Fallen VC Idols

Baldwin Louie — Mon, 21 May 2001 18:00:00 -0400

They talk about it at their children's school plays. They ask the question at Palo Alto power lunches: Who among them, the Silicon Valley venture capitalists wonder, will be first to turn in a lousy return for their funds?

It's a question no one asked in the boom times, but this is a very different world for VCs. Venture investing in the first quarter of 2001 was down 59 percent from record highs. Dozens of venture-backed dot-coms have gone out of business, and hundreds of others are still years away from profits. Funds that invested rapidly at the peak of the frenzy have seen the value of their investments fall 75 percent or more.

"There are some big-name funds out there in trouble, there's no question about it," says Kathryn Gould, an 11-year industry veteran and a partner at Foundation Capital, echoing a sentiment expressed by many VCs. "I hear it from our limited partners, who are invested in a lot of the big funds."

The limited partners - wealthy individuals, pension funds and college endowments that invest in venture funds for double-digit returns - are bracing for single-digit returns this year, well below the triple-digit returns seen in 1999 and even the average 27 percent return over the past 10 years. In the worst-performing funds, the limited partners could face losing the capital they originally invested.

It's no surprise that plenty of also-ran venture shops and incubators that popped up during the bull market are struggling with soured investments. Many limited partners sought out the top VC firms precisely to avoid such a risk. But some of those top firms - the ones that supposedly had the wisdom and experience to know better - made what now look like serious missteps at the height of the bubble. They often focused on dot-coms with little hope for profitability. Worse, they invested so quickly that they had little left over to nurture startups through the downturn that followed. Now Draper Fisher Jurvetson, Hummer Winblad, Redpoint Ventures, Softbank Venture Capital - even the undisputed superstar of the venture world in the second half of the 1990s, Benchmark Capital - are sitting on at least one problem fund.

REPERCUSSIONS OF THINGS PAST
Several leading VC firms raised funds during the peak of the Internet bubble. But five - Benchmark Capital, Draper Fisher Jurvetson, Hummer Winblad, Redpoint Ventures and Softbank Capital Partners - were aggressive in investing much of their funds early in now-struggling dot-com startups.
FIRM	FUND	YEAR RAISED	AMOUNT (IN MILIONS)	% OF FUND IN- VESTED	% OF MONEY RETURNED TO INVESTORS	% OF COMPANIES FUNDED AFTER APRIL 2000 ****	DIVERS- IFICATION FACTOR
Benchmark Capital	Benchmark III	1998	$149	100%**	0%**	53%	Poor
Draper Fisher Jurvetson	DFJ V	1998	$180	80%**	24%**	44%	Moderate
Hummer Winblad	Hummer Winblad IV	1999	$315	75%***	N/A	48%	Poor
New Enterprise Associates	NEA IX	1999	$871	65.1%*	0%*	68%	Good
Redpoint Ventures	Redpoint I	1999	$600	60%*	0%*	66%	Moderate
Softbank Venture Capital	Softbank V	1999	$600	100%**	0.01%**	50%	Poor
US Venture Partners	USVP VI	1999	$278	84.3%*	0%	55%	Good
As of Sept. 30. As of Dec. 31. Estimate. ** Excludes companies that have gone public or been acquired. Sources: Insider VC, Venture Economics and Venture One

Correction:
An earlier version of this article should have stated that Benchmark Capital's third venture fund has invested in a software company, Collabra. Also, due to an editing error, the story should have stated that Benchmark III has no investments in networking equipment, and that the $10 million loss the fund faced on an investment in 1-800-Flowers was as of Sept. 30, 2000.

Additionally, the story incorrectly stated that Tim Draper is an investor in Red Herring.

What is there to say about love beads, Peter Frampton, Michael Dukakis and Net mutual funds, except that they came, we tried them and now they seem just plain embarrassing.

The latest Net fund failure is the Strong Internet fund, which conceded defeat this week and announced it will take refuge in Strong's Technology 100 fund. The fund's Net nature boosted its curiosity factor among reporters, and though coverage was widespread, analysis wasn't. Uber-analysis firm Morningstar was quoted everywhere. Stock fund analyst Paul Herbert commented on the funds' faddish nature to the Milwaukee Journal Sentinel, Strong's hometown newspaper, then was found echoing the same ideas in his own piece on Morningstar. That must be what they mean by convergence.

