC data. It jumped from $1.5 mil per deal in 2005 to $3.6 mil in 2006. Wow. Average round size for "Early" stage rose too. Seems like this makes it harder for the best companies to get the small, non-dilutive rounds they need to get started and encourages a less capital-efficient approach to company-building.

We continue to hear entrepreneurs tell us that they can find very few good firms willing to lead a deal that needs less than $5 million. In my experience, some of the best founders don't want or need a first round that size. I am hoping that more funds will focus on small, early deals as we have been doing here at Walden.

Hot and Cold Segments
The good news for this constituency is that Software investment managed to stay steady despite large increases for other segments such as CleanTech and Media. Health care showed stronger growth than tech in general. Networking and Equipment was one of the few areas that showed a real drop in investment between 2005 and 2006.

Overall, enterprise software remains a mainstay of venture, but I also see some early signs that it has lost a bit of luster. Several firms have dropped their Software teams in favor of other segments over the last few years, citing better returns in health care and CleanTech.

As you are aware from my past writing, I tend to see VCs more as lemmings than trailblazers, so I expect to see more funds de-emphasize traditional software investing over the next 5 years. By no means do I expect a big drop-off in the near term, but the funds I see going out to raise money are not as focused on enterprise software as they once were. I do see a noticeable decrease in focus on Networking and Equipment deals.

Shrinking VC Universe
Today Dow Jones also confirms what we have all been seeing for the last years, the incredible shrinking universe of venture firms. At the peak in 2000, over 1,200 firms invested in at least one deal. Between 2005 and 2006, that number dropped from 887 to 837, a loss of 50 firms.

The numbers will continue to drop because 240 of those 837 did not make any new deals, they only completed a follow-on round or 2. That's a good indication that they may not be able to raise a new fund.

Thus you had really only about 600 firms active and many of those only did one deal. Only 369 did more than 4 deals in 2006. If you combine the shrinking number of active firms with the small rise in capital raised by VCs you see again that the industry is headed towards a much smaller number of larger funds. This bodes poorly for small first rounds.

2007 Outlook
2006 showed that the venture industry has reached a fairly stable pace of investment and has not returned to the bubble behavior as some have worried. Let's hope that this allows us all to build exciting businesses in new areas without 20 competitors appearing on the scene to ruin the opportunity.

If we can get some software IPOs going in early 2007, we may see a bounce in investment later this year. If not, money will continue to bleed slowly away from IT and towards consumer or healthcare segments.









Matt Miller is a managing director at WaldenVC.

Keep up with all the latest software VC news and deals at the SandHill.com VC page.