Money remains tight for IT start-ups

Venture capitalists investing in companies that have already proven themselves.

First-time investments in IT companies in the second quarter lagged behind such investments in general, indicating that the network sector has not turned around yet, according to a survey of venture capital firms.

While the total number of companies receiving first-time funding rose slightly in the last quarter from an all-time low of 138 to 153, IT start-ups didn’t fare as well.

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These network industry statistics were supplied to Network World by three organizations that compile the quarterly MoneyTree Venture Capital Survey: PricewaterhouseCoopers, Venture Economics and National Venture Capital Association.

In the network industry categories – computers and peripherals, IT services, networking and equipment, semiconductors, software and Internet communications – only 63 of 338 deals were for first-time funding. That is about 18.6%, down from the previous quarter’s mark of 21%.

Part of the reason is that big corporations are not spending as much on IT infrastructure, says Todd Dagres, a general partner at Battery Ventures. “Now they’re protecting their turf. They’ve already built their infrastructure and in this environment are looking to take advantage of what they’ve put in the ground, not expand it,” he says.

Exceptions to the rule are in the areas of storage and security , says Tracy Lefteroff, global managing partner of the venture capital practice at PricewaterhouseCoopers. Security firm CoreStreet received $4 million in start-up money and is poised for another round, CEO Peter Hussey says. “There’s probably never been a time in our history with more focus on security,” he says.

Even so, venture firms seemed more cautious, with more of them interested in funding later rounds but not as willing to make initial investments, Hussey says. In addition to focusing on security, CoreStreet also seemed more attractive because it already had a product in beta tests with government agencies, and the founding team had run successful start-ups before, Hussey says. The company also is sitting on 14 U.S. patents for its technology, he says.

Web-services infrastructure start-up Active Endpoints received $6.5 million and found the scrutiny by venture capitalists to be more intense, says Fred Halohan, company president. Investors are trying to determine when large corporations will start buying. “When will the economy rebound enough so innovative customers will step up and buy again? Now they have their horns pulled in,” he says. The venture-capital firms he spoke with seemed concerned about companies they invested in earlier but are not yet profitable.

“[Investors] are supporting what they already had on their books,” Lefteroff says. “The majority of the money is going to support existing companies in later-stage deals.”

With Active Endpoints marking his third start-up, Halohan says his past successes also might have helped. “We’ve had two prior ventures, and we haven’t lost anyone’s money yet. There’s something magical about that,” he says.

Investment in software companies remained high, with $864 million invested, up from $810 last quarter. That is partly because software is a broad category ranging from consumer to service provider, but also because software companies deliver products faster than hardware companies, Dagres says. 

First-time investment in telecom companies was at a new low – only two start-ups got funding. That lag, plus ongoing consolidation among existing providers, could result in less choice for business customers, who then might start spending to create their own wide-area services, Dagres says. Overall investments in telecom start-ups actually increased 21% to $615 million, but that was for second- and third-stage investments, the survey says.

Investment in companies that make network equipment for businesses also was down for the quarter, from $458 million to $427 million. One reason is that a few major vendors dominate this market, making the prospect for tiny competitors bleak, Lefteroff says.

For more information on the MoneyTree survey, click here .