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Even In Bad Times, Good Ideas Will Get Funding

A year ago, big-time venture capitalists were such revered individuals that you expected some enterprising entrepreneur would put their faces and track records on trading cards. People like Ann Winblad of Hummer Winblad Venture Partners and John Doerr of Kleiner Perkins Caufield & Byers were on their way to achieving rock star status.

Then the technology bust of 2000 took hold and suddenly the watchwords became not "hot IPO" but "irrational exuberance." The VCs were suddenly not so VIP.

Yet at a recent Wharton conference entitled, "Private Equity in the New Millennium," venture capitalists generally agreed that while things got a bit wild in the last year or two, the present and future can still be profitable. "Yes, times are different than they were three years ago, but they are also different than they were three months and even three days ago," said Jesse Reyes, managing director of Venture Economics, who reports on private equity performance in his company’s Benchmark Reports. "The brand new technology is not going to go away. Things will go in cycles."

Reyes said that he compares current conditions to those in the middle 1980s. In the early 1980s, a big wave of tech companies went public – Microsoft, Apple, Compaq, Lotus – with great fanfare and great gains.

"Then four or five years later, there was a giant hole," he said. "There were single-digit returns instead of the double-digits promised to investors in many companies and the well of venture capital dried up considerably."

Reyes’ statistics show that while the emphasis in the press seems to be on the slowdown in initial public offerings, of more significance is that the median company received $27 million in venture capital in the fourth quarter of 2000; in the first quarter of 2001, it is getting only $15 million to $20 million.

"The days of $25 million first-round funding are indeed gone," said Dan Roach, managing director of Garage.com, the Silicon Valley-based venture firm. "But the opportunities are still there. Good ideas continue to be funded and valuations will just be more realistic."

The theme of "we’re still here for good ideas" was repeated over and over by the venture capitalists at the conference. "It certainly was an interesting time two years ago, quite heady," said Steve DesJardin, a partner in Encore Venture Partners. "But often good ideas came around, and there weren’t enough good people to run them. Now we think it’s a time of great opportunity if, and only if, you have a long-term, at least three-to-seven-year time line … You should be a builder, not a trader. Traders have cloaked themselves as VCs. But true VCs look to build companies. As a good VC, you are as much a part of the companies as the entrepreneurs."

Safeguard Scientifics, a publicly-traded technology incubator and fund investor, has lost about 90% of its market value in recent months. But Garrett Melby, Safeguard’s vice president of e-services, said that the company was doing business much the same as it has in other business cycles. "We have prospered when the markets were favorable and built companies when they were not," said Melby. "While the opportunities for entrepreneurs and careers in venture capital are obviously not as strong as in the last two or three years, tech investing is still a great place to be.

"There may be fewer opportunities, but they will be attractive ones," he added. "The rates of return may not be as rapid, but the ideas that are being funded now have better long-term business plans, so in the long run, that is what will work."

Carter Sednaoui, CFO of Accel Partners, said his firm has of late avoided health care ventures, but, ironically, its health-care portfolio has contributed more than $26 million to Accel’s bottom line, more than its tech portfolio. The company’s success comes because "we are development drillers, not wildcatters," said Sednaoui. "It’s been one hell of a party the last five years, but essentially, we haven’t done anything different from the previous 15; it’s just that everyone was more successful. Venture capital is an interesting business, but what the recent times prove is that you should not be attracted merely by the financial gratifications, but by the idea of building companies."

Robert Walsh, a general partner at Summit Partners, a late-stage growth investment firm, suggested that valuations across all industries won’t be rising rapidly for a while and, thus, anyone thinking about becoming a venture capitalist had better be creative and do his or her research. "Everyone now has to think about being on the leading edge in ideas. IT services, for instance, was big for us in 1997 through 1999, but not now. You have to be looking for the next thing, or someone will beat you to it … On the other hand, there is no short-term path, though it seemed that way to those who jumped in during the last couple of years. Your job is to help entrepreneurs build their dreams and so to build yours."

Some venture capitalists contend that now is actually a better time for the venture capitalist industry than two years ago. "The risk is out," said Fred Wilson, managing partner at Flatiron Partners, a New York venture firm. "Too many companies were being formed in one industry or another and values were too high. Now more bad companies, or at least bad valuations, are unlikely to occur. There may be fewer deals, but more will be good ones."

Venture capitalists should not be afraid to sunset companies that aren’t going to make it in the long run, added Accel Partners’ Sednaoui. "We actually have an Intensive Care Unit at Accel. On Mondays, we discuss those companies in the ICU and see whether we can help them succeed … The point is to make money. Sometimes that means getting out."

But the real question is when to get in. And the venture capitalists at the conference agreed that there is no magic formula for that.

"How do you value a company? To tell you the truth, I have no idea," said Jason Sanders, general partner at Crosslink Capital. "I don’t mean that to sound stupid. But it is more an art than a science. The problem is that if you are wrong, your investment can go down to zero, and if you are right, you can make a lot of money. It is an art not everyone can do."

Sam Baker, managing director of the private equity group at Pilgrim Baxter & Associates, Ltd., agreed with the art vs. science notion.

Pricing a venture deal is an art because "you are forecasting cash flow way out," he said. "You can jerk yourself around with an Excel spreadsheet, but [it’s important] to keep in mind that you want to invest in companies and managements that will grow over time. This is not just about the next quarter."

Roach attributed much of his company’s success to Garage.com’s dynamic founder, Guy Kawasaki. "Guy is a shameless promoter of our portfolio companies," said Roach. "It’s a California thing. You have to do that to make your money the best and the smartest. To be a successful venture capitalist, you have to be pro-active. You hear the word ‘network’ a lot, but that is what it is all about.

"You have to build it into your psyche that you are always looking," Roach added. "The people who are most successful are extremely networked. They meet people at conferences, they send Christmas cards, they make notes. When it comes time to make that important phone call, that other person will say, ‘Yes, I had lunch with that guy in June,’ and that may seal the deal."

Most importantly, the venture capitalists told the audience, it is vital to know that you are doing business and not being sentimental. "You can be friendly and nice, but you want most to be commercially successful," said Mitchell J. Blutt, executive partner at JP Morgan Partners. "If you are commercially focused, the company you are funding will appreciate you because you have made your objectives clear. Then your friendliness isn’t a mask."

This article is published with the permission of knowledge@wharton.com.

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