During the first quarter of the year VCs invested $5.8 billion in 758 deals, a 19 percent decrease in dollars from the previous quarter and a 15 percent decrease in deals. This isn’t unexpected as the industry has also seen its ability to raise funding from its investors drop after the financial crisis in 2008 and 2009, and because the first quarter is historically the weakest one for VCs. The VC industry moves in five-to-seven-year cycles, so anticipated trends from even a few years back can take a while to be felt, and then they can change on a dime. Or a deal.

But this trend won’t be felt for long, and there’s one huge reason why: Instagram. The sale of that photo-sharing site to Facebook for $1 billion in funny money and cash caused every single venture firm to sit up and take notice. And behind Instagram are several successful exits with LinkedIn, Yelp, Zynga and Splunk going public.

Facebook has filed to raise capital on the public markets and that should lead to more interest in the asset class, plus it will also have the stock to do crazy inflated deals such as Instagram. Zynga’s assertion this week that it planned to make more acquisitions is only the start of an all-out race to the top to be the king of the consumer web. So entrepreneurs can expect more opportunities to raise capital and the anticipated shrinking of the industry won’t last long.

On the funding side, the dollars flowing into seed and Series A deals also dropped to 45 percent of total deal volume, while the average size of such deals increased to $2.7 million. Again, this doesn’t reflect the change in the market post-Instagram and as VCs start doing deals again in the second quarter. In fact, it’s getting frothy out there with some startups commanding crazy post-round valuations of up to $7 million after taking on a Series A/seed round of $1.5 or $2 million.

In January I pointed out that the trends in early stage funding indicated that the Series B rounds were when entrepreneurs were feeling squeezed. VCs were willing to toss money at any deal in the early stages as a way of claiming their territory. However, if those investments didn’t show significant traction, revenue or product development, they weren’t getting their Series B dollars. Venture firms want a Pinterest by the second round, so entrepreneurs should use their Series A rounds prudently.

The hunt for whales at the Series B level concerns Chris Dixon, a co-founder of Hunch who wrote last week:

The problem with this model of Series A and B investing is that, in reality, many of the companies with big hits weren’t overnight successes. Pinterest, OMGPOP, Twitter, and Tumblr were around for years before taking off and all benefited greatly from having patient investors. In the current financing environment, a lot of good companies won’t live to get Series As and Bs and big VCs will pay valuations on hits that are priced to perfection.

The question that remains to be seen is if the Internet has crossed over so totally into a consumer-market story that venture success and returns drop to reflect the crazy competition that’s endemic in the consumer marketplace. A home run is only a home run if your returns are high, and paying too much to get into the round can give a venture firm a publicity win, but less of a monetary one.

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While the area is more famous for the tech luminaries and startups it lost to other regions — Harvard alums Facebook’s Mark Zuckerberg and Microsoft’s Bill Gates being the most famous examples  – it still can claim a roster of impressive tech startups.

As a Silicon Valley-based partner for Boston-based North Bridge Venture Partners‘  Paul Santinelli has studied the differences between the two technology hotbeds up close and come up with a few conclusions. ”Boston is strong in infrastructure, comms [communications], and enterprise software — the kinds of technologies needed to build businesses,” he said in a recent interview.

Silicon Valley — which led the league in VC money with more than $3 billion invested in Q4 2011, according to the PricewaterhouseCoopers/NVCA MoneyTree Report, is much more focused on the consumer markets, Santinelli said.

But in the post-minicomputer, post-PC world, why build a business in Boston? “That’s a question we had to answer in a very real way when we got started,” said David McFarlane, Co-Founder and CEO of Akiban Technologies, a Boston-based NewSQL database startup. Some of the company’s backers wanted it to relocate to Silicon Valley, he said, but Akiban resisted.

“There’s a tremendous amount of talent in the Boston area where there are quite a few database and data integration companies. There are a number of founding architects that came from Object Design, from Archivas, Blue Agave, and Oberon and InterSystems,” he said. Object Design was a pioneer in object-oriented databases; Blue Agave, a demand management specialist, was acquired by I2 Technologies (which was then acquired by JDA Software); Archivas was a storage startup acquired by HDS; InterSystems is the company behind the Cache database (an outgrowth of the  MUMPS database) used by many hospitals and healthcare organizations.

