To fund a PowerPoint: Bucking the trend, some VCs still target early-stage startups
thedeal.com
by David Shabelman And Andrea Orr
June 16, 2008 - The time has never been better to invest in very young technology companies, but that doesn't mean it's easy.
That's one reason why most venture capitalists tend to focus on larger, less risky investments, where markets are more defined and opportunities more obvious. Yet several firms are placing all or a substantial part of their bets on early-stage startups, many of which have not progressed far beyond the concept stage.
These VCs must be prepared to fail, even more so than those who focus on investments beyond the Series A. Some firms, like the venerable Sequoia Capital, even wear failure as a badge of honor. Huge exits are rare, but the attraction of early-stage investments is obvious. For one, investments of less than $1 million can now quickly take a product from an idea to launch, making it far easier to discern whether the concept can gain traction or is destined for the dustbin.
"Software is nearly free, bandwidth is cheap, there's outsourcing and offshoring for engineering resources and people don't have to spend $1.5 million for Sun and Oracle equipment and the data center," says George Zachary, a venture partner with Charles River Ventures. "It's brought a $2.5 million Series A round of funding down to $250,000 seed funding."
The payoffs can be handsome. Madrona Venture Group, for example, participated in a $1.5 million Series A for a company that was little more than a university research paper about predicting airline prices. The startup evolved into Farecast.com, which was acquired by Microsoft Corp. for a reported $115 million in April.
Several other firms have achieved similar success or are actively hunting for it. Tech Confidential looks at a baker's dozen of technology-focused VC firms with an eye for the early stage.
Accel Partners
From the digital media provider RealNetworks Inc., which went public in 1997, to the highly valued and enormously popular social networking site Facebook Inc., Accel Partners' Internet investments have represented some of the most transformative technologies and services.
Palo Alto, Calif.-based Accel has always included seed investing as part of its early-stage strategy and three years ago launched a concerted effort to do more of this in consumer Internet and online gaming. Partner Theresia Gouw Ranzetta says the increased focus on seed investments is a nod to the mileage a young company can get on $500,000 as well as the ability to get quick user data feedback from startups' sites that are up and running.
Still, this preference for seed investments will not bar Accel from investing in a promising later-stage company. Case in point: Earlier this year, Accel stepped in at the Series D level of funding for Etsy Inc., a three-year-old online marketplace for buying and selling homemade goods. That $27 million funding round exemplified how even businesses that have gained traction on a shoestring budget conclude that a fat later-stage round can help accelerate their expansion. While Etsy had completed three prior funding rounds by the time Accel stepped in, its management had been opposed to accepting too much venture capital and had raised just $5 million in all of its prior rounds.
Ranzetta says that competition among venture firms to get in on the best early-stage investments is intense, though it still doesn't quite compare to the frenzy of 1999.
Bessemer Venture Partners
If it takes a lot of self-assurance to be able to own up to your failures, then Bessemer Venture Partners is oozing confidence. The 97-year-old global firm, with offices in Menlo Park, New York, Bangalore, India, and Shanghai, prominently displays on its Web site a list of companies -- including eBay Inc., Google Inc., Cisco Systems Inc. and Apple Inc. -- that it declined to invest in over the years.
Bessemer calls the list its "anti-portfolio" and notes that its long history has afforded it "an unparalleled number of opportunities to screw up."
Laughs aside, the list illuminates the fact that success need not hinge on participation in one key deal. While Bessemer missed out on many of the most successful exits, its 2003 gamble on the then little-known Skype Technologies SA paid off big when eBay Inc. acquired the Internet-based phone service for a staggering $4.1 billion in 2005.
A number of Bessemer's top Internet exits, however, date back to the Web 1.0 days, including HotJobs.com Ltd., which went public in 1999 and was later acquired by Yahoo! Inc., as well as eToys, the online toy store that completed an IPO in 1999 but later went out of business.
These days, Bessemer is investing more selectively in consumer Internet companies as part of a broader portfolio that includes biotech, networking and software businesses and is growing increasingly focused in overseas investments. Last summer, it earmarked $1 billion for investments in India.
Still, it continues to see promise in U.S. Web 2.0 startups trying to change an established business paradigm, such as Zopa Ltd., a sort of eBay for banking that operates an online community where individual lenders and borrowers can connect with each other and set their own rates.
Charles River Ventures
Charles River Ventures established its successful and unique QuickStart seed-stage program for Internet companies in 2006, when it found the cost to develop Web-based companies had dropped significantly and the speed with which these startups could get to scale increased.
