The Cautious Return of the VC

Baldwin Louie — Mon, 06 Aug 2001 15:00:00 -0700

Last Monday, the partners at Bessemer Venture Partners in Menlo Park, Calif., decided to fund two young technology startups. The week before, the firm's partners voted to invest in two other tech-related companies still in the embryonic stages, according to partner Chris Risley.

Two years ago, a single venture firm bankrolling just four startups in two weeks would have been considered lethargic. Six months ago, by contrast, there were no deals at all. The VC climate during the past 12 months can be likened to the deep freeze of a nuclear winter. But Bessemer's upsurge in activity is emblematic. A range of players, from entrepreneurs and VCs to the lawyers who serve as a young company's trusted counsel, say there are signs of life on that edge of the universe where VCs and entrepreneurs dream of creating another eBay. Blades of grass, it seems, are growing from out of the rubble.

"You're starting to hear about people getting funding for new companies," says Karl Jacob, formerly an entrepreneur in residence at Benchmark Capital, who sold one startup to Microsoft and now heads Keen.com. "Skepticism is still at an all-time high, but I don't think there's any doubt we're starting to see more VC investments in early-round companies."

There's every reason to be skeptical about any statement portending a sunny future for venture capital. The university endowments and pension funds that provided billions of venture dollars in hopes of a tenfold return will be lucky, in many cases, to recoup their original investments. And the turnaround many CEOs predicted for the second half of this year hasn't materialized. If anything, the prospects for the next six months are worse than what was seen in the first half of the year.

Another reason for skepticism is that VCs as a breed are congenital optimists. VCs are in the business of believing; their every pronouncement of good times ahead should be received with a healthy dose of wariness.

This time, though, other players are saying that firms might be tentatively dipping their toes into the high-risk waters of early-stage financing. Lawyers, for example: Scott Dettmer, a founding partner of Gunderson Dettmer, a Silicon Valley law firm, has served as consigliere to scores of fledgling companies. In recent weeks, he's noted a "thaw in the venture community." Entrepreneurs are once again seeking legal advice, freshly minted business plans in hand. He and his partners are being asked anew to review the details of early-stage venture deals - a fact he attributes to a return to fundamentals among entrepreneurs.

AOL Time Warner's interest in merging its cable operations with AT&T's is based on an unusual principle. Not market dominance - though AT&T's 13.7 million cable television subscribers would more than double AOL's cable customer base. Not operating efficiencies - though Time Warner could easily improve AT&T Broadband's paltry 23.4 percent estimated operating margin. And not high-speed Internet access, though AOL would gladly add the 1.3 million high-speed subscribers of AT&T affiliate Excite@ Home.

Those are compelling reasons, but there's another motive, one that reveals the ways of the cable industry: The deal would keep AOL from making a profit. A merger of AOL's cable operations with AT&T Broadband, at a cost of more than $60 billion, would create years of losses from interest and depreciation. For AOL, nothing could be sweeter.

How's that? The business of publicly traded cable companies is like few others. The key to their financial leverage is that they never turn a profit, so they never have to pay taxes. The problem, an odd problem indeed, is that cable subscriptions generate loads of revenue - AOL Time Warner got $1.5 billion in cable revenue last quarter alone, 17 percent of the company's total revenue. With that kind of inflow, the only way cable companies can avoid profits is to spend huge sums.

The early days of cable made this easy. As cable rolled into new neighborhoods, firms had massive expenses. But when the system was turned on, it started generating cash. So the companies built new systems, avoiding profits - and taxes. And as the cable market matured, two new trends took hold: system upgrades and a wave of mergers, which saw big cable companies borrowing money to buy smaller competitors. The resulting debt created a new, tax-deductible expense.

Big debt, of course, isn't necessarily a bad thing, any more than a big home mortgage is - as long as you make the payments. So the health of a cable business depends on generating cash while generating losses. Cable investors aren't so worried about a net loss when a company is EBITDA positive (that is, before items like depreciation and income). And the EBITDA for AOL's cable business is higher than that for AT&T's, despite lower revenues. "The cable industry has been historically cash-flow-driven," says Raymond James analyst Phil Leigh. "It's in their interest to reduce their taxes. There is no industry more sensitive to reporting a profit."

In this light, with almost $20 billion in long-term debt and interest of $26.4 million a week, AOL Time Warner is a great success. If Bugs Bunny were around today, he'd probably say his parent company was in hock up to its armpits, bub.

Last week's $1.64 billion acquisition of British publisher IPC Group by AOL adds another cash-flow-rich business - and another big cost. Magazines are the perfect cash-flow business: Subscribers pay a year before the product is even made. According to influential Goldman Sachs analyst Anthony Noto, magazine subscriptions already account for 3.6 percent of AOL's revenues.

If AOL gets its way, the irony won't escape information-economy cognoscenti: AOL Time Warner, the mother of all Internet companies, goes to great lengths to generate costs and avoid profit, while other Internet companies are now forced to seek profit at all costs.

"The business plans we're seeing are again based on business models that make sense," Dettmer says. "They're plans that entail a lot of hard work, but we also know they're tested models that work."

