>>07/26 09:19
Venture Capitalists Sit on $100 Billion, Startups Beg for Cash
By Joel Dreyfuss
Menlo Park, California, July 26 (Bloomberg) -- Rodrigo Flores, 39-year-old founder of software startup newScale Inc., is making a $15 million pitch.
Flores clicks through his PowerPoint slides as a dozen venture capitalists in the Menlo Park, California, offices of New Enterprise Associates (NEA) fire questions at him. Another 10 in Baltimore are connected by video.
The probing has a single purpose: to make sure that the product Flores is selling -- technology to improve various office systems for customers such as Starbucks Corp. and Hewlett-Packard Co. -- will continue to have buyers.
And it reflects the new reality of the venture capital business: a focus far more intense than in the recent past on the details of making a business work -- and on making sure dollars are being well spent.
The glitter is gone from Sand Hill Road, which runs through Menlo Park south of San Francisco and serves as the home of many of the venture capital firms that financed the technology boom of the 1990s.
Officials at several high-profile firms, including Barksdale Group and Octane Capital Management, have said they will not raise another fund. A dozen other firms have reduced the size of their funds.
One of them, Benchmark Capital, has said it will invest only $500 million of the $750 million it raised in 2000 for its first European fund.
81 Percent Less
In the first quarter of this year, U.S. venture firms invested $5.1 billion -- 81 percent less than the $27 billion they spent in the first quarter of 2000, according to VentureOne Corp., which tracks private equity spending.
``The venture business cycles between greed and fear,'' says Charles Newhall, a cofounder and general partner at NEA, one of Silicon Valley's most active venture firms. ``We are clearly in the fear cycle.''
Venture funds returned net profits of 273 percent in 1999 and 31 percent in 2000 to limited partners -- the institutional investors and private individuals who provide most of the capital for venture funds. Last year, the funds posted a net loss of 39 percent, according to Cambridge Associates, which tracks fund performance.
With such results, the limited partners, who usually have no say on investment strategy, are less willing to be passive investors.
`Numbers Transparency'
``We like to talk to our (venture) partners monthly,'' says Rick Hayes, senior investment officer for private equity at the California Public Employees' Retirement System, the largest U.S. pension plan. ``We like to see numbers transparency -- especially in tough times where relationships are made stronger.''
Venture firms have often cashed out of investments by taking their companies public or selling them to larger companies. With the Nasdaq market down 75 percent on July 25 from a high of 5,049 on March 10, 2000, there are few opportunities for initial public offerings.
Just 16 IPOs worth $1.6 billion took place in the first quarter of 2002, according to Venture Economics; in the first quarter of 2000, 129 offerings brought in $12.4 billion.
Venture firms are holding on to lots of cash. According to PrivateEquityCentral.net, a Web site that tracks venture spending, the funds have $106 billion in the kitty.
``There's a good bit of dry powder from funds raised in 2000 and 2001,'' says Charles Froland, head of private equity for General Motors Corp.'s pension plan. ``There's plenty of capital available.''
Firms Remain Cautious
Still, the firms remain cautious. ``How long are we going to be in this nuclear winter?'' asks Ron Kase, a general partner in NEA's Menlo Park office, a modern two-story building nestled in the low hills along Sand Hill Road. ``People say two years; it could be three, four or five, and you need to have the staying power.''
One place to glimpse the new mood of U.S. venture capital is NEA's weekly partners meeting, a rambling, informal affair sometimes lasting three or four hours.
It starts at noon eastern time, or 9 a.m. in California. The East Coast partners -- based in two 110-year-old town houses near downtown Baltimore -- wander in and out of their wood-paneled conference room to grab a catered lunch of grilled chicken breasts, salad and fruit.
Coffee and Water
By the end of the meeting, the California partners are eating lunch while those in Baltimore and in a third office in Reston, Virginia, are nursing cups of coffee or bottles of water.
Most of the partners and associates attend the weekly meeting at one of the three offices. Partners on the road sometimes join in by phone. The general partners, who have legal responsibility for the firm, all vote on deals; partners, who are a step down on the management chart, along with less senior principals and associates, get to voice their opinions and aren't allowed to vote.
NEA has a staff of 27, comprising 11 general partners, a founding partner, seven partners, three principals, four associates and two administrators. One general partner has left, and two lower-ranking partners and two associates have been added since 2000. The firm gets about 90 proposals per month -- two- thirds fewer than than the 250 a month in 2000.