Ori Herrnstadt, McFarlane’s co-founder and Akiban CTO agreed. “The caliber of architects you found here in the database world was unmatched. The Vertica, the Netezza, the Object Design guys were all here,” he said.  (Vertica, Netezza and Object Design ended up at  Hewlett-Packard, IBM and Progress Software respectively.)

Other hot database or storage oriented startups in the Boston area include Kinvey, ParElastic, Ginger.io, Sonian, Hadapt, Cloudant and VoltDB, the latest brainchild of serial database entrepreneur Michael Stonebraker, who backed Informix, INGRES, Streambase and, Vertica.

It doesn’t hurt that MIT, Harvard, Tufts, Boston University, Boston College, Brandeis, Bentley, Babson, UMass/Boston and other colleges are shoehorned into a compact area around the city. Those schools provide a steady stream of young talent to power startups. Another key part of Boston’s deep bench comes from its background as the home of the minicomputer — the mid-range machines that bridged the mainframe and PC eras. Those minicomputer companies — Digital Equipment Corp., Prime Computer, Data General, Wang Labs, ComputerVision — have gone the way of the dodo bird, but left behind an impressive array of technology experience that remains relevant.

Boston’s proximity to east coast financial companies is another plus. Those companies are not only a possible source of investment but a potential customer base, Santinelli said.

Still, as evidenced by the number of local companies snapped up by outside tech giants, the Boston-Cambridge nexus can feel more like a farm team to distant big leaguers. IBM alone has bought 20 local area companies since it purchased Lotus Development Corp. in 1995. IBM’s most recent purchase was Burlington, Mass.-based Emptoris last December.  Oracle (bought Cambridge-based Endeca in October) and others have cherry picked promising startups in the area. There simply aren’t many tech giants based here any more. On the plus side, the well of expertise still runs deep in the area that witnessed the rise (and fall) of the minicomputer era.

Photo courtesy of Flickr user John Stracke

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A total of $6.9 billion went into 997 VC deals in Internet-specific companies over the course of 2011, an increase of 68 percent in dollars and 24 percent in deals from the previous year, when $4.1 billion went into 807 deals. Internet companies accounted for 24 percent of all VC investments in 2011, compared to 18 percent in 2010, the MoneyTree report said.

From the Q4 2011 MoneyTree report (click to enlarge)

But the year didn’t close on the strongest note for Internet VC investments. In the fourth quarter of 2011, $1.29 billion went into Internet companies, a 23-percent decline in dollars from the previous quarter and about even with the fourth quarter of 2010, when $1.25 billion was invested. What made 2011 such a huge year for web VC investments was really the exceptionally strong second quarter, when $2.4 billion was invested in Internet companies.

Another interesting data point from the survey is the large amount of seed and early stage investments seen in 2011 across all industries that received VC funding. Seed and early stage funding as a whole was the higher in 2011 than it has been in at least seven years, according to the MoneyTree report, accounting for 1810 of the 3673 total deals completed in the year — nearly 50 percent of total deal activity.

From the Q4 2011 MoneyTree report (click to enlarge)

The current level of activity may seem a bit frothy, but with the huge numbers of people using the Internet today, many people think this is just the beginning for the industry’s growth in terms of companies and revenue potential. And the non-stop buzz that surrounded the tech industry in 2011 shows the investment dollars were just accompanying the larger excitement around the space. But whether it’s overly hyped or not, with 2012 on deck to be a strong year for web startup exits, particularly through initial public offerings, the Internet VC funding frenzy probably won’t slow down significantly any time soon.

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VC field: white and male, especially at the top

On Monday the National Venture Capital Association (NVCA) and Dow Jones VentureSource released the results of the 2011 Venture Census survey, which polled nearly 600 individuals in the VC industry. Of the respondents, 87 percent were Caucasian, nine percent were Asian, two percent were African American or Latino, and two percent were of “mixed race.”

