Venture Capital, Withering and Dying
Sunday October 21, 2001
The New York Times
By AMY CORTESE
<<RICHARD THOMPSON and Larry Braitman made a fortune on Flycast Communications, an Internet advertising services company they founded in San Francisco in 1996 and sold about three years later to CMGI (news/quote) for $689 million.
It was a classic tale of success in the Internet age, and the two men decided — in the peculiar vernacular of the Web — to leverage their success at starting Flycast by creating a venture capital firm to finance other new technology businesses.
Just as the 20th century gave way to the 21st, they opened Signia Ventures on the fifth floor of a midrise office building in San Mateo, Calif. Mr. Thompson, 47, and Mr. Braitman, 43, put up $50 million of the money they received for Flycast and st and big institutions to finance Internet start-ups or small biotechnology companies — then hitting jackpot after jackpot by selling stock in those companies to insatiable investors.
Ted Dintersmith, a general partner at Charles River Ventures, a 30-year-old firm in Waltham, Mass., compared it to a baseball game where "suddenly they moved the fences in to 125 feet" from 330 or more. "There were a lot of pop-ups that suddenly were home runs," he said.
Today, the fences that venture capitalists are swinging for might as well be 550 feet away. With some market indexes off 50 percent or more and with uncertainty growing after the terrorist attacks on Sept. 11, investors have become much more discriminating. That has made it nearly impossible for venture capitalists to use the stock market to cash out of their speculative investments. So far this year, 29 venture-backed companies have tried initial offerings, compared with 252 in 2000. There are also fewer mergers and acquisitions.
As a result, many venture-capital newcomers have sharply reduced their investments, closed offices or shut down. Even Kleiner, Perkins, based in Menlo Park, Calif., and other established firms have slowed the pace of their investments after watching an unusual number of their companies go bust in the last two years. "There's not a lot of good news today in the venture business," said James W. Breyer, managing partner at Accel Partners in Palo Alto, Calif.
VENTURE capitalists, once the celebrated rainmakers of the new economy, now seem adrift. Elbow deep in troubled deals, they are pruning their portfolios, closing companies whose prospects are dim and concentrating instead on the handful that they think can survive a long downturn. The few investments they are making are usually in traditional software and health care.
In turn, the innovative technology sector, which had been the engine of growth, has been throttled back, and many promising but risky companies are either dying from lack of cash or hibernating until the market recovers. That is not good news for the economy. Last year, companies financed with venture capital since the 1970's accounted for 5.9 percent of the jobs in the United States and 13.1 percent of economic output, according to a study to be released tomorrow by the National Venture Capital Association, a trade group.
Venture capitalists point out that their business is cyclical and that they have been through down cycles before, as when a boom fueled by personal computer makers and suppliers limped to a halt in the late 1980's. But at the peak of the PC boom in mid-1983, venture capital under management was just $10.8 billion. Now, more than $200 billion is under management, so a downturn's magnitude is much greater — and the reverberations felt more widely.
Venture capital investors themselves — entrepreneurs like Jim Clark and Michael Dell and athletes like Wayne Gretzky and Andre Agassi, not to mention pension funds and endowments — are seeing their capital shrink and their profit distributions dry up. Cash and stock payouts from these funds fell more than 80 percent in the first six months of the year, compared with the same period of 2000, according to Venture Economics, a firm that tracks venture capital.
As their returns shrivel, limited partners are growing disenchanted with what some call excessive management fees. Ominously, they are sometimes balking at their commitments to put more money into funds.
Venture capital funds lost 18.2 percent, on average, for the 12 months ended June 30, according to Venture Economics, while Internet-specific funds were down 27.7 percent. The triple-digit returns, on paper at least, that venture capitalists were promoting as recently as last year have melted away. "Everyone in this industry is hurting big time," said Tom Crotty, a partner at Battery Ventures in Wellesley, Mass.
That is especially true of the newcomers — the investment bankers, corporations and entrepreneurs who jumped into the venture business when it was hot. Signia Ventures was hardly alone in closing: Octane Capital Management, a venture firm in San Francisco started in 1999, decided in April to close and to give back to investors what was left of the $265 million they had entrusted to the firm — about half their initial stakes. Primedia (news/quote), a magazine publisher based in New York, shut down its venture arm in early October. And Veracity Capital Partners — a firm started in January by professionals at Battery and BCI Partners, a private-equity firm in Teaneck, N.J. — disbanded after a few months when the founders realized that they would never raise $250 million.
"We were sick of banging our heads against the wall," said Mark Hastings, a co-founder of Veracity, who remains a partner at BCI.
Even the established firms have not been spared.