"We are seeing a lot of seeds where, at the completion of the round, you can see something with real customers," says George Zachary, a partner with Charles River Ventures, which has offices in Waltham, Mass., and Menlo Park.
QuickStart provides startups with $250,000 in the form of a loan, meaning there's no equity dilution, and companies can more easily stay in stealth mode since they can avoid any public filings.
So far the program has been an unmitigated success. Zachary says in the first year of the program, CRV funded eight companies, and six have since raised Series A rounds. Of the 11 it funded in 2007, four already have raised Series A funds.
Among the program's successes are BuddyTV, which builds online communities around popular television programs; Vlingo Corp., a mobile voice startup that just raised $20 million in a Series B round of funding led by Yahoo!; and Lookery Inc., an advertising network for social network application providers, including those on Facebook.
"We're looking for compelling entrepreneurs who can quickly tell us what they are, who are smart and to the point and can paint a large vision of what they are doing and why they can develop a breakout company," Zachary says.
First Round Capital
For First Round Capital, many of the 60 Internet companies that have been in its portfolio since its founding in 2004 were little more than good ideas.
"Most of the time we're funding [a] PowerPoint [presentation]," says Josh Kopelman, managing director with the firm. "It's an incomplete team, technology and business model. But for us we want to understand how the founder approaches the market."
The company's investments include 1-800-FREE411, MyYearbook.com and, most recently, online recruiting service Dayak Inc.
First Round aims to make 15 to 20 investments a year, with an average investment size between $400,000 and $800,000. This is often enough to get an idea to market, Kopelman says.
"The goal of a successful seed-stage investment is to take an entrepreneur's hypothesis, validate it, derisk it or disprove it as quickly and as capital-efficiently as possible," he says.
Kopelman has plenty of experience to draw on when sizing up an investment. He co-founded Internet information company Infonautics Corp. in 1992 while he was a student at University of Pennsylvania's Wharton School of Business. It went public four years later. In 1999, he founded Half.com, a fixed-price marketplace connecting buyers and sellers, which was acquired by eBay Inc. in 2000 for $350 million. In 2003, he co-founded TurnTide, an anti-spam company bought by Symantec Corp.
"I've been there and sat in their shoes," Kopelman says. "It makes it easier sitting on the other side of the table, to empathize and understand their emotions and the process."
Flybridge Capital Partners
David Aronoff, a general partner with Boston-based Flybridge Capital Partners, admits he isn't sure what the exact business model will be for Internet video-related companies, but he does know that startups that can help move and manipulate this kind of content will be valuable ones.
To that end, the firm, formerly called IDG Ventures Atlantic, participated in two rounds of funding for Blackwave Inc., a maker of Internet storage and delivery systems for video distribution, and Transpera, whose technology lets users send video from the Internet to their phone or vice versa.
"The Internet is changing consumption, delivery, preparation, the entire life cycle of video," Aronoff says. "We saw ... some that were terrific investments, but not terrific companies. The situation is a lot different now. Bandwidth capacity has exploded worldwide, and the price of that bandwidth is cheap."
The other major change driving the market for video delivery providers is quality content.
"The first time around there was no content. People were transmitting stuff of very little interest over a narrow band," Aronoff says. "Now you have professional, first-run content in terms of production and viewing technology."
But Aronoff adds there are too many companies doing similar things, and some parts of the sector are overfunded. Because broadcasters are still looking at finding the right model, they're experimenting with a number of companies, making it difficult to predict which ones will be widely adopted. Because of those issues, he says VCs are seeking later-stage deals to reduce their risk.
"I'm just trying to get as educated and as smart as I can," he says. "Some of it is backing great people with unique insight and unique relationships. But in some situations, we'll look to see how the race is going and be willing to pay up."
Greycroft LLC
With offices in New York and Los Angeles, Greycroft invests between $500,000 and $3 million in digital media companies at inception, increasing on a staged basis to double that amount over time. The firm, started in 2006 by Alan Patricof, an early investor in Apple Computer and AOL, raised $75 million for its fund and has invested in nearly two dozen digital media companies.
Among its investments is influential political blog The Huffington Post; digital media firm paidContent.org; advertising infrastructure software maker WideOrbit Inc., which announced a $14.5 million third round of funding in February; online ad network Collective Media, which focuses on high-end publishers, such as the Tribune Co. and Buzzd, an entertainment listings service offering both branded editorial content and real-time user content that closed a reported $3 million round of Series A funding in April.
Madrona Venture Group
The best VCs don't wait for the business plans to arrive at their doors, but the growing pressure to invest at a very early stage means that more companies are getting funded before they have a formal business plan at all.
