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