Testing Time for the VCs

By Daniel Eisenberg

A double major in neuroscience and computer science would keep most college kids pretty busy. But when Yale junior Joshua Newman, 20, scampered across campus this spring, he wasn't thinking too much about finals. He was more concerned with raising $10 million by the fall--and then giving it away. A native of (where else?) Palo Alto, Calif., Newman just happens to be a budding venture capitalist, one of the early-stage investors who fund high-tech ventures before they go public, in exchange for a potentially lucrative stake. His fledgling fund, Paradigm Blue, plans to give about $500,000 to promising dorm-room start-ups that can't possibly get a meeting with the cozy club of old-line VCs.

Newman has already raised some $8 million. Until recently it wasn't too hard, even for an undergraduate, to line up donations. As long as tech stocks were pushing the NASDAQ index to record highs, VCs could take scores of seedling companies public before they had time to fail, and walk away with triple-digit gains. The recent market downturn doesn't seem to faze Newman. "We're taking a long-term view," he says, like a Silicon Valley pro.

Well, what choice does he have? For the moment, at least, NASDAQ isn't rolling out the welcome mat for most dotcoms, and high-flying Internet IPOs are practically a distant memory. Like his fellow VC wannabes, from buyout king Henry Kravis to anonymous Florida retirees, Newman isn't about to let a little thing like a bear market crush his dreams of jump-starting the next Yahoo and riding it to the bank. Never mind that the vast majority of VC bets have failed or that inexperienced players may have a tough time picking winners in a choppy market.

"A lot of people have been moving into the industry assuming it was all reward and no risk," says Chris Nawn, a general partner at Technology Crossover Ventures. By contrast, Nawn's company has warned its investors not to expect the stratospheric returns of recent years.

Last year some $52 billion in venture capital was funneled into start-ups, almost three times 1998's total, according to Venture Economics, a division of Thomson Financial Securities Data. That doesn't include an estimated $30 billion more in seed capital plunked down by "angels," wealthy individual investors who help get start-ups going before they hit up the VCs. Through the first three months of this year, that feverish pace continued, with VCs doling out $23 billion, mostly to dotcom prospects.

Celebrities and sports stars, from Martha Stewart to Joe Montana, are jumping on the VC bandwagon. In the past several months, corporate heavyweights IBM, News Corp., Time Warner (parent of TIME) and Arthur Andersen, to name a few, have launched their own funds. Even the CIA has set up a venture arm, In-Q-Tel. And later this year, Silicon Valley start-up MeVC, along with VC Draper Fisher Jurvetson, will roll out a publicly traded venture fund that lets individuals with a net worth of at least $150,000 plunk down a minimum of $5,000 to play.

How can this be? When the dreaded tech-stock shakeout hit in April, the flood of new cash to aspiring entrepreneurs was supposed to dry up. But while the money may not be as easy to come by these days, the fact is, the venture capitalists have generated so much, routinely raising $1 billion in a matter of weeks, that they have no alternative but to keep spending. From April through June, $15 billion more may be dished out.

That doesn't mean that money is falling from trees. Many VCs claim that the tech-stock slowdown will, in the long run, prove to be healthy, imposing a level of discipline that all but vanished in the era of dotcom mania. "It's a return to sanity," says Russ Ramsey, president of Friedman, Billings, Ramsey & Group Inc., a venture firm in the booming Washington tech corridor. "It will separate the quality from the trash."

Even as would-be venture capitalists are still diving into the business in droves, veteran VCs are actually scrutinizing business plans and repeatedly saying no rather than giving anyone with a half-baked idea $10 million. Money-losing consumer and e-tail sites and their wasteful ad campaigns are out; infrastructure providers with real business models and hefty profit margins are in. As Michael Moritz of Sequoia Capital jokes, "All of Silicon Valley has been sent to the fat farm."

Trimming the ridiculous valuations of start-ups has been one of the first drills. Much as the shares of tech companies on Wall Street have fallen back to earth, the values granted start-ups in search of a cash infusion have also tanked. In this buyer's market, VCs once again hold the upper hand--paying 20% to 50% less for a stake.

In return, they are having to work for a living. Now that the IPO window has effectively shut for the majority of dotcoms, venture capitalists will have to get back to nurturing their newborns for three to five years before going public. That means shelling out more of their own money, cutting off the weaker companies, keeping a closer eye on the start-ups' budgets and persuading disgruntled employees saddled with worthless stock options not to bolt. Some VCs are considering selling or merging underperformers, an exit strategy that was rarely discussed during the halcyon days of, say, March. "It's hard to build an enduring company in a year," says Jim Breyer of Accel Partners.

