Clean and sober

It’s not a great time to be a venture capitalist. Limited partners want to know why they aren’t getting 300% returns on their money. Entrepreneurs in dire need of funding want to know why the firm can’t corral more VCs into a second round. And the backlog of start-ups that a year ago would have been public by now continues to grow, delaying returns and soaking up cash.

On the other hand, it’s a great time to be a venture capitalist. Really. That’s because start-ups’ valuations are down, bringing VCs larger stakes at a cheaper price; entrepreneurs are hungrier and, therefore, more willing to grant firms time to scrutinize their business plans; and money is still plentiful because VCs are staking companies out of the megafunds they raised in 1999 and 2000.

So which is it? A little of both.

The main certainty is that the VC game is changing, and venture capitalists and entrepreneurs need to adapt to the reality that the land rush in telecom is over.

So what happened? Both VCs and entrepreneurs deluded themselves into thinking they could come in and make a quick buck, says Don Lynch, chairman and CEO of broad:margin, a telecom consulting firm.

“When the Telecom Act of ’96 was signed, people thought you could get into business quickly on a resale model,” Lynch says. “The economics of resale didn’t work. So everybody started to see how much stuff they could put in the ground—the VCs went along with that, as well as the equipment vendors. There was a spending spree in the industry that was incredible.”

Consider the flow of money: In 1999, VC investments in communications start-ups more than doubled to $8.2 billion from $3.4 billion in 1998, according to VentureOne.

On its own, fourth quarter 1999 surpassed all of 1998 for amounts raised by venture-backed companies. The splurge continued through 2000, and although investment in communications and networking companies slacked in the fourth quarter, the year finished with VC investments of $18.1 billion.

Entrepreneurs certainly were partly to blame, VCs say. “It was an ego-driven process,” says Morgan Jones, general partner at Battery Ventures. “The guy who could get to 100 employees the fastest was the winner.”

Moreover, entrepreneurs had big dreams. “We saw way too many entrepreneurs who believed that if they built it, they would be a $500 million company in a couple of years,” says Sean Dalton, general partner at Highland Capital Partners.

But the VCs also take their share of responsibility, saying that the pressure to capitalize on fast-moving market opportunities and put capital to work in an exploding economy helped push them into some unwise investments.

“I think there’s shared responsibility,” says Lorraine Fox, general partner at Crescendo Ventures, a communications-focused VC with more than $1 billion under management. “There were some notions like ‘Get big fast’ that ignored the business model and paths to profitability.”

The dry season

Venture investing has definitely slowed in the last quarter of 2000 and in the first quarter of 2001 as VCs re-evaluate portfolios, market opportunities, new deals and their investing process as a whole (See Figures 2 and 3 on page 48).

“I think you’re going to see VCs on the sidelines for months to come, until they understand who’s shaking out and who’s not. They’ve been burned,” Lynch says.

For one thing, VCs are expending more time, energy and financing with existing investments.

Convergence Partners, a three-partner firm in Silicon Valley, said it might not make any new investments over the next few months. “We try to preserve cash because [the existing] companies will be in our portfolio longer,” says Russ Irwin, general partner at Convergence Partners. “We don’t know when the IPO and M&A windows will open up again.”

Most VCs are focusing on supporting their portfolios with domain expertise and company building services and ensuring they have 12 to 18 months of cash to fund their business plans, Fox says. Fox devotes 70% of her time to portfolio start-ups and 30% to new investments.

Crescendo recently hired business development professionals in the U.S., Europe and Asia to get its fledgling outfits off the ground quicker. The firm’s Afterburner Program helps entrepreneurs focus on the business by handling “infrastructure” service relationships such as executive searches, public relations and equipment leasing.

Indeed, large later-stage financing rounds raised by some start-ups are due to the fact that the companies have to stay private longer because the money is not available on the stock markets or from acquirers.

“Some of the larger rounds are being made by VCs that have already invested in the company, while a year earlier these companies may have gone public,” says John Taylor, vice president of research for the National Venture Capital Association.

For start-ups and emerging companies in need of funds to continue operations, the fact that the bulk of the money could be going into nurturing existing companies is problematic.