Because relatively few people had heard of the Strong fund, its demise became a chance for reporters to revisit the crash-and-burn of Merrill Lynch's Internet Strategies fund, coverage of which got lost in the media's weekend black hole after the firm announced last Friday that the fund would merge with Merrill's Global Technology Fund. While Strong Internet had attracted $96 million in assets at its peak, Merrill's fund had scarfed up a piggish $1.1 billion. The Wall Street Journal pointed out that the 13-month-old fund had the dubious distinction of having launched one month after the market peaked. Only two weeks ago, Morningstar had pegged it as one of 10 funds to avoid ("even those few who still want an Internet-focused fund can do better").

Having left their investors with a tin cup's worth of assets, many funds now find themselves equally bereft, Reuters noted. "Then there's the embarrassment factor, which was probably a big part of what led Merrill and Strong to kill off their funds," Russel Kinnel, Morningstar's director of fund analysis, told the wire service. How bad is it? By now, some red-faced Internet funds have less than $100,000 in assets, Reuters quoted Ramy Shaalan of fund researcher Wiesenberger/Thomson Financial as saying. $100,000? Why bother? Better to close up shop, throw on the beads and cue up a Frampton LP.

Another Net Fund Folds (Reuters)
CNNfn

Another Fund With 'Internet' in Its Name Is Going Away
TheStreet.com

Strong Aims to End Internet Fund
Milwaukee Journal Sentinel

Another Net Fund Heads for Oblivion
Morningstar

Dot-Com Dead Pool for Funds
Morningstar

10 Stocks and 10 Funds to Avoid (Morningstar)
CNBC.com

Strong Capital Joins Growing List of Firms Abandoning Web Funds
Wall Street Journal (Paid subscription required.)

Merrill Internet Fund Logs Off After Dim Life
Wall Street Journal (Paid subscription required.)

Of course, many venture funds are still so young that a couple of big hits could cover a long list of bad bets. In the image-obsessed world of VCs, however, even one down year is the kind of thing that could tarnish a firm's reputation.

"The way venture capital works, or at least used to work, was you invested in a fund over two or three years so you captured several years' worth of trends," says one longtime venture capitalist who, like most VCs and limited partners interviewed for this story, would only speak anonymously. "But in '99, you saw some well-known VCs go through their whole wad in a six- to nine-month time frame, so they only captured a partial year of trends. Those are the funds the limiteds are worried about."

Eighteen months ago, a venture fund reporting a negative return was unthinkable. The Nasdaq was climbing toward 5000. Tech IPOs were tumbling out the door, with investment bank analysts minting new metrics to justify the skyrocketing stock prices. So venture capitalists blithely laid down tens of billions of dollars on dot-coms. The biggest risk VCs faced seemed to be missing out on the next eBay.

"If a deal was hot enough, you locked the door and didn't let the founders out until they had at least verbally committed to a deal," says Neil Weintraut of 21st Century Internet Venture Partners. "We realized only once it was too late that we forgot to pay attention to this one important factor called profitability." It's a confession akin to a pro-ball scout proclaiming a player has all the intangibles to become a starter in the NBA - except he can't shoot.

VC money legitimized the dot-coms, and stock investors legitimized the investments with inflated valuations. The highest-profile VCs got drunk on their own celebrity and personal wealth. At the peak, stars such as Redpoint Ventures' Geoff Yang were wondering aloud whether there was any downside left in the game. "If the company doesn't work out, we'll sell for $150 million," Yang told Fortune in 1999. "If it does, it'll be $2 billion to $10 billion. Tell me how that's risk."

Yang got his answer when stocks crashed in 2000. Now the wider world no longer buys the story that dot-coms will rule the world; those flying the highest during the boom times are today's goats. The technology world's best-known investment bankers operate under a cloud of scandal as federal investigators question the legality of their IPO allotment practices. The Internet's best-known research analysts are reeling from charges they touted highly speculative stocks more out of self-interest than in a belief in companies whose shares are now trading 90 percent or more off their highs. And the venture capitalists, once lionized for their ability to spot huge hits, are getting their comeuppance. Last week, for instance, Webvan, the ultimate VC poster child last week was worth $77 million, down from a market capitalization of $2.5 billion only nine months ago.