At a partners meeting in May, Managing General Partner Peter Barris, who's in charge of the day-to-day operation of the firm, pushes the group through a half-inch-thick stack of status reports on many of the 220 active companies in NEA's portfolio.
Show of Hands
He calls for votes -- carried out by a show of hands or a brief response -- and records them for the minutes and tries to cut through the banter, asides and comments.
Newhall, 57, a gregarious man with thinning hair, urges bigger and riskier bets. ``It must be his medication,'' jokes Sigrid Van Bladel, 36, one of two female partners in the company.
Newhall sometimes calls her ``the billion-dollar babe'' because of the funds she has at her disposal.
The firm's current fund, raised in October 2000 and its 10th, is called NEA 10. With $2.3 billion to invest, NEA 10 is one of the largest venture funds, and the firm has funneled more than a third of it into health and information technology startups.
`The Fear Cycle'
``I prefer to invest in the fear cycle,'' says Newhall.
Last year, NEA was the most active venture firm, with 84 deals, according to VentureWire, a newsletter that tracks venture activity.
In the period from Jan. 1 to June 14, NEA tied for No. 2, with 32 deals -- behind J.P. Morgan Partners' 35. NEA made 134 deals in 2000, its most active year.
Unlike firms that set a flat annual fee of 2-2.5 percent of total capital, NEA submits to a committee of its largest investors an annual budget that includes salaries, fees and operating costs.
``We behave like a corporation with a board of directors,'' says Barris, the managing general partner.
Bondurant French of Adams Street Partners, which manages $5 billion for institutional investors, says NEA's annual management fee is less than 1 percent of the fund.
For NEA 10, that would mean an annual budget of about $20 million. French has been an NEA limited partner for 16 years and serves on the NEA investment committee.
The firm pays all general partners the same annual salary. Lower-ranking partners and associates also are on salary. There are no bonuses.
Accrued Interest
Most members of the firm share in the profits or accrued interest left after limited partners have recovered their capital and profits. ``NEA's upside is entirely on the performance of the fund,'' says French.
Like most venture firms, NEA will not disclose its profit ratios. Barris says the firm's results have consistently been in the top quartile of all venture capital firms.
Some of the numbers can be gleaned from comments before a state of Washington investment committee in September 2000, when the state was considering investing in NEA 10.
A consulting firm told the state committee that NEA's eighth fund, a $565 million pool raised in 1998, had an internal rate of return -- the annualized return on investment -- of 280 percent at that time.
NEA's seventh fund, a 1996 pool of $310 million, had an IRR of 102.1 percent, according to Brinson Partners Inc., the consultant to Washington State.
Triple-Digit Returns
Such triple-digit results may be a distant memory. NEA cofounder Newhall says he can deliver net returns to limited partners in the ``mid-20s on NEA 10.
Most venture firms spent the past year ridding their portfolios of dead companies, especially the dot-coms that had no hope of becoming viable businesses.
NEA, which had never put much money into dot-coms, has pruned its portfolio anyway. ``We've gone through a cleansing process,'' says Barris.
The firm pulled out of 21 companies last year -- including Pathnet Telecommunications Inc., based in Reston, and Norigen Communications Group Inc., based in Toronto -- compared with just three the year before.
So far this year, NEA has closed two software companies to get down to 220 active investments. Barris won't disclose how much money the firm has written off; he estimates that the industry as a whole has written down about 50 percent of its recent investments.
$155 Million Fund
NEA had to raise a $155 million fund last year to provide additional support for companies that received money from its 1998 fund. Venture investors do not like to use money from new funds to support companies originally supported under earlier funds, because it suggests that new money is being used to prop up old deals.
The firm invested $186 million in 23 new companies last year, and it has also anted up $396 million in follow-up deals. As of June 30, NEA had put $102 million into 16 new investments and $186 million into existing companies. NEA takes 25-30 percent of the profits when companies go public or are sold.
Rodrigo Flores's company, newScale, got $13 million from NEA and another venture capital firm last year. Flores's pitch at this past spring's NEA partners meeting is for a B round, or second step, investment.
The Initial Worry
Once his 60 minutes are up and he leaves the meeting, the partners discuss his prospects. The initial worry: possible competitors in the form of players such as SAP AG, Siebel Systems Inc. and PeopleSoft Inc., which make similar so-called enterprise software aimed at streamlining certain office activities like arranging a conference call or ordering and setting up a computer for a new employee.