“There are a lot of companies out there scrambling for funding,” Lynch says. “It’s going to be very quiet over the next nine months.” By some estimates, even if a company does get funding now, the average time for a deal to be completed is between three and six months.

It’s not only the money that VCs are willing to put on the table, but also the tightening in the other capital markets that exerts pressure on start-ups. For example, broadband network provider Digital Access raised $450 million two years ago, but recently it had to close up shop because it couldn’t raise the $850 million in debt that its business plan called for.

The argument against a continued “dry” venture capital market is the large inflows of money into VCs’ funds the past couple of years. Limited partners invested $69.1 billion in 249 VC funds in 2000, a doubling of 1999’s $34.5 billion mark, and 18 funds hit or exceeded $1 billion, according to VentureOne.

Highland Capital, still in the midst of investing its $550 million fifth fund, is “putting the finishing touches” on its sixth fund, which Dalton says will be larger than $500 million.

The significance is that VCs have large coffers from which to stake businesses. “There’s a lot of money that wants to invest in small companies,” Taylor says.

Indeed, some companies are raising large funding rounds, but they are more likely to be later-state rounds that attract strategic investors and corporate VC funds, Taylor says.

In February, GiantLoop Network, a provider of fiber optic networks for corporate campuses, raised $120 million from Greylock Partners, Pilot House Ventures, Cabletron Systems, Nortel Networks and Sycamore Networks.

Sigma Networks, a provider of broadband interconnectivity in metro markets, raised $145 million in expansion financing from Benchmark Capital, Salomon Smith Barney and Epoch Partners. And Telseon, a gigabit Ethernet network provider, captured $100 million in third-round funding from DLJ Global Communications Partners (the telecom investment arm of DLJ Merchant Banking Partners), Foundry Networks, Cabletron Systems and some of its second-round VC partners.

Some VCs are even hinting that the down cycle is already over and that they’re getting out their checkbooks again.

“In the last month or so we’ve seen [VCs] come back to some degree,” says Mark Evans, partner at Great Hill Partners. “At the end of the day, money has to be put to work.”

Although Great Hill has not closed any deals yet in 2001, it has made a preliminary commitment to an unnamed telecom company and plans to pour some additional money into Edge Connections, an Atlanta-based building local exchange carrier, in the next 60 days, Evans says.

Other VCs voice a similar optimism. “We’re definitely in the active investment mode,” Jones says. “There’s no particular reason why this is a bad time to invest. You naturally have a little bit more caution.”

The anecdotal evidence, however, suggests that Battery Ventures has lowered its rate of investment. In 2000, the firm completed 60 new and follow-on financings. In the first quarter of this year, however, Battery has made only five investments.

Sour times

Even if more VC money begins to flow back into seed deals, VCs are apt to be more scrupulous about whom and what they stake. In that way, the market downturn has actually been good for VCs and maybe even entrepreneurs.

The pullback has resulted in a weeding out of weak start-ups and management teams, according to Fox.

The current environment makes you double-check your thought process, according to Jones. “You make doggedly sure you have real product differentiation and make doubly sure about the [management] team.”

In the rush of the past couple of years, the notion of freely available capital led to funding of start-ups deeper into an existing category. In other words, not just one or two companies in a product space were funded, but also the fourth and fifth entrants in the category, even if they had little differentiation.

Valuations are now based purely on the ability to generate cash off the assets, Lynch says. “Now if you want valuation, it comes down to building solid operations that generate a return.”

Another benefit of the bust: People are taking their time looking at new investment opportunities. Venture-backed companies are more accepting of the due diligence performed by VCs and not rushing into deals.

“VCs have much more leverage than they did five months ago,” says Andrew Rush, managing director at DLJ Merchant Banking Partners.

Having greater familiarity with the business plan and operations means VCs can be more effective at the board level, Dalton says. “Now when I sit on the board of directors, I’m going to have a strong baseline.”

In the seeding stages, VCs are more likely to take a heavier hand and break off a service provider’s network plan into fundable pieces. For a service provider, that might mean tackling the first five or 10 cities in the network plan. The VC will examine what it can fund with only equity and if it can get the company to break even with its initial commitment of money.