Other corporate attorneys agree. Dennis DeBroeck heads the corporate practice inside Fenwick & West in Palo Alto, Calif. Based on conversations with a handful of associates working inside his group, DeBroeck estimates that during the third week of July at least seven startups approached his firm with concrete offers from VCs. Similarly, Casey McGlynn, a partner at Wilson Sonsini Goodrich & Rosati, has been getting more visits from entrepreneurs. "They've been scared, but now they're increasingly coming with new ideas," McGlynn says.

Other figures within the startup ecosystem are noticing similar trends. Representatives from several public relations outfits, especially those that cater to the startup community - and therefore were hit hard by the dot-com crash - report more newly endowed companies seeking publicity advice. SparkPR founding partner Donna Sokolsky says the firm is getting two or three calls a week from newly hatched and funded firms. That's fewer than the three dozen calls a week during the Internet's peak, but more than the two per month seen earlier this year.

Preliminary data from the second quarter shows an increase in early-stage financing that bodes well for the rest of the year. "A third of the industry is trying to figure out what happened," says Jesse Reyes, VP of research at Venture Economics. "A third is trying to evaluate its current portfolio. And a third has gotten rid of the dead wood and is now actively looking at new deals."

There'll still be plenty of pain through the end of the year, according to Reyes and others, especially for those firms seeking later-stage financing. But, after the usual summer slowdown, Reyes anticipates a slow but steady increase in early-stage deals through the end of the year.

"The perception of the new economy nine months ago was stupidly high," says John Doerr, a veteran VC at Kleiner Perkins Caufield & Byers. "Today it's stupid low. We're moving toward normalcy - I hope."

"The business plans we're seeing are again based on business models that make sense," Dettmer says. "They're plans that entail a lot of hard work, but we also know they're tested models that work."

The most pragmatic reason VCs give for the uptick in venture activity: They have more time to hear pitches, to hold tryouts. The same VCs who just 18 months ago were boasting that they sat on more than a dozen boards have spent the better part of a year mired in damage control.

"VCs have been on the sidelines not so much because we've been scared to invest, [but because] we've been so busy baby-sitting," says Lise Buyer of Technology Partners in Palo Alto. By now, however, the plug has been pulled on many time-draining companies. Distressed firms have been repositioned, workers laid off. For many companies, surviving the downturn is a matter of keeping their fingers crossed.

"I have to believe this period when people have been so busy cleaning up their portfolios is coming to an end," says Erik Straser, a partner at Mohr, Davidow Ventures in Menlo Park. "You'll see more problem children dying off this fall, but for the most part the dirty work has been done."

Rents are down, so once again it's possible for a young firm to find a decent office. The services of the ancillary professionals - the lawyers, recruiters and marketing pros so hard to reach 18 months ago - are available at reduced rates. There are a great many talented free agents floating around, either because of layoffs or because a company they helped found failed.

One positive after-effect of the market crash is that VCs have regained a sense of discipline that has made them more sober about picking investments. "There's a premium again on preserving capital," says Brad Koenig, an investment banker who heads Goldman Sachs' technology group. "There's again pressure to keep the head count and other expenses low until key metrics have been reached."

Also, the dramatic drop in the stock market, especially the Nasdaq, has weeded out those who arrived in Silicon Valley in search of a quick strike. "The armchair entrepreneur is gone, the guy who had a half-formed idea and wanted to see if he could get money," says Dave Cremin, a partner at Los Angeles-based Zone Ventures. Those who remain tend to be the technologists in the startup game because they think they've hit on a real breakthrough that could lead to a strong company.

One additional factor that might embolden some venture capitalists: The balance of power has again swung away from the entrepreneur and back toward the VC. Kim Malone is CEO and co-founder of New York-based Juice Software. In chats with her company's venture capitalists and with fellow entrepreneurs she knows from business school and social circles, she notices a newfound willingness of VCs to brave the early-stage waters. But in no small part that's because the prices and deal terms they can exact are so favorable to the VCs' position.

"The valuations from an entrepreneur's point of view are horrible," Malone says. "You really have to be willing to take a bath in terms of valuations if you want to sign a deal right now."

Of course, not every venture capitalist believes the time is ripe again for early-stage investments. Matrix Partners in Waltham, Mass., for instance, is not quite ready to dive back into the game. "There is still way too much money in the venture industry," says Paul Ferry, one of the firm's founding partners. "There are still too many companies that look like other companies. ... There are too many copycats, which mucks it up for everybody."

Others are not convinced that the renewed hopes are anything more than wishful thinking on the part of the venture community. "People are talking about investing," says Kevin Werbach, editor of Release 1.0, a widely read technology newsletter. "But from where I sit, there aren't that many new deals. VCs are still shell-shocked and scared."

Maybe for good reason. Venerable investment banker Sandy Robertson is among the better-connected players in the world of technology finance. While Robertson sees a slight rise in early-stage financing, he's not convinced this newfound optimism will help anyone but the most highly prized venture firms.

"With so much money out there - larger by a factor of 10 compared with five years ago - only the top-tier venture capitalists will see the best deals, the deals built around real engineering breakthroughs," Robertson says. Still, those top-tier firms had shut themselves out. Now the doors are open again - if only a crack. 7

Vishesh Kumar and Silvia Cavallini contributed to this report.

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The Cautious Return of the VC