Although in a press release the NVCA said the survey indicates “increasing ethnic diversity” in the VC industry, the new figures are largely similar to the findings from the 2008 Venture Census survey, in which 88 percent were Caucasian, eight percent were Asian, two percent were Hispanic and one percent were African American.

In addition, the VC field is mostly male, especially at the higher ranks. Of the total survey respondents, 79 percent were male and 21 percent were female, and in investment roles men outweighed women even more significantly. Of those who identified themselves as investors, 89 percent were male and 11 percent were female. (The Venture Census survey also polls people in administrative, operational, marketing and communication roles.) If anything, the field seems to have lost women in the past few years: In 2008, 86 percent of VC investors were male and 14 percent were female.

A more diverse future?

The good news is that the future of the VC field may be slightly more diverse than it was, as Caucasian males don’t seem to dominate the industry’s younger ranks quite as overwhelmingly. Of venture professionals who have been in the industry fewer than five years, 77 percent were Caucasian, 17 percent were Asian, 3 percent were African American or Latino, and 3 percent were of mixed race. And females were much more prevalent in the field’s younger workers: Of survey respondents under 30 years old, 28 percent were women. Of those in their thirties, 27 percent were women; forties and fifties, 22 percent; and over 60 years old, 13 percent.

Too busy to blog

Another interesting tidbit from the study is how often VCs use the social networking websites in which their industry has enthusiastically invested in recent years. Sixty-two percent of VCs polled use Facebook and just 30 percent use Twitter. LinkedIn is the social network of choice for the VC set, with 85 percent of respondents indicating that they are users of the site.

It is also somewhat surprising how much the majority of VCs seems to stay out of the blogosphere — both as readers and writers. Only 33 percent of survey respondents say they read blogs, and just 11 percent write them. To be fair, perhaps they are just too busy to surf the web: Forty-four percent of survey respondents in investment roles said they work more than 60 hours per week.

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• Q3 2011 saw five venture-backed IPOs valued at $442.9 million, down 92 percent in dollar value compared to the second quarter of 2011 and a 65 percent drop in dollar value from Q3 2010.
• Four of the five IPOs were from the information technology (IT) sector versus 14 of the 21 IPO during Q2 2011.
• Of the four IT IPOs, there were two Internet companies, one hardware and one software company. Among the notable IPOs during the quarter: Zillow.
• Four of the five IPOs of the quarter were based in the United States, while Tudou.com is from China.
• For the third quarter, 101 venture-backed M&A deals were reported, 35 had an aggregate deal value of $6.3 billion.

It is not a surprise Kayak delayed its offering and the Groupon deal is on shaky ground. The broader economic troubles are slowing demand for all kinds of stocks and IPOs are no different.

In case you were wondering: what was the impact on startups? Nothing in the near term, especially for companies that are relatively small and are still in the early stages of their life.

In addition, the companies that are being accorded jaw-dropping billion dollar plus valuations also have their work cut out. The troubles with the Groupon IPO are indication that there are no quick exits, despite what you might read, and companies need to grow into their valuations.

From the M&A perspective, 2011 is turning out to be softer than 2010, though in pure deal numbers. So far 310 deals have been announced in 2011 versus a total of 431 deals last year. It shouldn’t surprise anyone if we see a rapid escalation in M&A activity, especially if the IPO window continues to be shut.

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The second quarter of 2011 saw the highest total amount of money invested by VCs since the second quarter of 2008, according to the MoneyTree report released this week. Quarterly venture capital investment activity increased 19 percent during Q2 compared to the first quarter of 2011, during which VCs invested $6.3 billion in 814 deals (click on image to expand):

And if you think VCs have been putting a lot more money than usual into web startups, you’re absolutely right. Investments in Internet-specific companies rose to the highest quarterly level since 2001. Venture capital firms pumped $2.3 billion into 275 web-oriented companies during Q2 2011, a 72 percent increase in dollars and a 46 percent increase in such deals from the first quarter of the year:

Growth is normally a good thing for the venture capital ecosystem, but it may be starting to get out of hand. “This quarter’s increased investment levels signals an incredible opportunity for job creation and innovation, but if current dynamics continue, it will not be sustainable,” NVCA president Mark Heesen said in a release accompanying the MoneyTree report. “This level of investment cannot continue if we do not start to see a pick-up in exits and, subsequently, fundraising.”

