The semiconductor subsector saw its post-bubble peak in VC investment in 2004 and since then has seen a steady decline in both activity and level of investment. This can be attributed to a variety of factors, including the trend to high performing chips for consumer products, which by definition are extremely price sensitive and thus become more like a commodity and have less opportunity for large increases in value for innovative designs, speed or overall performance. For the vast majority of consumers, the processing power they currently possess in their laptops and smart phones are more than they will need for all but the most complex video game applications. Semiconductor innovation in areas such as power use are likely coming from the semiconductor manufacturers themselves and not from venture-backed entrepreneurial start-ups.

Silicon Valley has a disproportionate share of national semiconductor VC investment, so this trend could be a concern to the region going forward. In 2009, Silicon Valley represented more than 76% of the amount invested nationally and more than 64% of the total number of semiconductor deals.

Another possible indicator for the semiconductor industry can be seen in Google’s acquisition trends. Google has been on a buying spree, particularly in 2010 when they not only have resources but are seeing significant value available. Of the 23 acquisitions made by Google through September 2010 referenced earlier, just one was in the chip/semiconductor space.

Semiconductors Subsector Data Definition: Design, develop or manufacture semiconductor chips/microprocessors ore related equipment including diodes and transistors. Also includes companies that test or package integrated circuits.

Networking and equipment activity has seen a consistent decline since its post-bubble peak of 2006, largely due to the diffusion of communications technologies and the transition from hard wired equipment to wireless and mobile communications technology that has reached beyond the workplace and into consumers’ homes. This somewhat rapid departure from traditional networking technologies and equipment has likely fed the retreat of venture investments in the sector, but Silicon Valley remains in the center of the action, accounting for over 50% of the amount invested in this sector in 2009. Depending on how cloud computing infrastructure evolves and is deployed, there may be reason to believe this sector will rebound somewhat, though the likely dominance of larger providers could create an uphill slog for venture-back start-ups in this space.

Networking Subsector Data Definition: Providers of data communication and fiber optics products and services. Includes WANs, LANs, switches, hubs, routers, couplers, and network management products, components and systems.

The recession’s impact can clearly be seen in this subsector with a dramatic dip in activity and level of investment in 2009. This is expected to be a temporary trough however, as mobile and wireless technologies and VOIP take over the telecom landscape and generate multiple pockets of innovation and growth. Also, as consumer computer use rises and processor speed increases for most all products, there will be more and more need for additional bandwidth.  For all but the most complex computer gaming and video usage, a consumer’s challenge will be the size of the “pipe”, not the “power” of their machine. Investment in this area has been trending upward over the past 12 months, and California continues to lead.

Telecom Subsector Data Definition: Companies focused on the transmission of voice and data including long distance providers, local exchange carriers, and wireless communications services and components. Also included are satellite and microwave communications services and equipment.

Software and services not surprisingly remains a consistent driver of venture capital activity both in terms of investment and number of deals. Despite a decline in 2009 likely tied to the recession and general investor unease, Software continues to vastly outpace the other subsectors in both in terms of dollars and in the actual number of company investments. New applications and new products will continue to drive the growth in the software sector for the foreseeable future, a good sign for Silicon Valley given the strong concentration of existing software developers and the academic institutions that will continue to feed it.

One cautionary note in software relates to health care software, specifically for hospitals and providers. The federal stimulus bill provided $20 billion for health care institutions to upgrade their software and medical records system, which spurred a flurry of activity in software development and systems delivery, because the funds were only available for a period of time. It may also have helped prop up the software VC sector, which saw less of a decline than other subsectors in 2009. Once those funds are used up or the program expires, it could lead to a fairly dramatic slowdown in activity.

Software Subsector Data Definition: Producers of bundled and/or unbundled software applications for business or consumer use including software created for systems, graphics, communications and networking, security, inventory, home use, educational, or recreational. Also included is software developed for specific industries such as banking, manufacturing, transportation, or healthcare.

IT Services

IT services saw a predictable dip in level of investment and # of deals in SV during the mid-2000s, immediately following the bubble. The sector has seen steady growth and activity since then, with 2007 and 2008 actually exceeding the number of deals from the previous high of 2001. The enthusiasm from the investor community for this subsector likely lies with the explosion of e-commerce opportunities as well as the subsequent concerns about internet security, privacy of information, and the expanding need for data processing. Nationally, the trend in this sector effectively mirrors these charts, with Silicon Valley representing roughly 30% of both the number of deals and the amount invested nationwide.

