Venture capital odyssey: part II

Never mind the dotcom collapse, the scaled-back follow-on funds, the right-sized returns expectations: the mood among the five venture capitalists gathered in the room could be described as almost convivial. According to these Sand Hill Road veterans, the US venture capital business, which has been through two years of fermentation, is finally adopting a healthy pallor.

And the numbers seem to agree with them. US venture investment totaled nearly $5.6 billion (€4.45 billion) for the second quarter of 2004, according to The MoneyTree survey released in October in conjunction with PriceWaterhouseCoopers, Thomson Venture Economics and the National Venture Capital Association (NVCA). That figure is nowhere near the industry's all-time high of almost $29 billion over the same period in 2000, but it marks a steady, upward trend from the post-bubble's low of $4.25 billion.

Clearly, the outlook is brighter, but as our assembled experts agree, the venture game requires harder play and more seasoned players.

If there's one thing these venture capitalists have learned following the aftermath of the tech collapse is that bright ideas don't always translate into big bucks. In fact, with IPOs harder to come by than ever before, venture investing, particularly on the early stage-side, has become more about staring hard at the numbers and specifics of an individual company than creating flotation fantasies that might ultimately fall flat.

Heidi Roizen, a managing directorat Mobius Venture Capital's Palo Alto office says that “now we're back to doing the same things, and in perhaps even a little more tightly constrained market, the opportunity for liquidity is farther out and probably of lower value. There will usually be no premium in there other than the reality of the numbers you can ultimately achieve. Therefore, we have to run these companies more efficiently and stay in them for a longer period of time”.

Stu Phillips, a partner at US Venture Partners in Menlo Park, confirms that because of the more challenging public markets, he's seen both entrepreneurs and venture capitalists scale back. “It's one thing when you have a company that goes public with a multibillion valuation that wasn't sustainable”, Phillips says. “In this kind of environment today, you have to look for companies that you can get profitable and not rely on access to the public market as a source of funding. You can't go into responsibly financing a business without the belief that says, ‘I can make this company stand alone and I can build value, and ultimately whatever the exit is, I can rely on it taking care of itself'”.

Many of the venture dollars invested during the tech boom were directed at telecom equipment makers, which were extremely capital intensive. Robert Simon, a director at San Francisco's Alta Partners, explains that the decline of these money-hungry startups has coincided with a desire among venture capitalists to sink less capital into each investment: “We had an investment in a Canadian telecom company, a developer and manufacturer of large telecom systems equipment. Along with our venture partners, we invested about $100 million, which is an example of the type of investing that was undertaken by the venture community in the 1999 to 2000 timeframe that is not likely to be repeated because of the capital requirements to make that investment successful. None of us want to make $100 million bets, even collectively anymore”.

But Scott Sandell, general partner in the Menlo office of New Enterprise Associates (NEA), still sees a need for large amounts of capital to be available to companies. About 20 percent of his firm's portfolio is in much-later stage companies, mainly in healthcare companies, which soak up about 40 percent of total NEA dollars invested. “Companies are not able to go public in quite the same way that they were back in the heyday”, says Sandell. “One of the reasons we continue to think that larger fund sizes and larger investments per company make sense is that we expect these companies to be private for much longer”.

Relations between GPs and LPs in the venture capital community have become more complex as the supply and demand dynamic has shifted dramatically toward fund managers. Though venture funds these days are, by and large, coming up smaller than their predecessors, our GPs confirm that investor appetite hasn't been satiated. Steve Bowsher, general partner at Menlo Park-based Interwest Partners, which closed a $600 million fund just in September, says investors were both more eager to recommit, and more demanding in the due diligence process. “The [fundraising] process went remarkably quickly, which I think reflects that after a couple years of not a whole lot of activity happening, people prepared for a wave of firms out to be raising money this year and next, so they're getting focused on processing firms through the funnel. But at same time, the LPs did much more due diligence than they had done in the past. They talked to more CEOs of more portfolio companies, more LPs came and visited us, did more one-on-ones with not just partners but principals and associates as well”.

The industry functions best with a high degree of transparency

Sandell says he's noticed a certain angst among LPs that the venture space is still too crowded. “The LPs are concerned that there's more capital that wants to get into the asset class than is appropriate for the number of legitimate investment opportunities. They're worried that there will be too many venture capitalists chasing too few good deals, and ultimately too many companies funded in each sector, resulting in lower returns for everybody”.

But the roundtable participants agree that the venture business has indeed changed from the aberration of the tech bubble, during which return on investment wasn't directly tied to financial fundamentals. Roizen notes: “I personally am seeing fewer copy-cat companies getting funded. You're not seeing in a compressed period 20 companies doing the same thing getting funded”.

These days, firms are rushing to demonstrate to LPs that they understand such risks. Simon breaks down risk into its underlying components: technical risk, market risk, management risk and competitive risk. “The thing that got out of control – which historically the venture community had been good at – was underwriting technical risk and management risk, and then it avoided market risk. It all got out of whack between 1997 and 2000. We were underwriting market risk, and essentially the results proved we weren't good at it. We got our hat handed to us, collectively”.

