After the feeding frenzy of recent months, venture firms are scrutinising their investments more closely. But it is not all gloom says Katharine Campbell

Did someone take away the punch bowl just as the venture capital party in Europe started to swing?

For most of the past decade, investing in young technology businesses had been a pretty lonely business. Then the climate started to improve, thanks to a number of factors.

These included a growing respect in Europe for entrepreneurs and the creation of junior bourses, notably the Neuer Markt, whose success galvanised the previously stodgy German market to a remarkable degree.

Last year, the internet set the scene alight. Everyone, it seemed, wanted to be in European technology venture capital.
Leading Silicon Valley firms began to take a real interest in the region for the first time, while buy-out houses decided they too could play at early stage investing. Investment banks, corporations, management consultants, accountants - they all joined the scramble.

In the last 12 months, European venture funds alone have sought and/or raised about E16bn ($15.3m), according to estimates by Initiative Europe, a private equity data specialist.

The party atmosphere has of course been abruptly punctured. First came the Nasdaq correction, which spilled into European markets.

Then last month Boo.com, the online sportswear retailer whose founders include Ernst Malmsten and former model Kajsa Leander, collapsed, after consuming E141m of investors' cash in less than 18 months.

Netimperative, an internet news service, followed hard on its heels. A host of IPOs have been cancelled or postponed - including TeleCity, the internet infrastructure company, and Letsbuyit, the online retailer.

Suddenly everyone has been reminded why venture capital is so named. In the US, the shake-out is occurring after many fat years. As at September 1999, the mean one-year returns from venture funds, net of costs, were 136.4 per cent, according to Cambridge Associates, a private equity adviser.

However, in Europe the punch bowl has been removed much earlier in the cycle. So how serious is the current bout of nerves? It depends who you are.

"This is basically good news," thinks Michael Jackson, chairman of Elderstreet Investments, one of the more seasoned UK technology venture capital firms. "The whole thing had got completely out of hand."

He refers to the short but sharp feeding frenzy when venture capitalists tumbled over one another in pursuit of every next good (or not so good) idea.

With exuberant stock markets ready to accept ever younger, flimsier businesses and providing almost instant paper profits for venture funds, it was hard not to get sucked into it all. "You had to be a very brave man to sit on your hands in that climate."

Neil Rimer, partner at Index Ventures in Geneva, also remembers the intense pressure. "There was a period when we were worried we were doing too much hardcore technology and not enough pure play dotcoms."

He recalls Boo as "one of those Scandinavian deals everyone knew about that was heavily oversubscribed. You had either to chase it or lose it - you knew there would be no negotiation."

It was a period when "everyone was bending traditional investment criteria. It took a lot of discipline to keep away. Everyone was buying everything."

Now the excesses of recent months will work themselves through the system - with a good number of painful casualties along the way.

Some of the deepest froth is to be found in the internet incubator scene. A year ago, there was but a handful of early (and serious) pioneers such as Speed Ventures in Sweden. Now there are a couple of hundred in London, according to some measures.

The visible tip is made up of the publicly quoted entities which, for a short period, were able to capitalise on the dearth of quoted internet stocks to raise money at astonishing valuations. "It was a vicious circle," says Mr Jackson of Elderstreet. "These guys were having to spend money (making investments) just to keep the share price up."

The likes of Jellyworks and Oxygen Holdings have seen their share prices collapse, and the wave of inevitable consolidation has begun with the acquisition by NewMedia Spark of Softtechnet.com. Fledgling businesses backed by some of the more inexperienced operators will be feeling duly nervous.

Unfunded businesses will have a much harder time as venture capitalists have turned a lot fussier. Some are telling entrepreneurs they are doing no new deals while the dust settles (and while they sort out their current portfolio).

Others are still investing - like Simon Murdoch of Chase Episode 1, a new specialist internet venture fund. He is simply, as he puts it, being "even more selective".

Now that investors have watched business-to-consumer businesses burn through wads of cash and still struggle to acquire customers, there is a renewed interest in "real numbers". A year ago it was the "top down" figures that mattered in analysing a prospective investment - big picture stuff such as the size of the market and the strength of the management team.

Now, says Mr Murdoch, much more attention is being paid to "bottom-up" analysis - so far as that is possible in very young, often unproven businesses. "People are asking questions like whether it matters that the cost of acquisition of each new customer is twice as high (as that in a comparable business)."

For those companies contemplating their second round of financing, life is particularly perilous. Word is of "down rounds" - at lower valuations than the heady figures they secured for their initial financings. That is if they can get funded at all.

With the IPO window more or less closed, venture firms are also scrutinising existing investments. "We are all looking through our portfolios and asking ourselves, 'golly how many of these are going to need funding in the next six months?'" says Mr Jackson.

"When there are good expectations of high valuation from public markets you are less concerned about spend and burn rates. Now we are looking narrowly at these things and suggesting cuts."

Following its pulled IPO, Letsbuyit is considering staff lay-offs. It is also talking to its backers about the feasibility of a private financing round. Venture firms say that such companies will have to be content with raising less money than they would have done from the public markets and at a lower valuation - again, if they succeed at all.

Still, all is not doom and gloom. There will undoubtedly be consolidation and fall-out on a considerable scale in coming months. It will become clearer as to which of the new participants are any good. It will become harder to raise new funds.

If the public markets turn really bearish, certain categories of participant will in time disappear - probably with the corporate venture funds in the lead.

But some businesses continue to generate buzz. Take Flutter.com, a person-to-person betting site, which has just closed a E34.7m second round financing led by Chase Episode 1 and UBS Capital.

Venture firms were falling over themselves to be in the deal. One investor admits the company achieved "a fantastic valuation".

The management team is rated very highly and the business model is deemed "viral as hell", meaning that customers themselves will readily expand the community by telling other people. Benchmark Capital, the US Silicon Valley firm, put E5.23m into Flutter.com, its first investment from its new E784m European fund.

While it prefers to lead a deal, and to get involved at the earliest stage, it said it could "not afford" to miss this particular transaction.

ore generally, the huge sums already committed to venture funds suggest the scene will not just dry up overnight. That money will be invested more slowly - and on the whole at more favourable valuations.

But as Josh Hannah, co-founder of Flutter.com, says: "Relative to any point in history except two or three weeks ago, the climate in Europe is hugely more favourable (for funding a new business), of course it is."



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