IT Services Data Definition: Providers of computer and internet-related services to businesses and consumers including computer repair, software consulting, computer training, machine leasing/rental, disaster recovery, web design, data input and processing, internet security, e-commerce services, web hosting and systems engineering.

Acquisitions are becoming a desirable way for companies to create new applications, products and services, without the time, investment and risk associated with internal research and development. After a drop in acquisition activity in 2008 & 2009 by the big buyers, 2010 has shown a robust rebound. According to research firm CB Insights, the following are the number of purchases by the largest technology companies through September of this year:

With the exception of a handful of acquisitions by IBM HP, and Oracle, all of those acquired so far this year were private companies. This portends potential quicker and more lucrative exit opportunities for investors and potentially compensating for the decline in I.P.O. activity.

Both Promising and Ominous “Clouds”

Cloud computing and all its components and applications stands to be at least as transformative a driver of VC activity and ICT evolution than social networking and mobile communications. Cloud software and infrastructure will present strong opportunities for start-ups and the technology as envisioned could generate significant operational savings for larger, data-heavy companies.

Even the greatest concerns and potential drawback to the cloud – data security, interoperability, and reliability – are ripe for the Silicon Valley laboratory to tackle. These concerns are perhaps the most critical in regards to health care records and research, which is also where visionaries see the cloud having the significant innovation in allowing transfer of patient information, insurance data processing, and sharing of biomedical research.

While it is widely accepted that there are miles to go before the cloud reaches its full potential, the horsepower that exists in Silicon Valley and elsewhere will likely cover that ground at breakneck speed.

There are other more ominous sorts of clouds for Silicon Valley as well. While California and Silicon Valley in particular is still a dominant force in ICT and in early stage venture investing in the sector, other regions are gaining ground and Silicon Valley may begin to see some cracks in its armor.  The overall tightening of the I.P.O. market seems to have hit the region harder than others. Benchmark Capital’s Bill Gurley recently pointed out in a November 22, 2010 New York Times article that of the 42 venture funded high technology I.P.O.s since 2008, only 11 came from Silicon Valley. “In other words, 74 percent of these I.P.O.’s hail from outside of the S.V. echo chamber,” said Gurley.

Overview

Overall, the Silicon Valley ICT venture capital activity has performed largely as expected given the two primary pressures – one up and one down. The rapid growth and innovation in technology in the past 3-5 years, which includes the ubiquity of mobile devices, the rise of social networking as both a personal and business tool – has helped to continue to fuel investment activity in SV, which continues to serve as the primary lab bench in the industry. The trends outlined in the following charts generally mirror national activity in each of these sectors.

However, the global recession has had an unavoidable constricting effect on entrepreneurial activity and appetite for risk, and changes to the traditional investment and exit path for venture capital is also having an effect on the region. Because of the economic slowdown, venture capital firms have had to be more patient, tying up capital in companies longer than they had planned or have had to historically. In addition, many have had to make follow-on investments to sustain their portfolio companies through the recession, further reducing the available capital for new start-ups. When one looks within the subsectors analyzed in this memo, these two pressures clearly show through.

Looking forward, there is reason to anticipate – though with a healthy dose of caution – a significant uptick in VC activity for a number of reasons:

• Overall optimism that the economy has begun to turn the corner and that markets will exist for new products and services in the near future.
• Marked increase the Silicon Valley Venture Capital Confidence Index, in which University of San Francisco’s Mark Cannice surveys a wide range of investors and analysts and tracks there outlook over time.
• Increased opportunities for investors exist generated by the acquisition trends of larger and emerging technology companies. This has helped to offset the decline in IPO activity and give investors a greater confidence that their returns will be realized in a predictable – and likely shorter – time frame than they have historically had.

The technology sector is likely to benefit from an economic recovery sooner than other industrial sectors, because there will be a greater demand to make both capital and R&D technology investments that have been put off during the recession. This infusion will provide resources for emerging companies and will allow larger established companies to make the acquisitions they need to remain competitive and diversify their offerings.