Venture capital firms hold information about their funds' performance close to their chests - especially the current valuation of their investments. Even so, there are plenty of clues that point to a fund in trouble: How close is it to prematurely spending all the money it raised? How many of its companies have been able to raise money since the stock market crashed? How much of the fund did the firm plunk in the dot-com pot? How many startups have gone out of business in the fund's short life? And how much money are limited partners getting back on their investments?

FIRM	DESCRIPTION	COMPANIES IN FUND INCLUDE ...
Draper Fisher Jurvetson	Led by Tim Draper, DFJ charged into the online retailing and b-to-b sectors in its fifth and sixth funds. More than half the companies in the fifth fund have yet to raise new funding in a tough market.	BestOffer.com, DigitalWork, Everdream, InfoRocket.com, SeeUThere.com
Hummer Winblad	John Hummer and Ann Winblad have never produced a home-run investment. It is unlikely that its fourth fund, the first to focus on the Internet, will improve the firm's track record.	Homes.com, Lavastorm, Mambo.com, Pagoo.com, Rivals.com
Redpoint Ventures	Geoff Yang and his five partners invested in 40 startups in 14 months. Their silver lining: More investments in infrastructure firms than in dot-coms.	BigBand Networks, eNet China, HelloBrain, MetaTV, TeraOptic Networks
Benchmark Capital	The firm's third fund, raised in 1998, was almost exclusively invested in dot-coms. David Beirne and Benchmark partners opted to spend most of the fund's capital in nine months.	Collab.net, Epinions.com, Guild.com, Living.com, Respond.com
Softbank Capital Partners	Gary Rieschel admits his fund was overweighted in sectors that "got smashed." He's already telling investors the best they can expect are money-market-like returns.	Asia Online, BlueLight.com, iChristian.com, Rentals.com, Secure Commerce Services

Additionally, the story incorrectly stated that Tim Draper is an investor in Red Herring.

FIRM	DESCRIPTION	COMPANIES IN FUND INCLUDE ...
Draper Fisher Jurvetson	Led by Tim Draper, DFJ charged into the online retailing and b-to-b sectors in its fifth and sixth funds. More than half the companies in the fifth fund have yet to raise new funding in a tough market.	BestOffer.com, DigitalWork, Everdream, InfoRocket.com, SeeUThere.com
Hummer Winblad	John Hummer and Ann Winblad have never produced a home-run investment. It is unlikely that its fourth fund, the first to focus on the Internet, will improve the firm's track record.	Homes.com, Lavastorm, Mambo.com, Pagoo.com, Rivals.com
Redpoint Ventures	Geoff Yang and his five partners invested in 40 startups in 14 months. Their silver lining: More investments in infrastructure firms than in dot-coms.	BigBand Networks, eNet China, HelloBrain, MetaTV, TeraOptic Networks
Benchmark Capital	The firm's third fund, raised in 1998, was almost exclusively invested in dot-coms. David Beirne and Benchmark partners opted to spend most of the fund's capital in nine months.	Collab.net, Epinions.com, Guild.com, Living.com, Respond.com
Softbank Capital Partners	Gary Rieschel admits his fund was overweighted in sectors that "got smashed." He's already telling investors the best they can expect are money-market-like returns.	Asia Online, BlueLight.com, iChristian.com, Rentals.com, Secure Commerce Services

Additionally, the story incorrectly stated that Tim Draper is an investor in Red Herring.

Steve Lisson devotes his time to such questions. He is at once an industry gadfly and a font of information on venture funds; his Web site, InsiderVC.com, is followed closely by many in the business. With the help of Lisson and research firm Venture Economics, The Standard has assembled profiles of major VC funds raised in 1998 and 1999. Because dozens of funds opened during the peak of the tech bubble, we limited our list to several high-profile firms.

While any fund raised during the last few years is enduring tough times now, not every one is in the same boat. Funds raised by Battery Ventures, Kleiner Perkins Caufield & Byers, New Enterprise Associates, Sequoia Capital and US Venture Partners have their share of ailing dot-com investments. But they diversified into areas like biotech, networking and software for big companies. Also, they didn't spend their money as quickly as Benchmark and Draper did with their vintage 1998 funds, or as Hummer Winblad, Redpoint and Softbank did with their 1999 funds. The latter are the ones slowly coming into focus as strong candidates for subpar performance.