"Everyone has bad deals," said Bud Colligan, who founded the software maker Macromedia (news/quote) and is now a partner at Accel Partners, an 18-year-old venture firm. "The question is: Do you have 50 percent bad deals or 90 percent?" Mr. Colligan and Mitch Kapor, another Accel partner, recently decided to stop investing in new companies and to focus on their existing portfolio.
Most vulnerable are funds that were raised and invested at the height of the bubble, in 1999 and 2000, when 70 percent of all high- technology venture capital for the last two decades was invested. The competition for deals was so fierce that venture capitalists virtually threw money at start- ups, many of which had no clear plan for making money. Some venture capitalists also invested large amounts in companies that were about to sell stock, in hopes of quick profits when the stocks started trading; that aggressive strategy cost them dearly when investors turned their backs on such shares.
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That is not to say that all venture investments made in the last few years were bad. It is still too early to calculate performance in such young funds, and one big hit could more than compensate for many duds. But the sheer volume of deals and the high valuations at which they were made all but assure that the crop of venture capital funds invested in the last few years will be among the worst-performing ever.
"Money invested in 1999 and 2000 is not going to do very well," said Clint Harris, a managing partner at Grove Street Advisors, which makes venture capital investments for the California Public Employees' Retirement System, called Calpers.
Funds started at that time are not all that are at risk. So are the firms created in those years to ride the momentum. One firm that epitomizes bubble investing is Technology Crossover Ventures, created in 1995 to capitalize on the investment opportunities of the Internet. A news release dated April 4, 2000, just days before the bubble burst, announced TCV IV, a $1.6 billion fund that, the release said, was "the largest-ever fund for Internet investing."
The firm's investment model called for it to invest in public and private companies at various stages of development. The model relied heavily on a thriving stock market to let the fund cash out quickly; as the markets turned sour, so did the firm's performance. TCV IV has invested only half of the money it raised and could still do well. But TCV's $380 million Fund III, raised in late 1998, worries at least one investor, who said "it will be a struggle" for it to return any cash.
THE Softbank Corporation is also paying the price of promiscuous investing. The company, which made a name as an early investor in Yahoo (news/quote), created the $606 million Softbank Technology Ventures V fund in 1999 and invested quickly, only to have nine Internet companies in the fund go bust. Among the losers were DoDots Inc., which ate up $7.5 million of the fund's cash; and Urban Media Communications, which burned through $30 million. As of the end of last year, the fund had lost 29.8 percent of its value, said Steve Lisson, the editor of InsiderVC.com, a Web site that tracks venture capital. As of March 31, the fund was near the bottom of 136 funds ranked in a report for the State Universities Retirement System of Illinois.
Other Softbank funds were heavily invested in prominent duds like Webvan, the grocery- delivery company that closed in July; Kozmo.com, a home-delivery service that burned through $280 million before closing in April; and AllAdvantage, a site that paid members to surf the Web and shut down in early February. In September, Softbank Europe Ventures said it would close some offices and abandon plans for a new $600 million fund. It returned $200 million it had raised for that fund.
Another loser in the State Universities ranking was the Summit Accelerator Fund, started in 1999 by the private equity investor Summit Partners in Boston. That fund was down almost 19 percent on March 31.
Few firms escaped unscathed, regardless of experience. Benchmark Capital Management rewarded investors in its earlier funds with winners like eBay (news/quote), the auction site, and Ariba, which lets businesses buy supplies online. But it also backed some bombs, including Webvan, an online furniture seller called Living.com and an online sporting goods retailer, MVP.com, that was also backed by Michael Jordan, John Elway and other professional athletes. All three businesses have closed.
Benchmark has wiped any trace of Webvan off of its Web site, but that deal and others are memorialized in "eBoys," by Randall E. Stross (Crown, 2000). The book glorified the firm's six towering partners, who averaged 6 feet, 6 inches tall and included the venture newcomers David Beirne, who joined from the recruiter Ramsey Beirne, and Bill Gurley, a former Wall Street analyst. At least Benchmark got off relatively easy: it invested $3 million for 12 percent of Webvan, while later investors, including Sequoia Capital, paid $53.5 million for roughly the same stake.
Kleiner, Perkins, Caufield & Beyer, among the most renowned venture capital firms, has had a string of start-ups go awry. One was Kibu, a Web site for teenagers started in 1999 with $22 million from Kleiner and Mr. Clark, a founder of Netscape; Kibu closed last fall. Another was Coreon Inc., which sold broadband services; it laid off its remaining staff and is returning some of the $73 million it raised from investors in February. A third, BroadBand Office, which provided high-speed Internet access to buildings, filed for Chapter 11 bankruptcy protection in May and has since merged with Yipes Communications.
