Crunch Time for VCs

Not long ago, Ronald C Conway was probably the single most active venture

capitalist on the planet. In just 20 months, the 49-year-old founder of Angel

Investors, a Silicon Valley firm that seeds Internet startups, sank $160 million

into 206 companies. His star-studded collection of investors includes Shaquille

O’Neal, and eBay founder Pierre Omidyar. But now, Conway is calling it quits.

He plans to shutter Angel Investors after the current two funds run their

course. Although his overall returns will be strong, the past few months have

wreaked havoc on his portfolio: Twenty of the companies he backed and an

estimated $10 million in seed capital have been wiped out. "When the bubble

burst, all hell broke loose,’’ he says.

Hold on tight. Conway is a leading indicator of what lies ahead for the

financiers of the Internet Age. After the biggest boom years ever, the

venture-capital industry is headed for a gut-wrenching shakeout that will have

repercussions throughout the economy. Think of the industry as an over-inflated

balloon. During the past five years, the number of venture firms more than

doubled to 1,010, the number of companies financed surged 150%, to 5,380 last

year, and the amount of money invested soared nearly tenfold to $103 billion,

according to researcher Venture Economics.

‘Real debacle’

Now comes the pinprick. Many of the tech companies that have gone public over

the past two years–most financed by venture firms–are proving to be

downright terrible businesses. Venture-backed companies taken public in 2000

fell an average of 24% from their offering price, the first negative return

since Venture Economics started keeping the statistics 15 years ago. Burned

investors have slammed the door shut on the market for initial public offerings.

After tech IPOs reached a peak of $8.7 billion during March of last year, there

was not a single dollar raised in the public markets by such upstarts in

January, according to Thomson Financial Securities Data.

With the stocks of their public companies tumbling and many of their

seedlings running out of cash, venture firms are seeing their returns plunge.

The average one-year return to venture funds has sunk from a high of 164% in

1999 to 43% in the first nine months of 2000. And Venture Economics is

predicting that returns will dip into negative territory for the 2000 fourth

quarter. "This has all the makings of a real debacle,’’ says Jesse E

Reyes, a Venture Economics vice-president. "The industry will go through a

downturn in performance, the number of companies invested in, the amount of

money raised, and, ultimately, the number of firms that exist.’’

The fallout will be savage. Harvard Business School professor Morten T Hansen

estimates that at least half of the 200 US incubators, which provide money like

traditional venture firms along with office space and other administrative

services, will go under within two years. Many of the thousand or so venture

firms also will close their doors once their current funds are depleted. The

first to go will be fair-weather newcomers who never established strong track

records. Even veterans are feeling the pain. The 11-year-old Silicon Valley firm

Hummer Winblad Venture Partners had to write off more than $44 million in one

fund because of worthless investments in Net retailers HomeGrocer.com and

Pets.com. Though that’s just two companies out of 37 in the fund, the

write-offs represent more money than the firm has lost in total since its

founding.

And the wreckage within the venture community is the least of it. Venture

capital has a profound impact on the technology sector and the global economy.

Venture money was the primary fuel that powered the commercialization of the

Internet and other transformation technologies. Without those breakthroughs, the

economy would not have enjoyed its supercharged run over the past decade.

Already, that flow of capital is contracting: Venture bucks slowed to $19.6

billion in the last quarter of 2000, down 26% from an average of $27 billion for

the three preceding quarters, according to the National Venture Capital

Association and Venture Economics. It’s the largest percentage drop in funding

since 1993–and the biggest overall dollar decline ever.

Even more worrisome is a shift in the kind of investments. Venture firms are

backing away from risky, change-the-world companies and focusing on safer, more

incremental technologies. If this play-it-safe mood persists, it could undercut

the tech development necessary to keep the economy healthy. "The coming

five years will probably be less an era of radical inventions than the

completion of ideas from the last couple of years,’’ says Richard Shapero, a

partner at Crosspoint Venture Partners.