One thing GPs in the venture capital world are having trouble hiding from are disclosure issues being raised across the country. Case in point: The attorney general of Texas recently supported a ruling that would force the state-sponsored venture-initiative Texas Growth Fund to reveal portfolio-level information. This development has produced a big “Yikes!” among venture capitalists, not to mention among LPs exposed to these potential disclosure rules.

Phillips comments: “You potentially are exposed to having an elected official saying, “Well never mind that ruling, this is what's going to be done.” And that's a level of variability that the venture business is very poorly equipped to deal with. I think the most disquieting thing about FOIA is that the venture industry is one that functions best with a very high degree of transparency. You as a GP want that transparency, the LPs want that transparency, so something that flies in the face of disclosing that information and the ability to keep it confidential is a huge problem”.

There is some angst among LPs that venture is still too crowded

Roizen argues that relations with LPs are suffering as a consequence of the FOIA battles: “I think by and large, the LPs we have understand, specifically as it relates to portfolio company information, why it is disadvantageous to those companies to have that information [be made] public. So they have been very receptive to saying “Hey, we really want to understand what's going on with your portfolio companies, but we acknowledge you're not necessarily going to be sending us reams of printed documentation.””

Sandell says that NEA has had to adjust its practices surrounding what information gets distributed, and how. “LPs guide us on what the practice has to be, because once it's in their hands, they're required to make it public. The critical issue is not that our LPs are uneducated about the issues of disclosing portfolio company data, or even have any great desire to have that data. The problem is that they are bound by law or public policy to disclose the data even when they don't think it's a good idea”.

Bowsher adds that a longer-term development, in addition to certain venture capital firms refusing capital from LPs that are exposed to FOIA issues, may be those venture capital firms similarly refusing to co-invest with other firms that take FOIA money. Bowsher predicts this would be “detrimental to the industry and a shock to the system”.

Though there isn't a cut-and-dry solution, Simon suggests perhaps even the “creation of some sort of intermediary institution, whether a fund of fund, or some other thing like Grove Street Advisors [the Wellesley, Massachusetts based gate keeper working with CalPERS], where the state pension funds invest, and then the money gets pooled and goes into the venture community. The vehicle can provide some curtain between sensitive data and the public”.

Venture firms now have more reason than ever to band together and fight for common causes through trade organisations. Roizen, a board member of the NVCA, says a stepped up lobbying effort on the part of venture capital is not designed to be “obstructionist”, but rather “we want to do the right thing so that we can continue to have the venturebacked economy, which is important to our businesses, to our entrepreneurs, and to the American economy as a whole. The NVCA is working very hard on some of these issues that didn't appear to be important to you when you're fighting, as we all were, in 1999, 2000, 2001, for the life of every individual company in our portfolios. It's hard to pull yourself out and think about the greater issues of what effect stock-option expensing is going to have on our companies, what is FOIA going to have as an impact”.

VCs refusing to co-invest with firms that take FOIA money would be a shock to the system

Simon points out that West Coast firms in general have been less involved in politics than their East Coast counterparts. “The NVCA has been primarily a networking organi sat ion for the venture community up until recently”, says Simon. “Now we sort of have been dragged into it. We're now pretty active in issues that are related to our portfolio companies and our LPs. The stock-option expensing is a perfect example. On the surface it doesn't seem like a big deal, but it's a huge deal for motivating and incentivising people to take the risk to leave a relatively secure job in a larger entity and mortgage their house, take reduced salaries for three to four years and some upside. You remove that incentive, and it dramatically changes the whole picture for driving new job creation”.

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Beyond the swathe of issues facing US venture firms domestically, the GPs are convinced that in order to maintain competitive returns over the next couple decades, they must start paying attention to the Asian markets, in particular to China. Sandell notes: “For the people who aren't convinced that that's true or expected that it might happen sometime in the future, consider that four of the top 10 global tech IPOs this year are Chinese companies. The reason it's so important to see what's happening in China is that if you look at the US and examine what made the US the best place for venture capital-funded companies in the last 40 years, a lot of it had to do with the market happening here first. Early adopters of technology were here, so US entrepreneurs were on version three by the time they went to Germany, and entrepreneurs there were still on version one”.

He adds: “Consequently, the USfunded companies won the world market for almost every new IT innovation that happened during that period of time. What we're seeing in China in some sectors is the market is happening there first, and the innovation consequently is happening first there as well. We expect many of these companies that start in China will later enter the world markets not only with more mature products, but also with a lower cost structure because of the low cost of almost everything in China”.

But the China question is still a long way from being answered. Phillips warns that from “an earlystage perspective, we would lose our shirts right now investing in China but this will change over time. The infrastructure isn't as developed. You can't contrast Israel and China in the same article, let alone the same sentence. India and China have fantastic education systems, particularly at the university level, and entrepreneurs are just as bright and motivated as anywhere else. But particularly in China you have a dearth of middle management because of the history that 95 percent of the country worked for a state-owned entity”.

