March 17, 1999
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In Funding Internet Start-Ups,
The Usual Rules Don't Apply
By GEORGE ANDERS
Staff Reporter of THE WALL STREET JOURNAL
MENLO PARK, Calif. -- The audition is about to begin. A nervous young man steps into a conference room, wearing a green tie that clashes fiercely with his powder-blue shirt. "I'm not much on formal presentations," he says. Even so, he wants $10 million from a total stranger.
Across the table, Jeff Brody flashes a warm smile. If Mr. Brody were looking for the next great athlete, singer or movie maker, it might be time to shout: "Next!" But Mr. Brody is a longtime venture capitalist in Silicon Valley. He spends his entire week hearing pitches from entrepreneurs seeking money from his firm, Brentwood Venture Capital. And Mr. Brody thinks his latest visitor, 28-year-old Andrew Busey, just might have the right stuff.
Gradually Mr. Busey relaxes and starts spelling out his plan to sell furniture over the Internet. If this business takes off, he says, it will change the way Americans buy their sofas. It might even command a stock-market valuation of $2 billion or more. As the two-hour meeting wraps up, Mr. Brody declares: "I'm very intrigued. Send me a list of your references. I'd like to dig into this."
For the next two months, Mr. Brody will inch closer to bankrolling this glimmer of a new enterprise. At times, he will exult about how big a success it might become. At other times, Mr. Brody and his partners will pull back in dismay, worried that online furniture shopping just isn't going to happen, no matter how much they invest. As Mr. Brody bluntly tells a colleague: "We could lose a lot of money if we're wrong."
These days, the entire venture-capital industry is wrestling with a bigger version of Mr. Brody's dilemma. Financiers in Silicon Valley and elsewhere are pouring $300 million a month into tiny new businesses built around the Internet, according to VentureOne Corp., a San Francisco research firm. That amounts to 30% of all venture spending, more than the combined total for biotechnology, electronics and microchips. Yet no one feeding this Internet frenzy can pinpoint the difference between tomorrow's great enterprises and utter follies.
No Clear Edge
In the online world, it is futile to look for the traditional hallmarks of a great start-up: unique technology, brilliant engineers and a clear path to profits. Hundreds of Internet companies are being built atop nearly identical computing platforms, with no clear edge for any one of them. If there is a logic to which start-ups prevail, it has much more to do with their ability to create a memorable brand than with sheer technological mastery.
Brentwood Venture Capital
(www.brentwoodvc.com)
Sizing up entrepreneurs' resumes and financial plans is even more baffling. College dropouts in their early 20s claim to have better insights than seasoned managers with M.B.A.s or Ph.D.s. Practically every young Internet company expects to post losses for years to come, on the belief that rapid revenue growth is the only financial goal that matters. As for strategic planning, it typically is limited to one word: improvise.
Yet venture capitalists dare not walk away. For all its goofiness, the Internet economy is producing enormous jackpots for early investors. Three companies founded within the past five years now have boggling stock-market values: online bookstore Amazon.com Inc., with $21.4 billion; auction-company eBay Inc., with $19 billion; and Web directory provider Yahoo! Inc., with nearly $35 billion. In each case, venture backers have seen their stakes jump more than 500-fold in value. Even if current prices prove to be a short-lived bubble and Internet stocks plunge 50% or more, these will remain some of the best venture investments of all time.
Big Losses, Big Potential
So financiers are groping their way toward new guidelines for the Internet age. Tolerate big losses in companies' first few years, they say, but focus on enterprises that are targeting giant markets. Such companies have a good chance of going public at a lofty price even in the midst of losses, because investors are so optimistic about the Internet's potential.
Look for "first movers" into a new Internet specialty, venture firms add, on the belief that later entrants will always be playing catch-up. And when things get too confusing, simply place a lot of bets and hope the winners will outweigh the losers. "If you don't strike out at times, you aren't swinging for the fences," says Robert Kagle, a partner at Benchmark Capital, Menlo Park, which funded eBay in 1997.
Right now, the 39-year-old Mr. Brody is one of Silicon Valley's hot hands at sizing up Internet talent. He is a onetime electrical engineer with a Stanford M.B.A. and the robust good spirits of a former interfraternity-council president. He backed WebTV Networks Inc. several years ago and helped negotiate its sale to Microsoft Corp. for more than $400 million; he also was an early investor in NextCard Inc., an online credit-card issuer that is expected to go public later this year.
