THE NET'S NEXT ERA: VCs Go Back to the Future
NOVEMBER 14, 2001
It's not that funding is unobtainable, just that entrepreneurs must pitch harder and settle for less -- particularly Web-related startups
Former RealNetworks' (RNWK ) executive Sujal Patel's timing could not have been worse. Just as venture capitalists began turning off the money flow to Internet startups in 2000, Patel came up with the idea for a new company based on an opportunity he had spotted in data storage.
His concept: Most Web sites featuring so-called rich media content lack the storage architecture to handle the streaming media and music files that often draw large numbers of Web surfers. Many news sites found that out on September 11, as millions of people tried to downloaded video footage of the terrorist attacks on New York and Washington and their sites froze.
Patel was certain long before September 11 that he could beat this problem. What concerned him was the ability of his startup, Isilon Systems, to crack a venture-capital market that had grown profoundly skeptical of most Web-related business plans. Isilon began its search for seed money in January, 2001. After eight months of negotiating, it finally secured $8.4 million -- a small sum compared with what it might have scored 18 months ago and perhaps 25% to 30% of the amount Patel will eventually need to get his product to a wide market.
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"BACK TO BASICS." "It's a very difficult environment," says Sharon Wong, Isilon's director of marketing, whose seasoned perspective also makes the altered conditions of today somewhat easier to accept. "I've had a long enough career to remember what VCs used to be like before the boom of 1999," she says, adding: "This is not a huge disappointment as much as it is the VC market getting back to basics."
A year after the great Web gravy train ran off the rails, Isilon's experience sums up the environment in which Web entrepreneurs must now operate: While money is still available to nurture and develop a great idea, that cash is harder to find and comes in much smaller installments. According to the National Venture Capital Assn., VCs invested $7.7 billion in 873 companies in the third quarter of 2001, down 73% from the all-time high recorded in the same period a year ago (see BW Online, 11/12/01, VCs Remain in Low Gear").
Activity declined even though the industry holds more than $45 billion in "overhang" -- venture-capital jargon for the unprecedented amount of uninvested capital, says Laura Jennings, an Atlas Venture partner in Seattle. One reason so much money remains unspent: Caution is now a way of life. Many wary VCs are valuing startups at 50% to 70% less than in 1999. Typical financing nowadays is in the ballpark of $2 million to $10 million for each round of investment, rather than $20 million to $50 million that was common in the boom days of 1999.
ONE REAL CHOICE. The VCs also are distracted: "Venture investors today are primarily focused on managing their current investments," says Brian Jacobs, a San Francisco-based partner with St. Paul Venture Capital. And they are managing aggressively, too. "There are three things we can do with a company we invest in," says Jacobs. "Take it public, sell it, or shut it down. Right now VCs can't take much of anything public, it's difficult to sell anything -- so many companies are being shut down."
The moribund IPO market is the main culprit. More than just the slowing economy, spectacular e-commerce failures, such as grocery-delivery business Webvan and online gift-certificate company Flooz, have made investors skeptical of Internet startups. And the wariness isn't confined to the Internet. According to IPO.com, September, 2000, was the first month since 1975 in which not a single IPO came on the market. That was down from October's already anemic seven, says Kyle Huske, an IPO.com analyst.
While telecom, software, and optical networking have been major beneficiaries of investment in 2001, Internet outfits continue to represent the largest concentration of venture funds. In many cases, however, that isn't a vote of confidence so much as a glum reflection of the harsh new realities: The cash is staying put simply because it's stuck. According to Huske, it could take five years or longer for many VCs to cash out of their Net investments. In 1999, by contrast, many VCs expected to cash out in less than three years.
TEAM PLAY. With the IPO market so slow, VCs are looking for other ways to exit with a profit -- maneuvers such as as management-led buyouts or selling to a larger company, Jacobs says. They're also teaming up with other private-equity firms before investing.
Consider startup Ecast, which is developing Internet "jukeboxes" that play music and games using a broadband connection. Ecast had St. Paul Venture Capital as the lead investor in a $12.4 million follow-on financing in September -- in which three other VCs were also involved. "Typically the lead investor is looking for all others to participate in the later rounds," says Ecast CEO Mouli Cohen. "We were able to get everyone to open their checkbooks, and that was very important."
Ecast may have benefited mightily from its broadband connection. "We're still early in the rollout of broadband, but we feel that it represents an inevitable wave -- a major investment opportunity," says Michael Gorman, general partner for St. Paul Venture Capital, which is in Minneapolis. "I think of broadband in the same way we thought of wireless communication several years ago. It went from something new and fascinating to just part of what you expect people and businesses to have."
So here's how it works these days: The right company with the right technology and management in a potentially hot market is going to get a reasonable amount of money -- but probably not much more than it needs to achieve liftoff. That's venture capital today -- the way it was before the Internet bubble began to inflate.
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By David Shook in New York
Copyright 2000-2001, by The McGraw-Hill Companies Inc. All rights reserved.
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