Most our participants agree that going in alone and doing direct investing in startups would be foolhardy at best, but the country does present opportunities for investment in later-stage companies with Chinese partners. Sandell points to the sheer size of the market: with such a large population base, companies are becoming “large and successful on almost nothing. It's partly because there's not a lot of domestic capital available to the entrepreneurs early on. They have to find a way to do it without a lot of venture capital. It's quite impressive to see what they've accomplished”.

Most participants remain light with regard to their activity across the Atlantic, though they did not deny the existence of opportunities. Simon comments: “Europe, especially the Scandinavian countries, are huge users of the wireless and mobile application. We are seeing some leading companies coming out of Scandinavia in that sector. On the life sciences side, you see a lot of startups because the universities and the government agencies over there are actively funding basic research”.

Simon says “a common construct” for US participation in the European venture market “is maybe having US headquarters, with research and development in Europe. Or if not that, you might have a dual listing when the company goes public. It's probably less common now given that the European markets have failed to materialize, and NASDAQ is still preferred”.

Simon's Alta Partners itself has a stake in a semiconductor company in the UK, and a semiconductor-processing company in Sweden with US headquarters in Boston. In both these cases, he says, Alta “came in shortly after the first round. So we were the US validator. We can help them get into the US market or get into other markets, or help them with some additional management.

You can't go into financing a business without a belief that says, ‘I can make this company stand alone'

Bowsher, whose firm has done two direct investments in European companies, points out that part of InterWest's reluctance to venture forth in Europe and other outside markets is a general lack of familiarity with regions far removed – both geographically and culturally – from Sand Hill Road. “We joke our foreign investment strategy is our Texas office”, Bowsher says. “Having an office there and investing there feels different enough to us. We find the prospect of opening an office in another country intimidating right now. There are very few globally based venture capital firms with multiple offices in multiple countries. That model has not proven itself in the past, though there are certainly exceptions. We think about China or we think about Europe in more of an ad-hoc or one-off basis”.

But by no means does Bowsher feel his firm's presence had anything to do with validation – long-term, the entrepreneurs wanted to work with a US venture firm. “We are closest to those markets, we understand them best, and we should be able to be particularly helpful to them in attacking those markets. In addition, ultimately both companies want to be listed on the US stock exchange. One of the challenges for us long-term is that the best companies start right next to the most attractive markets. And for a long time, all the most attractive markets were here in the US”.

Stu Phillips


US Venture Partners (USVP)

Since its inception in 1981, US Venture Partners has raised more than $2.5 billion in eight funds, including a $1 billion fund that closed in January 2001. To date, more than $1.1 billion has been invested in more than 271 early-stage companies in a broad range of startup sectors. Phillips joined USVP in 1997 and focuses on investments in systems, communications, storage and software. Previously, Phillips was vice president of central engineering at Cisco Systems.

Heidi Roizen

Managing Director

Mobius Venture Capital

Formerly SOFTBANK Technology Ventures, Mobius Venture Capital was founded in 1996 and currently manages approximately $2.25 billion in assets. The firm focuses primarily on early-stage investments in sectors that include software, healthcare informatics and consumer and small business applications. Roizen joined the fund in 1999 and focuses on consumer-facing investments. She also serves as a board member for the National Venture Capital Association. Prior to joining Mobius, Roizen was a consultant to numerous technology companies, including Microsoft, Intel and Compaq. From 1996 to 1997, she was vice president of worldwide developer relations for Apple Computer.

Scott Sandell

General Partner

New Enterprise Associates (NEA)

NEA has been investing since 1978 and manages about $6 billion in assets. The firm focuses on early-stage businesses in life sciences and information technology, and has invested in more than 500 companies over its 25-years history. NEA closed its 11th fund on $1.1 billion earlier this years and expects its next fund to be even larger. Sandell joined NEA in 1996 as an associate, become partner in 1999 and a general partner in 2000. He concentrates on IT, including software, semiconductors and systems. Scott started his career at the Boston Consulting Group and later joined C-ATS Software as the company's first salesperson.

Robert Simon


Alta Partners

Alta Partners was formed in 1996 by four of the senior partners of Burr, Egan, Deleage & Co. (BEDCO), a venture capital firm formed in 1979 that focused on early-stage investing in life sciences, information technology and communications. Alta currently manages seven venture fund programmes totaling approximately $1.5 billion in committed capital, and has funded about 120 life sciences and information technology companies. Simon joined Alta in 2000 as part of the IT team. Prior to Alta, Simon was a Venture Partner with Sierra Ventures, investing in data storage and enterprise software companies.

Stephen Bowsher

General Partner

InterWest Partners

InterWest Partners, founded in 1979, invests in both information technology and life sciences early-stage companies. The firm currently manages $1.6 billion in capital and has invested in more than 230 companies. InterWest closed its eighth fund this past September on $750 million. Bowsher joined the firm back in 1999, after serving as veteran manager of E*TRADE Group. He also held business development roles at two high tech start ups, Catapult Entertainment and FreeLoader, Inc.