In 1994, he joined Brentwood, which has made nearly $1 billion of venture-capital investments since 1972. The firm was an early backer of Apple Computer Inc. in the late 1970s, and more recently has rung up big profits from its stakes in Xylan Corp. and a predecessor to Bay Networks Inc., two telecommunications-equipment companies that have attracted multibillion-dollar takeover bids. Two of Brentwood's most recent funds, raised in 1993 and 1995, have achieved portfolio returns of better than 90% a year to date, and Brentwood late last year raised an additional $300 million for new investments.
As one of six general partners at Brentwood, Mr. Brody is inundated with visitors who want to sell everything from perfume to electric power over the Internet. Most afternoons, he sits with them around a huge cherry-wood table in a conference room, listening politely but noncommittally to their pitches. "Intriguing" is one of his favorite responses. "Compelling" ranks close behind.
'A Tired Deal'
After the visitors depart, Mr. Brody offers much franker comments. "It's such a narrow market, and the management team is so inexperienced," he says of one business-services project. Reviewing a separate proposal for online chat services, he declares: "That's a tired deal. They've been shopping it around for a long time and don't have a lead investor." Such projects soon vanish from his sight. If they get funding, it won't be from Brentwood.
Two or three times a month, though, Mr. Brody's eyes light up as a pitch meeting hits full stride. He takes a lot more notes, documenting every detail of what might be the next big money-maker. He starts telling entrepreneurs how much Brentwood can help them recruit a management team or solve business problems. And he flatters his guests.
"You've got an excellent business plan," Mr. Brody tells the online-furniture enthusiast, Mr. Busey, in the midst of their first meeting. They agree that the $60 billion-a-year furniture business is "broken," as evidenced by their own recent frustrations in trying to find the right items in the midst of sprawling showrooms. Customers want something better, Mr. Brody says. When Mr. Busey spells out a plan to share online revenue with interior decorators who provide customer referrals, Mr. Brody says: "That's good. That's really good."
Parts of Mr. Busey's presentation are raw as can be. When Mr. Brody asks what the new company's Web site might look like, Mr. Busey pulls out an artist's sketch pad covered with red and blue doodles of a sofa and a lamp. There isn't anything approaching a working version with fully written computer code. Mr. Brody doesn't mind. He gazes at the page with a dreamy stare, as if he were an architect looking at a hollowed-out construction zone.
Shrewd Questions
Yet Mr. Busey shows a shrewder side, too. Mr. Brody questions whether furniture makers might refuse to do business with the online store if they believe it menaces their retailers. Possible but not likely, Mr. Busey says. He has recruited his own 58-year-old father, a longtime furniture-sales executive, to join the new company and handle manufacturer relations. "My dad thought this whole idea was nuts at first," Mr. Busey says. "But after a month of talking about it, he really saw how it could work."
Near the end of his pitch, Mr. Busey lays out a budget that would be impudent in any field except the Internet. "I'd like $5 million to $10 million to get the site up," he says. After that, he projects $46 million of losses over the next three years. That's a virtue, Mr. Busey insists; it amounts to "an Amazon level of aggressiveness. To really win at this, we need to spend money." As for profitability, that can wait until 2002.
Mr. Brody doesn't flinch. He wraps up the meeting on an upbeat note, escorts Mr. Busey to the door, and then shares his thoughts with a visitor. "I liked Andrew," he says. "He needs fearless investors. We'd have to put up a whole lot of money before we know whether this works. He wants to base the company in Austin, Texas, which makes it harder for us to monitor. But the basic path is well-trodden. You know what needs to get done to have a great online store."
Another Hit
A few days later, Mr. Busey is back for a second presentation. This time another Brentwood partner, John Walecka, joins the talks to see if he agrees with Mr. Brody's hunches. The meeting is a hit. Mr. Walecka bolts to attention when Mr. Busey mentions that in 1993, he was a project manager for Mosaic, the precursor to the hugely popular Internet browser developed by Netscape Communications Corp. At the end of the meeting, Mr. Walecka declares: "Andrew, this is a terrific opportunity. Good luck."