The consensus in the meeting is that Flores has enough of an edge. One partner asks how big newScale can get.
The group discusses whether it's a $20 million-$30 million business or a $90 million-$100 million business.
``I think this has the potential to be a new category of enterprise service,'' says Mark Perry, a general partner who sits on newScale's board.
The partners are trying to spread their risk. In the old days, before the dot-com meltdown, many firms stopped syndicating their deals to other venture companies.
$6.5 Million to Break Even
Perry is talking to several other firms about newScale. Flores said he needed $6.5 million to break even; the partners want to make sure he is funded well enough to succeed. They agree to seek another venture investor who'll split a $9 million round with NEA.
Getting an outside partner for the second round is important. When the IPO market died and many of NEA's companies came looking for more money, the firm revised its rules.
Traditionally, all deals required a general partner as a sponsor or advocate and the support of a simple majority of six general partners. Now, if there's no new outside investor for a follow-on round, there must be a second sponsor within NEA for the deal and two-thirds of the partners must support it.
At one Monday meeting, a company called Pharmion Corp. gets an hour to make its case. Pharmion is a new breed of pharmaceutical company: a specialty firm with a catalog of products either orphaned by mergers and acquisitions or discarded because large pharmaceutical companies think the potential market is too small.
Experienced Managers
CEO Patrick Mahaffy and his team are experienced managers. He led NeXstar Pharmaceuticals Inc., a small pharmaceutical company, to $120 million in sales and sold it in 1999.
NEA is a prominent investor in health care and already put up $20 million during Pharmion's early rounds. Mahaffy, who's raised $90 million so far, is looking for another $35 million.
NEA's partners are generally upbeat about Pharmion. ``You can buy products that are already on the market but not getting the attention they deserve,'' says Sigrid van Bladel, who specializes in health care. She has a Ph.D. in molecular biology and an MBA from Stanford University. ``If you have a specialized sales force to promote these products, you can actually increase sales dramatically,'' she says.
Poor Results
The health care business suffered from poor results from 1998 to 2000 compared with information technology. Van Bladel, 36, says three of the seven NEA partners involved in health care switched to information technology during the boom years:``All health care sectors were doing so badly, and those in technology were doing mind-bogglingly well.''
She says the firm considered abandoning health care completely. ``We committed to stay in it after a lot of soul- searching, and now we're happy that we did,'' she says.
Around the table, Newhall and Jim Barrett, a former biotech executive, are advocates of a deal with Pharmion.
Other partners dwell on the biggest risk: some of the products are still awaiting U.S. Food and Drug Administration approval.
Mahaffy expresses confidence the results will be positive. After he's left the room, Newhall and Barrett suggest putting up as much as $20 million.
Weakened Blood Vessel
Another health startup also gets a hearing on the same day. BioCure Inc. has acquired rights to a gel that can be injected into an aneurysm -- a bulge in a weakened blood vessel -- to prevent rupture.
The new product promises to add to the growing arsenal of noninvasive treatments that can be given without performing major surgery. In keeping with their more pragmatic attitude, the partners focus on the bottom line.
``What kind of profit margin do you get?'' asks one partner. ``Eighty-seven percent'' is the answer from CEO Adrian Hunter.
There's a ripple of approval, until all realize marketing costs haven't been taken into account.
Negotiations after the meeting bog down. NEA and BioCure can't come to terms on what the company is worth and, therefore, how much of it NEA will end up owning.
Later, Barrett expresses confidence that Pharmion will sail through the regulatory process. ``They have a very strong clinical development group,'' he says.
`A Group That Large'
Mahaffy says the process of presenting to NEA was intimidating. ``It isn't often that I end up presenting to a group that large,'' he says. ``Only a few investment funds ask you to present to all the partners.''
In the end, NEA backs most of its bets with money. NewScale gets $9 million: $6 million from NEA and $3 million from Crosslink Capital, a San Francisco venture firm.
Pharmion also wins the support of the firm; NEA will put in $13 million of the $35 million that the pharmaceutical company needs.
The news is bad for BioCure; talks about how much the company is worth have bogged down.
BioCure may have to look elsewhere for money. NEA will press forward, doling out chunks of its fund -- carefully.
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