How bad could it get? Venture Economics’ research shows that investments

are still being made at an $80 billion annual rate, sky-high for a business that

was only $22 billion in 1998. But the historical evidence suggests that

investments could drop much more. After the stock market crash of 1987, venture

capital financings plunged 51%, from $5.2 billion in 1988 to $2.6 billion in

1991. The number of new companies receiving venture money dropped 61% to 283

during the downturn.

Venture capitalists are bracing for a downturn that could be just as

dramatic. Though they hope that the second half of this year will brighten, most

expect the gloom to continue at least through 2001. "One hundred billion

was invested last year. Maybe $30 billion to $40 billion will be invested this

year,’’ predicts Oliver D Curme, a partner at Battery Ventures. His

reasoning: Most of the $100 billion in venture money was poured into flawed

businesses that could collapse. "That will have a very chilling impact on

the view of venture capitalists and entrepreneurs.’’

To make sure they don’t wind up on the same junk heap as the collapsed

companies, VC firms are launching a revolution within. No more cutting checks to

inexperienced entrepreneurs with unproven business plans an hour after hearing

their pitch. Gone, too, are the lemming-like stampedes to create copycat

startups, such as the 150 finance sites launched in the last year alone. And say

adios to the days when a venture capitalist sat on more than a dozen boards,

spreading himself so thin that the startups suffered.

By Linda Himelstein in BusinessWeek. Copyright 2001 by The McGraw-Hill Companies, Inc

Divine overhaul

Some of the cash-rich, market-cap-poor companies are taking the opposite

approach. Realizing their original business plans were failures, they’ve done

180-degree turns and overhauled their strategies. Divine interVentures, for

example, went public as an incubator and started up more than 50 companies. In

February, with its stock market value lower than the $190 million in cash on its

balance sheet, Divine announced plans to remake itself into a software company–CEO

Andrew Filipowski’s area of expertise. It even changed its name to Divine. The

moves have helped a little: The stock of the Chicago outfit has climbed from its

low of $1 a share to $1.69, although that’s still well off the $9 a share at

which the company went public last July.

In December, the California company, Ventro, closed two of its online

business-to-business marketplaces–the Chemdex market that allowed companies to

buy and sell chemicals on the Net and the Promedix market for medical supplies.

Ventro then said it would change its focus to helping other companies build

marketplace sites. So far, they haven’t convinced investors that its new plan

is any more viable than its last one. Its market capitalization is still only

$50 million, even though it has a treasure trove of $235 million on its balance

sheet.

Then there are those companies that are sticking to their guns. They simply

think the stock market is unfairly punishing them and, if they perform well,

their stocks will recover. Consider Neupert at Drugstore.com. "We’ve made

a lot of changes in the last six months–laid off a substantial part of the

workforce, dramatically reduced marketing plans, and reconstructed the business

model to break even," he says. That’s why he’s confident his business

will survive, even though its stock has dropped from $67.60 in 1999 to $1.31.

Autobytel is staying the course, too. The company, with $82 million in cash

and a $41 million market valuation, expects investors will become bullish once

it hits operating profitability in the third quarter. "We are well enough

established that we aren’t taking down marketing costs, nor are we

anticipating any large-scale layoffs," says CEO Mark Lorimer. "After

all, we’re going to post profits in a few (months)."

Despite the risks, cash can be a powerful lure for potential acquirers. If a

purchase can be completed quickly, the leftover cash can help fund the

operations of the surviving company. The women’s site iVillage acquired

Women.com Networks for stock in February, partly to get its hands on its

one-time rival’s $30 million in cash. The two sites combined some operations

to reduce expenses and now should have plenty of money to make it to the third

quarter when the business is expected to begin generating cash. "The deal

that we cut with Women.com makes sure that we have enough dollars for a rainy

day," says iVillage CEO Douglas McCormick.

There may yet be a handful of deals like McCormick’s in the wings. But it’s

a treacherous market these days and potential acquirers will have to weigh the

risks carefully–before moving licketysplit. The free cash is disappearing

fast.

Pallavi Gogoi–BusinessWeek