Any recitation of the funds in greatest jeopardy should start with Hummer Winblad and Draper Fisher Jurvetson. Ann Winblad and Tim Draper, the public faces of their respective firms, are better known for being well-known than for their skill at spotting promising startups. Winblad is a columnist for Forbes ASAP, and Draper is an investor in Upside and a long-time friend of Tony Perkins, who founded both Upside and Red Herring magazines. Yet both firms have suddenly turned press-shy. Representatives of the two firms declined to comment for this article.

After mixed success in three funds that focused on software companies, Hummer Winblad raised $315 million for its fourth fund, which it invested almost entirely in Internet ventures. "It's like the entire portfolio was made up of dot-com, swing-for-the-fences deals," says a limited partner for one of its funds, who asked not to be named.

So dismal are the prospects for Hummer's fourth fund - among its were a laundry list of dot-bombs including Gazoontite, HomeGrocer, Pets.com and Rivals.com - that general partner John Hummer recently felt compelled to send a letter to its limited partners. "It is an understatement to say how bad we feel about this," he wrote.

For his part, Draper took a scattershot approach that not only backfired when the dot-com sector collapsed, but also made the firm look careless. "I don't even count Draper as a real venture fund," says an institutional investor who has money in roughly 50 venture funds. "They're like this index fund that indiscriminately invested in everything."

Additionally, the story incorrectly stated that Tim Draper is an investor in Red Herring.

Both Draper V, a $180 million fund, and Draper VI, which raised $375 million, are full of businesses with an online angle. Four companies in Fund V are already out of business. Draper VI has its share of firms from the Internet bubble, including Club Mom, a content site for mothers; Amazing Media, a banner ad technology firm; and Product Pop, an Internet-marketing services company.

Draper did hit it big recently. Cyras Systems, a fiber-optics firm in Fund V, was acquired in March for $1.15 billion in Ciena stock. That's a significant score - but it's questionable whether Draper's take will be enough to balance out the other dogs in the fund.

Redpoint is a venture capital supergroup, with partners who defected from Institutional Venture Partners and Brentwood Venture Capital. But the firm's first fund, which raised $600 million, so far has been short on successes.

The six partners at Redpoint took just 14 months to invest in 40 startups, most of them Internet-related. There was an $8 million investment in BizBuyer.com, a b-to-b company that closed shop last year, and $22 million in NexGenix, one of many companies created to build e-commerce sites. Other investments include $3 million in an online beauty site, $4 million in an e-commerce company called eNet China and $6 million in a sci-fi Web site that shut down operations in April. A year ago, NexGenix filed to go public - Redpoint's first chance to cash out and distribute the proceeds to its limited partners - then pulled the offering in May. Four months later, NexGenix laid off an unspecified number of employees.

Redpoint's two saving graces were that it set aside about half its fund to keep its startups going and that it invested outside the dot-com realm. Yang figures roughly 70 percent of Redpoint's first fund is invested in infrastructure and software firms, though many were e-commerce companies that have shifted their focus hoping to stay alive. "At least we don't have 70 percent of the fund in e-retailing," he says.

Fate has been a little less kind to Softbank Venture Capital. The $600 million Fund V invested in 48 startups in approximately 12 months, including companies such as Buy.com, eCoverage, eOffering.com, Perfect.com and Rentals.com. The portfolio also includes iChristian, an online religious bookstore, More.com and Urban Media Communications, all of which have gone out of business; BizBlast, a company that hoped to help small businesses get on the Web but ended up laying off more than half its staff last fall; and iPrint.com, which went public just prior to the spring 2000 crash and traded last week at less than 50 cents a share.

According to Lisson, Softbank V has already parceled out all of the fund's money yet has distributed no money to investors. Softbank VCs admit the fund overindulged in vulnerable sectors.

Additionally, the story incorrectly stated that Tim Draper is an investor in Red Herring.

According to Lisson, Softbank V has already parceled out all of the fund's money yet has distributed no money to investors. Softbank VCs admit the fund overindulged in vulnerable sectors.