The next Monday, Mr. Brody thinks there is enough momentum to justify having all his partners discuss the Busey proposal for 30 minutes during their weekly meeting. He and Mr. Walecka stand at a white board, where they draw a big "T" and start listing pros and cons. On the left side are seven reasons to bankroll the furniture deal, including "opportunity to be first" and "compelling gross margins." On the right side are three drawbacks, including what is delicately termed the public's "limited experience" with online furniture shopping.
Across the table, senior partner Brad Jones seizes on that vulnerability. "I don't know anyone who buys furniture on the Internet," he says. People want to sit on sofas and test the cushions, he says. That is impossible to do online.
"Patterns change," Mr. Walecka jabs back. "Look at how many people bought toys over the Internet a few years ago. No one. Now lots of people do." His analogy is calculated to strike a nerve. Brentwood had three chances to bankroll eToys Inc. in its infancy, but said no each time to the enterprise, which now is about to go public as a rising Internet star.
'Underestimating the Challenge'
Mr. Jones won't budge. "You keep saying the Internet is going to change everything," he carps. "But I think you're underestimating the challenge of building this into a first-rate company. You can't make analogies. This isn't another Amazon. And I want to remind you that no one has made money so far selling merchandise on the Net."
Now Mr. Brody's pride is hurt. "I would fundamentally disagree with everything you say," he tells Mr. Jones. "How big is the book business -- $23 billion? And how big is the furniture business -- $60 billion? I think this is the chance for us to have a piece of a really big potential market."
For a few moments, Mr. Brody sounds as if he wants to ram through the deal on the strength of his own convictions, essentially ignoring his partner's doubts. A few minutes later, however, Mr. Brody is back to his usual conciliatory self. He suggests that Messrs. Jones and Busey meet face-to-face. "Then you can decide for yourself," he tells his partner. The executives decide to stage that meeting in Los Angeles, where Mr. Jones works most of the week. Civility has been restored, though Mr. Busey's deal now is in limbo.
All the while, other auditions are proving highly alluring to Brentwood, too. A Singaporean immigrant, Chih-Chao Lam, arrives one afternoon with what he calls "the antidote to e-commerce." His exact strategy is still in flux, but he is looking for ways to use the Internet to drive shoppers back into traditional stores. Mr. Brody likes the idea, especially as the two men talk about ways that big-name retailers might pay to get extra foot traffic from this start-up, known as Project Ganges.
Folding Tables and Soy Milk
Within a week, Mr. Brody visits Project Ganges's headquarters in a suburban shopping mall. This time, there is more than a founder and a sketch pad; instead, 11 employees are assembling a working Web site. The offices look like a tattered college dorm, full of $34.95 folding tables and boxes of soy milk. But to Mr. Brody, that is what a hard-charging start-up should look like. After a series of reference checks, he faxes a multimillion-dollar funding offer to Mr. Lam for a minority stake. The two men haggle briefly; by early March they have a deal.
Mr. Brody is every bit as eager to buy a stake in HomeGrocer.com Inc., a Seattle company selling groceries over the Internet. Once again, some of his colleagues are hesitant. "I don't think this ever will make money," Mr. Jones declares at a partners' meeting in early January. Online grocers simply are burdened with too many extra costs -- such as paying clerks to fill each basket, or hiring drivers to bring orders door-to-door -- that don't exist in the traditional shopping world, he argues.
True for now, Mr. Brody replies. HomeGrocer has been in business for more than a year and has been losing more than 10 cents on every dollar of sales. Still, he visited the company's headquarters and warehouse and was impressed with its top-quality image. Besides, he says: "The grocery business does $500 billion a year in sales. It's a huge market. You can debate the online distribution issue any way you want, but if someone figures it out, it's going to be a big business."
In addition, Mr. Brody notes, HomeGrocer got its initial funding from Kleiner Perkins Caufield & Byers, the venture firm in Menlo Park that backed Amazon. As a later-stage investor, Brentwood needn't worry much about guiding HomeGrocer's strategy. Brentwood instead could sit back and enjoy whatever acumen Kleiner Perkins provides.
Mr. Jones shrugs and says: "You've got my blessing."
Other Suitors
To Mr. Brody's chagrin, though, so many other people are flirting with the idea of funding HomeGrocer that he has a hard time getting to the front of the queue. In late January, he is ready to invest $4 million for slightly more than 10% of the company -- valuing the business at $35 million before his investment. That seems like a steep price to him, but other bidders emerge. He considers raising his bid in early March, but pulls back after hearing that other suitors may value HomeGrocer at as much as $90 million.