Madrona Venture Group of Seattle says that one of its best investments was in a company that was so embryonic it was little more than an academic research project.
In 2004, Madrona participated in a $1.5 million Series A round of a company that at the time called itself Hamlet Inc.
"It was literally a research paper from the University of Washington about predicting future airline prices," recalls Madrona managing director Greg Gottesman. "We were willing to go in at that stage."
Hamlet later changed its name to Farecast and built a site to help consumers outsmart the airlines' cumbersome ticket pricing system by predicting when prices were most likely to be low. In April, the company was acquired by Microsoft Corp. Although the deal price was not disclosed, sources quoted a price tag of $115 million, more than 4 times the $21 million Farecast had raised over three venture rounds.
"Our biggest competitors are not other VC firms, but self-funded deals," says Gottesman, who works to illuminate potential investments about the value VCs offer beyond cash. Madrona typically strives to be the first to provide institutional capital to a startup but, after that point, syndicated deals are the preference.
"We don't think we have a monopoly on brains," Gottesman says.
Among Madrona's other successful investments was the networking site Classmates Online Inc., which Internet service provider United Online Inc. acquired in 2004 for $100 million.
Milestone Venture Partners
Focused on startups on the East Coast, New York's Milestone Venture Partners invests in companies in media and marketing services, and healthcare and financial services information technology. It has $65 million under management and typically invests $1 million to $1.5 million in an initial round, holding an equal amount for follow-on investments.
Partner Edwin Goodman says his firm tends to be fairly conservative with the four to five investments it makes per year. The startups typically are post-revenue, though still losing money, are capital efficient and require less than $5 million to achieve profitability.
"Most of the companies we're in, if we do our job properly, they're solving some critical problem for companies and are fashionable in all times," Goodman says.
Among Milestone's portfolio companies are TargetSpot Inc., an advertising platform for online radio that closed an $8.6 million round of funding in March; M5 Networks, a provider of VoIP phone systems for small- to mid-sized businesses; online neighborhood news and information site Outside.in, which closed a $3 million round of financing in May; and GenomeQuest Inc., a maker of enterprise genomic search technology.
Mohr Davidow Ventures
There is no such thing as a killer app; there are only potentially good ideas that might become great businesses in the right hands. Mohr Davidow Ventures of Menlo Park, Calif., takes this truism a step further and argues that there really isn't an ideal time to invest in a startup. Rather, MDV assumes that even relatively mature businesses might be considered "early stage," given the room for growth they have remaining.
For that reason, although MDV describes itself as an early-stage investor, it doesn't get too caught up chasing only the youngest, lesser-known companies. Last year, for instance, MDV led a $20 million Series A funding of Hi5, then a four-year-old San Francisco social networking company that boasted 28.5 million unique visitors with no prior institutional funding.
"I think the definition of 'early stage' has expanded," says MDV partner David Feinleib. "All our investments are early stage in the sense that they have significant scaling and growing yet to do. They have all reached an inflection point where they really need to scale up."
The same year MDV invested in the relatively mature Hi5, it invested $2 million in a seed funding of PBwiki Inc., a San Mateo, Calif., provider of hosted business wikis that Feinleib describes as a product of the classic "two entrepreneurs out of Stanford."
Himself a Stanford University graduate, Feinleib says he often draws on personal connections to discover promising business plans and to reinforce the teams of these young companies in a way that makes the difference between good and great.
"Entrepreneurs will often call me and say, 'I thought I knew what great was, but then I found, X, Y, or Z, and they are amazing,' " he says.
Sequoia Capital
In 2005 Sequoia Capital invested $3.5 million in a video-sharing startup called YouTube that was not only unprofitable but had no clear model for making money. It didn't take long for Sequoia to be vindicated in its investment. The firm only had time for one more $8 million follow-on investment the next year before Google Inc. snatched up YouTube for $1.65 billion in late 2006.
For Menlo Park-based Sequoia, YouTube is only the latest in a long string of winning early investments that include Yahoo!, Apple, Oracle Corp., Cisco Systems Inc., Pay Pal Inc. (acquired by eBay for $1.5 billion in 2002) as well as Google.
Sequoia's list of past portfolio companies reads like a who's who of Silicon Valley, and its investment strategy favored very early-stage businesses started by inexperienced entrepreneurs -- including the 19-year-old founder of Apple and the two Stanford students who launched Yahoo! Inc. -- long before it became so popular to chase these embryonic companies.
Some other factors that distinguish Sequoia are a degree of confidence in its investment choices that make it reluctant to syndicate, as well as a willingness, uncharacteristic even in the VC world, to fail. The 37-year-old firm boasts that its appetite for risk results in a higher rate of failure than its rivals.