Additionally, the story incorrectly stated that Tim Draper is an investor in Red Herring.

"We were overweighted in services, and when that sector got hit our fund got smashed," says Gary Rieschel, executive managing director of Softbank Venture Capital. "We were also overweighted in Internet consumer and business-to-business, rather than core technologies."

Still, Rieschel pledges, "we'll have a few nice pops and even a couple of home runs." He's already told the fund's limited partners they can expect a return of 150 percent to 200 percent. That might sound like a good payoff, but funds typically have a 10-year life span. Doing even the more optimistic math means this comes to about 7 percent a year, which is barely better than a regular money-market account, despite the enormous risk inherent to venture investments during an economic slowdown.

Perhaps the biggest disappointment comes from Benchmark, a firm whose towering reputation gives it that much further to fall. The firm's success with Ariba and eBay sealed its reputation as one of the most successful VC firms of the late '90s. How, then, does it get lumped together with Hummer and Draper when insiders mention troubled VC funds?

Mainly because of the performance of Benchmark III, the firm's third fund. The fund raised $149 million in the second half of 1998, and then spent all that cash in nine months, a fraction of the three-year average before 1998. In all its other funds, Benchmark has invested in 21 networking-equipment and semiconductor startups, 10 software companies and another six firms in the wireless market - but fund III has only one investment in any of these categories: Collabra, a software company. The fund has three investments in networking services companies.

According to Lisson's data on Benchmark III, the partners invested in 24 startups, including Epinions.com and Living.com. By last fall, though, the fund was down to a portfolio of 18, half of which were in online retailing, with another three in the business-to-business sector. Four others have since gone out of business, including Great Entertaining and CharitableWay.com, representing more than $20 million in losses. Of the remaining companies, five have struggled with cutbacks and layoffs.

Benchmark partner Kevin Harvey denies that Benchmark III is performing poorly: "I feel confident that fund three will perform at the top of its class." He also says that Benchmark IV - raised in 1999 - is already proving a success with two public offerings.

Additionally, the story incorrectly stated that Tim Draper is an investor in Red Herring.

Benchmark had always defined itself strictly as an early-stage investor, but when it invested $19 million in 1-800-Flowers, the partners rolled the dice on a "mezzanine" investment - an investment in a company poised to go public. That proved costly. 1-800-Flowers is the one company in the fund that has gone public. But by September 30, 2000 it had racked up a loss exceedig $10 million for the fund, according to InsiderVC.com. After publication of this story, Benchmark said that loss has fallen to $2 million.

Compounding its bad bets, Benchmark failed to hold back enough of its reserves for further financing. VCs usually reserve about half of a fund's cash to make later investments in its most promising companies. Within the venture world, it's generally frowned upon to pull money out of a new fund to salvage a company funded by a previous one. According to its contract with limited partners, Benchmark is permitted to cross-pollinate between funds, but doing so, experienced VCs say, raises the question of whether you're trying to cover for old mistakes with new money.

In general, VCs try to avoid such cross-fund investments. "It's something you should do very rarely and only when you have complete confidence in a company," says Geoff Yang, a 16-year VC veteran. "Otherwise, there are huge opportunities to get second-guessed by your limited partners, who might think you're using one fund's money to prop up the investment of another." On at least three occasions, Benchmark has dipped into fund IV to invest in fund III companies, including a $3 million investment in the now-defunct Living.com.

Still, Benchmark remains confident in fund III's long-term performance. Despite the carnage so far, the firm is convinced at least five of the surviving companies could single-handedly provide a $1.5 billion return. VCs by nature are an optimistic bunch, but the boys of Benchmark may be an extreme example of the breed. The world around them has changed dramatically, yet they still believe that a $1 million investment in fund III will eventually return $150 million to investors.

That would take quite a turnaround. Until then, Benchmark, like other VC firms with hangover funds, can try again with newer funds, for which they've so far had little problems raising money. The question is, will their reputations recover as easily?

Kathi Black, Diana Moore, Katie Motta and Jeff Palfini contributed to this report.

Additionally, the story incorrectly stated that Tim Draper is an investor in Red Herring.

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Fallen VC Idols