"They have a lot of dead wood like everyone else," said an executive at a pension fund that invests with Kleiner, Perkins. The executive, who like others with money in venture funds agreed to be interviewed only if not identified, added that he would not be surprised if Kleiner funds raised in 1999 and 2000 had single- digit returns this year. In the recent past, some Kleiner funds have doubled or even tripled investors' money — on paper — in a single year.
Vinod Khosla, a partner at Kleiner, Perkins who spotted winners like Juniper Networks (news/quote), which returned 5,000 times investors' capital, said venture capitalists assume that some decisions will not work out. "If things don't fail," he said, "it means we are not taking enough risk."
Indeed, venture capitalists like Mr. Khosla contend that now is an excellent time to invest in start-ups. And venture capital firms have about $75 billion in cash that they have raised but not yet invested.
Mr. Khosla, for his part, favors technologies that can help companies reduce costs or increase productivity. With the threat of terrorism, security software and hardware are popular with venture funds, as are life-sciences companies.
Money is also available to companies with new ideas. One is Groove Networks, a maker of software that helps a company's employees converse electronically and share documents instantly with suppliers and customers. Partly on the reputation of its founder, Ray Ozzie, the creator of the Lotus Notes program, Groove raised $54 million earlier this month from Microsoft (news/quote) and Accel.
But many venture firms need to clean up their mistakes. While a lot of investments have already been written down — some to zero — people in the industry say a number of firms are still carrying deals on their books at older, inflated values.
"There was so much activity and so much excess in the last two years it will take several years for the system to work through the excesses," Mr. Breyer of Accel said. "We'll see a decrease in the number of V.C. firms as well as the number of venture capitalists."
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That is already apparent on the fringes of the business, which swelled to more than 1,000 firms at the end of last year, more than twice as many as in 1995. Fewer corporations invest through venture capital arms started just a few years ago, and "incubator" firms that invested in, advised and sometimes gave office space to start-ups are less accommodating.
Despite a handful of closings, like those of Signia and Veracity, many venture firms are unlikely to start boarding up their airy offices on Sand Hill Road in Palo Alto, the Park Avenue of venture capitalists. Venture funds are set up as limited partnerships to last at least 10 years. So even if there is no new activity at a firm, venture capitalists can linger for years on management fees — typically 2 percent annually — without generating a dime in profits.
Instead of closing quickly, venture firms in trouble are likely to become unable or unwilling to raise funds, and to have their star performers leave for better opportunities.
For now, the law of the venture jungle may be survival of the fattest. Venture capitalists who have raised $1 billion or more in recent months will have a better chance of surviving the slump. This year alone, nine firms — including New Enterprise Associates, Battery Ventures and Greylock in Boston — raised at least that amount. That should see them through the next couple of years; most do not expect to try to raise more money until 2002 or 2003. Stewart Alsop, a New Enterprises partner, said his firm might not even ask investors for all of the $2.2 billion they pledged to its latest fund.
Despite the capital raised in the last few years, some firms burned through cash like reckless start-ups, investing hundreds of millions of dollars in a matter of months. New Enterprises was the bubble's most prolific investor, backing a total of 122 deals in 1999 and 136 in 2000, according to VentureOne. As a result, New Enterprises and others are going back to investors to raise annex funds — also called bailout funds — to keep their investments afloat.
Firms seeking to raise more money may find a less-than-enthusiastic reception. The downturn and the undisciplined investing of the past are testing the ties between venture capitalists and their investors. Some venture capitalists have sued limited partners who threatened to default on capital commitments, which they promise up front and pay over several years. Although that is rare, Jonathan Axelrad, a lawyer at Wilson Sonsini Goodrich & Rosati in Palo Alto, said the rate of limited- partner defaults was "unprecedented." The firm, he said, is handling several such cases.
SOME investors, meanwhile, complain privately about the fees charged by venture capitalists. In a 10-year, billion-dollar fund, operating costs alone can be $200 million. On top of that is the "carry," the portion of profits that venture capitalists receive — as much as 30 or even 35 percent. More than a few limited partners have concluded that their interests may be at odds with those of the fund managers.
Low returns and high fees are leading many big pension funds and endowments to consider reducing their investments in risky businesses like venture capital. "The fund-raising market is extremely difficult right now and getting worse," said Mr. Harris, the Grove Street partner.
As one endowment manager explained: "So many of our firms raised a lot of money ending a year ago and have not come back since the world changed. Some we are worried about. When they do come back, we will give it a hard look and may choose to end the relationship.">> |