In the pre-Internet days, Mr. Brody says, he might spend the whole year looking for two or three good investments. There would be time for vacations, and time for multiweek, in-depth reviews of the best prospects. Now everything whizzes by at breakneck speed. Every week, he gets 40 or 50 new business proposals by courier, phone or e-mail. The pitches all start to blur -- so many bridal-registry deals; so many people trying to be the next Amazon or eBay of their specialty. Fewer than one in 100 ever turns into a deal Brentwood will finance.
"If you do this for a couple years, you can become pretty callous about the whole process," Mr. Brody says. He tries not to succumb, reminding himself almost daily that entrepreneurs are the heroes of American business. Even failed strivers get his sympathy. After all, he confides, he tried starting his own business in the late 1980s: a satellite-tracking venture that failed after two years.
"I've been on the other side of the table," says Mr. Brody, who joined Brentwood after working at a smaller venture firm for several years. "I know what it's like when you believe in your idea and things just aren't going your way."
Bumpy Ride
If Mr. Brody can finish persuading his partners to bankroll the online furniture idea, combined with the Project Ganges funding, he will have done nearly a year's worth of investing in just three months. But when Mr. Busey finally gets to Los Angeles to meet the skeptical partner, Mr. Jones, the meeting gets off to a bumpy start.
Rather than give his visitor a chance to talk about the big "broken" furniture industry or his days at Mosaic, Mr. Jones swiftly steers the conversation to what he thinks is another shaky part of the business plan: getting each furniture shipment into customers' homes. "Are you going to outsource shipping?" Mr. Jones asks. "Will your trucks go back empty?" "What will you do if there's damage and a customer refuses delivery?" Mr. Busey parries the questions for a while but soon begins to flail. The best he can offer is: "We'll hire a search firm that will look for a vice president, logistics."
In Menlo Park, Mr. Brody watches anxiously on a videoconference monitor. "Come on guys, get back to the presentation," he whispers to himself. And then Mr. Brody catches himself. "Andrew's got me right where he wants me," he says. "I'm trying to do his work for him. He's got to be able to answer these questions himself."
The Los Angeles meeting finishes with a handshake but not much excitement. After Mr. Busey leaves the room, Mr. Jones leans toward the camera and tells Mr. Brody what has become obvious to both men. "I think it's a pretty high-risk deal, Jeff. And I don't think these guys have figured out the logistics."
The Brentwood partners agree that Mr. Brody can propose financing the online furniture store, but they decide it shouldn't be on generous terms. A few days later, Mr. Brody calls Mr. Busey with his offer: $5 million in cash for about a 50% stake in the company, valuing Mr. Busey's business at just $5 million before the investment. That is barely one-third the valuation Mr. Busey was hoping for.
'The Best I Can Do'
Mr. Busey is surprised and disappointed. "That's too low!" he says. Mr. Brody raises his valuation to $8 million, which would lower Brentwood's stake, and says: "That's the best I can do." Mr. Busey says he wants some time to think it over.
Meanwhile, Benchmark Capital has been chatting with Mr. Busey. It, too, is intrigued by the potential to sell furniture online. Benchmark has made a whopping $4.2 billion paper profit on its original investment of less than $5 million in eBay. Now its partners are making some of the boldest financing offers to Internet start-ups.
Benchmark Capital
(www.benchmark.com)
Within a day, Mr. Busey has a counteroffer from Benchmark. He won't disclose the terms, but he says they are somewhat better for him than the Brentwood proposal. He accepts and begins doing all the things needed to turn his sketch pad into a real business. He hires several Web-site designers and starts working with Benchmark to recruit board members. He also negotiates an office lease, so the fledgling company can move out of a loft in his home.
Mr. Brody expected to feel a twinge of bitterness or at least regret at the loss of the deal. To his surprise, though, the biggest emotion he has felt since Mr. Busey turned down his offer earlier this month is relief. The online furniture business represented one of the bigger gambles of his venture career, he says. It was a chance to make a lot of money, but it also carried the risk of trying to sort out an investment in an industry he doesn't understand well. "I really wasn't sleeping well for a while," he says. "I'm sleeping better now."
At Benchmark, meanwhile, partners don't show the least hesitation about their latest investment. "We're going to build a great company," declares Benchmark partner David Beirne. "We believe we're very close already." |
