Venture capital is starting to regrow—but be warned, investors have learned their lessons from the dotcom days.

By John F. Ince 

On the hunt for business capital? We have some good news: The VC funding climate is improving. Unlike the feverish dotcom days, entrepreneurs starting businesses today have a better idea of what they’re getting into, and those entrepreneurs are bringing VCs out of hiding. “If successful, these companies won’t have as much competition as they would have had if companies were too easy to start,” says Andy Rappaport, a partner with VC firm August Capital in Menlo Park, California.

After the heady dotcom days and the crash that followed, VC funds are once again on the rise. According to Thomson Venture Economics and the National Venture Capital Association, in 2000, the industry raised $106 billion. In 2001, it dropped to $38 billion, and in 2002, it plunged to $3.7 billion. But in 2003, the industry rebounded, raising $10.5 billion, and in 2004, the industry continued its resurgence, raising $17.6 billion.

With this gathering momentum, VC firms have now emerged from the hibernation of their post-bubble years, when virtually the only financing getting done was to help existing portfolio companies stay afloat. “Over the past six months, we have seen a marked change in attitude in VCs,” says NVCA president Mark Heesen. “A lot of that is due to the fact that we have seen, and will likely continue to see, good exits through the acquisitions market and the IPO process.”

Indeed, in 2004, acquisitions of venture-backed companies almost doubled to $15.1 billion, up from $7.7 billion in 2003. Also, there were 93 venture-backed IPOs in 2004, raising $11 billion, up from 29 venture-backed IPOs, raising $2 billion, in 2003.

VC activity is heating up so much that some VCs are concerned we may be entering another period of irrational exuberance. “Over time, we’re likely to experience an upturn in VC investment opportunities. Right now, the opportunities are OK, but there’s too much money compared to the amount of investment opportunities, and that’s why the returns are going to be unsatisfactory to the limited partners who fund us,” says Rick Frisbie, founder of Battery Ventures, a Wellesley, Massachusetts, VC firm.

Rappaport feels this is going to put pressure on the bottom quartiles of VC funds. “There has always been a differential between the returns of the top quartile of VC firms and the remaining three quartiles,” he says. “That differential is going to continue to spread, especially because we are in an environment where there is still more money flowing into venture capital than VCs can productively put to use.”

The net result is that we’re likely to see VCs insisting that entrepreneurs be more disciplined. “VCs are going to be much more serious about making entrepreneurs meet certain mileposts before they get follow-on rounds of financing,” says Heesen. “Also, since the fund sizes are smaller, the money raised will be invested over longer periods of time, thereby imposing greater discipline on entrepreneurs.”  

John F. Ince is a former Wall Street banker and reporter at Fortune magazine, now freelance writing in Northern California.