But at a time when starting consumer Internet companies has gotten so cheap that a preference for early-stage investments is no longer unique, Sequoia continues to stand apart with its refusal to rest on its laurels. The firm's commitment to uncovering new technologies could be viewed as a slight to other companies it has backed in the past: Some of the early-stage companies in its portfolio today include SearchMe.com, a search engine attempting to improve on Google's search methods; and Funny or Die Inc., whose FunnyorDie.com Web site for user-generated comedy videos competes with YouTube.
SoftTech VC
SoftTech VC of Palo Alto has in just four years built itself into one of the most prominent and sought-after early-stage venture firms, underscoring how unknown investors still can succeed against the much more established firms that line Sand Hill Road.
Of its 23 investments, mostly in groundbreaking Web 2.0 businesses, SoftTech has already completed five exits.
For founder and managing partner Jeff Clavier, that winning strategy rose from the ashes of the technology collapse, a period when so much value had been lost in the first wave of Internet companies that dot-com had become a four-letter word.
"In 2004, people were still not convinced it made sense," recalls Clavier. "Web 2.0 did not really exist at that time."
Having recently left a position as president of Reuters Group plc's Greenhouse Fund in Palo Alto, Clavier had acquired both an appreciation for the plummeting costs of building an Internet company and an extensive circle of friends in Silicon Valley. Those friends were continuing to build consumer Internet businesses, even though investors were scarce.
Clavier started investing his own money in increments of between $25,000 and $100,000 in many of these businesses, which addressed new and emerging areas of interest on the Internet, such as blogs and video.
"The cash requirements were so modest that it created a unique opportunity for the angel investors to jump in," he says.
Fast-forward to 2008 and the Web 2.0 industry he gambled on has become firmly established. Truveo, a Web search engine that was one of Clavier's earliest investments, was acquired by AOL LLC in 2006 for a reported $50 million, while Kaboodle Inc., a site that combines social networking and shopping, was bought by Hearst Corp. for a value reportedly exceeding $30 million.
Clavier, who has since those early days formalized his personal investments and formed a $12 million seed-stage fund, will not comment on the sale prices of his portfolio companies other than to say the reported price tags are usually accurate.
Spark Capital
Calling itself "stage agnostic," Boston's Spark Capital has set its sights on a very wide swath of investment sizes.
The firm, founded in 2005, will invest anywhere from $300,000 in a seed round up to $20 million in a later-stage round. Spark closed a $260 million fund three years ago and raised a $360 million fund last year. It's latest will be invested in companies that sit at the conflux of media, entertainment and technology.
Among its early-stage investments are social networking technology firm KickApps Corp., mobile media company SendMe Inc.'s SendMe Mobile site, and Tumblr Inc., a Web-based service that allows users to publish digital files or brief blog posts to a single online location.
"The whole thesis for why we raised this fund was that the Internet was changing the way content was distributed, and hence there would be a lot of opportunities," says general partner Dennis Miller.
Like other early-stage investors, Spark takes a hands-on approach with its portfolio companies, doing a lot of heavy lifting in the early stages of development, all the while understanding the risks of backing very young companies.
"You try to make the best investment you can, but these are by definition highly risky investments," he says. "You try to look for some sustainable unfair advantage the company has, a remarkable management team, a big market they're going after or a unique product. It is a risk business and you have to go into it knowing that," Miller adds.
Union Square Ventures
New York's Union Square Ventures is known for backing first-time Web 2.0 entrepreneurs, such as Rob Kalin, CEO of Etsy, and David Karp, CEO of Tumblr Inc. But the firm also boasts notable exits: behavioral marketing firm Tacoda Inc., sold to Time Warner Inc. unit AOL LLC in 2007 for a reported $250 million to $300 million; Web analytics firm Feedburner Inc., acquired by Google Inc., also last year, for $100 million; and social "bookmarking" site del.icio.us, acquired by Yahoo! Inc. for $30 million in 2005. Among the notable startups in Union Square Venture's portfolio are AdaptiveBlue, a maker of tools used to enable contextual use of the Internet; Oddcast Inc., a developer of online avatars; and Twitter Inc., which provides a service that lets people blog from mobile devices.
Building on that success, the firm recently closed a new $156 million fund, dubbed Union Square Ventures 2008 LP, that will maintain its focus on early-stage Web services startups.
"You will also see us invest selectively in later-stage opportunities that we believe are poised to grow as more users become more dependent on the Web to manage their daily lives," says partner Brad Burnham.
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