Numerous start-ups financed before this spring's shakeout, not to mention the VCs who funded them, are learning that the hard way. In the past couple of months, any number of highly touted outfits, from Web portal AltaVista to Webstation.com (a DVD e-tailer), have had to postpone or withdraw planned public stock offerings; many of them need additional private funding, and fast. Others have already faced euthanasia. In May, only a few months after Boo.com the European high-end sports fashion e-tailer, launched its flashy site, it was forced to call it quits. The same VCs who lavished $120 million on the fledgling enterprise, including LVMH chief Bernard Arnault and Goldman Sachs, had quickly grown tired of its free-spending ways and wouldn't give it any more cash to play with.

For many of the new corporate VCs, though, cashing out is not the primary goal. When most nonfinancial companies start writing checks for entrepreneurs, they have a more limited, strategic agenda. Intel uses its $8 billion venture portfolio to fuel demand for its fastest microprocessors. Database king Oracle, which scored a whopping 600% return in its rookie year as a VC, launched its $500 million fund with an eye toward helping outfits that "are outside our core competency but good for the Net generally," as senior V.P. Matt Mossman puts it. Following the Japanese model of keiretsu, many firms hope their financial, marketing and technology support will establish a tight network of suppliers and (deeply indebted) customers.

Most old-economy ceos feel they simply have no choice but to join the speculative venture game, regardless of the prevailing Wall Street winds. Since 1996, the number of firms with venture programs has quadrupled, to 200, according to Asset Alternatives. They include Chevron, Starbucks and Sara Lee, among others. It's all about "avoiding extinction," says VC Tim Draper. To keep pace with the new economy, the argument goes, Fortune 500 ceos need to own a stake in it--finding innovation outside their doors.

"It's a good way to do research and development and stay on the leading edge," says Greg Quesnel, CEO of shipping firm CNF, which has set up a fund. When it comes to white-collar service professionals, acting as a VC is sometimes simply the price of doing business with cash-strapped dotcoms--and keeping your own employees from fleeing to them. At several San Francisco law firms, partners are pooling money to give start-up clients seed capital. Many consulting and accounting firms are accepting stock for services, providing so-called sweat equity. Still others, like Andersen Consulting, which has established a $1 billion fund, are directly investing the firm's money and giving their workers a share of potential profits in lieu of stock options. These companies stress that the newfangled relationships will not compromise their independence, but there are more material risks. "We are excruciatingly aware that this paper could turn out to be worthless," says McKinsey & Co. senior partner Dick Foster. "But we're in the age of equity."

Well-off individual investors want their share too. Across the country, people who have had no access to the rarefied world of private offerings can use the Web, at offroadcapital.com and earlybirdcapital.com to hook up with start-ups. Every month about 85 women from the District of Columbia area who make up WomenAngels.net get together to decide how they will make their next bet. Each member puts in $75,000 over three years, and there's a 50-person waiting list.

There's also a whole new class of entrepreneurs trying to help one another build start-ups. Pioneered by Bill Gross's Idealab, which got eToys (among others) off the ground and has filed to go public, the so-called incubators have become the latest entrepreneurial fad. With names like Thinktank and eHatchery, they typically provide a combination of office space and recruiting, legal and financial help to aspiring dotcom entrepreneurs in exchange for a chunk of the new firm. A group of Duke University graduates has launched its own college incubator, StartEmUp, to "take your idea from the dorm room to the boardroom," as its slogan goes.

Some skeptics criticize incubators for taking a cookie-cutter approach to innovation, but Jake Winebaum, a former Disney executive who co-founded ECompanies, thinks the hand-holding he provides is invaluable. "There's capital out there, but it's execution that counts," he argues.

And that, for many VC wannabes, is precisely the problem. They may have some spare change to throw around, but most are not likely to have the necessary networking skills and business experience, which are just as important. It may be only a matter of time before the new VCs, like the Net stocks, suffer a shakeout.

Until then, the lure of private equity may prove too hard to resist. "By the time the IPO has been written about in the Wall Street Journal, the real money has been made," says Gerald Benjamin, senior managing partner at International Capital Resources, which links angels with start-ups. In other words, if you give cash to a kid with another vague e-commerce business plan, don't be surprised if he burns it.

--With reporting by Anne Moffett/Washington

With reporting by Anne Moffett/Washington