Venture capital firms have had difficulty raising new funds for several years now. And while there is a lot of talk about the recent splashy exits such as LinkedIn’s blockbuster IPO, the fact is that the current return on investment is still not as high as many VCs — or their institutional investors — would like.

But for now, at least, it’s a good time to be building a venture-backed business. “Overall, the increase in investment levels in Q2 remains encouraging for entrepreneurs,” said PwC global managing partner Tracy T. Lefteroff. “At the current pace of venture capital investing, 2011 is on track to exceed $26 billion, which would put it as the sixth most active year in VC investing history.”

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For the year, venture capital fundraising during the first half of 2011 totaled $10.2 billion from 76 funds, a 67-percent increase by dollars compared to the first half of 2010, but a 15-percent decrease by number of funds. Ironically, in 2009 most industry watchers were concerned the industry had gotten too large on a dollar basis, calling for funds to raise between about $13 billion to $15 billion a year, when now, the concern is about the industry needing to get larger — at least when it comes to the number of players.

“The fact that the number of firms raising money successfully remains at such low levels confirms an ongoing contraction of the venture capital industry, which will serve well those funds that can obtain commitments – but that group is becoming more and more narrow,” said Mark Heesen, president of the NVCA. “While a smaller venture industry will intuitively produce higher returns, it is critical that the mix of funds remain geographically diverse and cover a broad base of industries if we expect to contribute to economic growth and innovation at the levels we have historically. For that reason, we would like to see more funds raise money in the second half of the year.”

While we’ve covered the need for the venture capital industry to shrink, we haven’t really taken a look at what it means should the industry become dominated by existing and older funds. In general, (successful) older funds raise more money since limited partners want to continue investing in success. And there’s pressure for venture firms to continue raising the amount under management to support a growing infrastructure of people who help run the firm while the partners are out investing.

But since much of today’s investments seem to focus on smaller deals at the early stage rounds, it can make it difficult for partners at these large funds to justify spending time on an investment that’s such a small percentage of the firm’s portfolio. Sometimes the larger firms spin out or create dedicated funds for smaller efforts, such as mobile focused funds, but I wonder if this trend means the older and larger firms will be limited to competing for deals at the later stage, and pushing up valuations. Of course, as long as there are hot IPOs that’s not a problem, but when that stops, where will that leave the funds whose portfolios are focused on expensive later-stage deals? Or are they competing here, because they can, and because when everyone in the market is partying hard, it doesn’t make economic sense to sit out?

While I’m not sure I really buy the diversity card that Heesen is trying to play (in general, VCs are about as diverse as a herd of cloned sheep) I do think the rise of larger, older funds could have unforeseen consequences for startups trying to raise money once they graduate from seed and angel rounds. And I think there may be unforeseen consequences for the industry overall if it runs too far out of balance.

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While the number of total deals hit its lowest point since the third quarter of 2009, VCs appeared to be falling all over themselves to invest huge chunks of change across the software, biotech/energy and media industries.

This quarter, 14 companies secured rounds of at least $50 million, while four drew more than $100 million. The industry hasn’t seen figures like that seen the third quarter of 2001.

As expected, the biggest windfalls went to established companies playing the IPO waiting game, as the later-stage investments rose 52 percent from the last quarter alone.

Cleantech played a large role in the later-stage surge. The capital-intensive industry had a near-record-setting billion-dollar quarter, grabbing six of the top 10 venture deals. The largest VC deal of the year went to Oakland-based solar-plant builder BrightSource Energy, which brought in $201 million in later-stage financing.

