Funding slows for software makers But outlays surged for energy, biotech, medical devices during 2007

VENTURE CAPITAL REPORT

Venture capital investment in computer software start-ups is flattening as the software industry consolidates, a weakening economy clouds its sales outlook, and other sectors gain fresh attention.

Software, an anchor of the Boston-area technology scene, remains the largest recipient of venture capital nationally. But while venture outlays for energy, biotechnology, and medical devices have surged, the latest MoneyTree venture capital report shows that growth in software investments slowed noticeably in 2007.

"Software isn't the Wild West it was 10 years ago," said Sunil Dhaliwal, general partner at Battery Ventures, in Waltham. "Software is a mature industry. At the same time, `clean tech' has captured everyone's imagination as the growth industry of the next decade. People believe that there are problems to be solved and money to be made."

Last year, software investments totaled $5.27 billion, a 3.1 percent increase over 2006, according to MoneyTree, a partnership of the PricewaterhouseCoopers accounting firm and the National Venture Capital Association, using data from the research firm Thomson Financial.

In contrast, outlays for biotechnology climbed 9.5 percent to $5.21 billion in 2007, raising the possibility that biotech could overtake software this year as the leading magnet for venture financing.

Even greater growth was seen last year in medical devices, for which funding rose 39.5 percent to $3.89 billion, and in the industrial and energy sector, for which funding rose 44.2 percent to $2.69 billion.

Industrial and energy, the sector that includes clean technology, accounted for four of the top 10 venture deals nationally in the fourth quarter.

The largest deal in New England was also in the energy space: a $37.5 million round for Boston-Power Inc., a Westborough maker of lithium ion batteries for laptop computers. None of the quarter's top 10 deals nationally, and only one in New England, were in software.

Part of the explanation can be chalked up to investing fashion. "We represent a disruptive technology, and the time is right for us," said Christina Lampe-Onnerud, chief executive of Boston-Power, which drew funding from a venture consortium that includes Oak Venture Partners, Venrock, Intel Corp., and Apple Inc.

Business software companies have been struggling with a number of trends that have squeezed their profit margins and eroded their revenue base, among them "open source" programs that compete with proprietary software and the software-as-a-service business model.

The industry is also consolidating, with giants like IBM Corp., Microsoft Corp., and Oracle Corp. buying up dozens of companies in Massachusetts and elsewhere to extend their product lines. That's left fewer "home run" opportunities for venture-backed software start-ups.

But a new factor is also spooking venture investors: questions about the impact of the economic downturn on financial services and other data-intensive businesses and organizations that have been reliable "enterprise" customers for software and related services.

"Finance has been a huge customer of information technology generally, including software," said Bill Helman, a partner at the Waltham venture firm Greylock Partners. Referring to management upheaval at Wall Street firms weighed down by portfolios of mortgage-backed securities, Helman warned, "The new guy at Merrill Lynch is going to come in and say, `I don't care what the project is, don't do it."'

His warning was echoed by Deepak Kamra, a general partner at the Menlo Park, Calif., venture firm Canaan Partners. Citing the tepid growth of software investing last year, Kamra suggested the softness in the economy may be coming into play. "Yes, we think there will be some effect on information technology spending," he said.

Venture investors doubt software customers in all businesses will cut back as deeply as Wall Street. But spending at hospitals and other healthcare enterprises could also be under pressure as they cope with higher operating costs and lower reimbursements from employers, insurance companies, and patients who are out of work.

While software clearly isn't the growth sector it was in the 1990s, Dhaliwal predicts it will cycle back eventually, along with other out-of-favor sectors like semiconductors and telecommunications. For now, he said, venture capitalists can make money in software deals by investing in smaller venture rounds and pushing portfolio companies to operate frugally and ship software development work abroad.

"The little secret about software investing is that for years and years you were able to pour money into that sector and make great returns," he said. "Today you have to be more capital-efficient."

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VENTURE CAPITAL REPORT / FOURTH QUARTER 2007

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Robert Weisman can be reached at weisman@globe.com