Plastic Logic, a Mountain View-based e-reader technology firm was a close second with $200 million. Meanwhile, New York-based software firm Appsense received $70 million in later-stage funding. Digital music startup Beyond Oblivion, also headquartered in the New York, received $77 million in early-stage funds.

Overall, VCs spent an average of $8 million per deal this quarter, up from $6.6 million this time last year and $6.8 million last quarter. The largest chunk went to the software industry, which received $1.1 billion, up from $809 million last year. A fifth of those funds went to multimedia, cloud computing, mobile apps and mobile devices.

The biggest dip in deal volume and funding came at the seed level. Seed investment shrunk down to $121 million from $423 million last year. And only 56 seeds were funded, down 36 percent from last year.

The decline in seed deals can perhaps be attributed to the rise of super angels, who are increasingly stepping up to fund fledgling startups, especially in the consumer Internet, mobile and digital media sectors that don’t require huge amounts of capital to get started.

At least for now, the VCs appear more interested in fertilizing select early to later-stage companies with big bucks than watering a whole bunch of seedlings. But when green starts to peek through the ground, VCs will likely appear, offering some green of their own.

Photo courtesy of (CC BY-SA 2.0) Flickr user Tracy O.

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The NVCA reports that during the first quarter there were 74 M&A deals with a disclosed total dollar value of $3.3 billion. Computer software and services and Internet-specific companies accounted for the bulk of the targets, with 63 deals and the lion’s share of the disclosed value, leaving a measly three semiconductor deals and four hardware deals.

The report also offers good news for the companies that have gone public, as well as for the 49 companies that have filed to go public soon: Of the 14 IPOs in the first quarter, 11 are trading at or above their offering prices as of March 31, 2011. That’s a good sign for Pandora, LinkedIn, Kayak, Boingo and Fusion-IO, which have all filed to go public, as it means they may actually make it out. Having a healthy IPO market also helps boost the M&A value of late-stage companies, which means we could see some companies snatched out of the filing process by larger vendors. Regardless, more IPOs and offerings that retain their value aren’t a joke, but they are something to smile about.

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The business world has always idolized and venerated a few top companies, but as the web focuses on consumers and rewards scale there seems to be less room for a Number 2 player in a portfolio and in the market. I think of it as the decline of the middle class of startups, but perhaps it’s also a reflection of the media frenzy around the biggest names and the focus on consumer-focused startups that need scale to make it big. Seth Levine of Foundry Group put it best on the conference calling the crop of super startups such as Facebook, Zynga and Groupon that have grown really rapidly to huge scale, “the new normal,” and saying that venture firms are now seeking out and rewarding companies that can rise quickly to the top with huge valuations and financings.

Unfortunately the venture capital data offered up on Thursday doesn’t detail valuation, but it does offer some positive insights. Early stage and first time financings are continuing to happen (although the dollars are shrinking while the number of deals are rising in seed stage deals). This could reflect this decline of the middle class in part because venture firms are happy to invest a small amount and then pull out if the startup doesn’t gain users rapidly. Although is also likely because startups today are far more efficient. In addition, the number of later stage deals is finally decreasing from record highs in the 2006-2008 time frame.

Later stage financings hit that high as it became more difficult for companies to file for initial public offerings, which meant that VCs who had invested in a company hoping for an exit during that time frame often had to keep it on the books, much like a parent may have to do with an adult child who doesn’t leave the nest. However, a combination of startups closing, acquisitions and a few initial public offerings have helped clear the decks for VCs and freed up capital for the early stage and expansion capital deals. Ironically, the crop of super startups that are defining the upper class are not as interested in going public, which could create some interesting effects in the venture industry later on, and can even be seen today in the wider popularity of the secondary markets.

Overall the venture industry has become smaller than it was during the 2006-2008 time frame. While it still hasn’t shrunk to the point that some experts had called for, it’s getting closer to a new normal baseline according to John Taylor, VP of research at the NVCA. However, without a credible IPO market and the rise of a few superstar companies raising several hundred million dollars instead of going public, I think we’ll see a disruption to that baseline amount invested soon enough. Either that or a change in the way venture firms disperse their cash.