“The filter is a little finer,” Evans said. “The scale of the start-ups will be smaller.”

Instead of propping up mediocre businesses with further funding, VCs are also more apt to bail out on a seed investment if prospects for a solid return don’t look good.

For example, Great Hill Partners pulled out of American Broadband, a cable overbuilder that it had helped start with an investment of less than $5 million, before spending a lot of cash on plant and equipment, Evans says. “We seed-funded the management team and made a larger commitment that was premised on raising capital from other private equity sources and having access to debt,” Evans says. “When the telecom market cratered last year, it became apparent that the equity and debt sources had dried up.”

Great Hill Partners backed off from the deal after only putting a modest amount of capital at risk, Evans says. “Overbuilding cable networks is very expensive. A lot of those companies have lost their funding.”

Follow-on rounds of investment, despite the examples cited earlier, can also be trickier. Ocular Networks, a developer of optical access solutions, closed a $30 million round in January and defied the odds, says Highland’s Dalton.

“It was the most difficult fund raising month I have ever experienced,” he says. “Every day the market was down 2[%] or 3%. Comps were down.” Instead of getting 20 voice mails a day asking about Ocular’s funding needs, “there were only three or four firms interested in the deal,” Dalton says.

In general, it now takes more time to raise follow-on rounds of investment, Jones says. “In 1999 and 2000 if you were going to be a follow-on investor, the biggest mistake was to sit on the sidelines. Now the biggest mistake is investing in the wrong thing.”

Make lemonade

Of course, one entrepreneur’s misery can be a VC’s dream. Competitive LEC and broadband providers that have fallen on hard times are good targets for venture capitalists looking for large chunks of low-risk companies.

Great Hill Partners, for instance, is “contacting management teams that were funded by other firms and off to a good start but are now stuck without a fully funded business plan,” Evans says.

While private equity can help such companies over the hump to the point of EBITDA-positive or cash-flow break even, if the network and the operations support systems are in place it means some of the execution risk has been removed for the VC.

“We can both remove the start-up risk and avoid taking such a steep entry price into a company that’s heavily marked up,” Evans says.

Battery Ventures, traditionally an early-stage investing firm, had shied away from investing in B and C rounds because valuations were out of control, Jones says. “Now the valuations for Series B have come back into line-it opens up that arena for us again.”

Red zones and green fields

So where are communications VCs placing their bets these days? First let’s start where they are not—service providers. The hard crashes of competitive carriers have cast a gloom over prospective investments—the very investments that seemed to have spurred the massive spending in telecom equipment.

Now the market is helping existing carriers manage complex operations, Dalton says. “The challenge for a carrier is figuring out how to make all this work: to integrate technologies—hardware, software, silicon and services—that can manage network growth and complexity.”

At the top of the must-have list for VCs is any company focused on increasing bandwidth in metropolitan area networks.

“The question is how quickly does it become competitive?” Evans says. “Right now there is a huge need for it.”

Optical equipment companies at many levels of the supply chains are also a hot ticket, despite the disappointments suffered by their public comparables.

“A lot of money is being invested in optical components and optical equipment companies, because the operators are going to have to replace a lot of their infrastructure,” says Maia Heymann, director at BancBoston Ventures.

On the other hand, it may be a little late to enter the game, Jones says. The optical components market has garnered more funding than it deserves, he says. Understanding the market need and having the capability to make product efficiently will separate the winners from the also-rans in that space.

“To spit working product out the door with good yields is hard,” Jones says. “If you get it wrong, a cheap part becomes very expensive.” Jones says about one out of every 20 optical component start-ups is building the necessary manufacturing capabilities. “Most of them are science fair projects,” he says.

Managed services—value-added services that fit on top of a co-location or hosting platform and provide security, virtual private networks and content distribution are another fertile area for investments, VCs say. That market will grow from $78 million in 2000 to $524 million by 2004, according to IDC.

On the infrastructure side, Crescendo has invested in Ejasent, a computing utility platform that allows e-businesses to allocate computing resources in real time and process applications at the edge of the network. Other backers of Ejasent include Bill Joy, co-founder and chief scientist of Sun Microsystems, and B.V. Jagadeesh, co-founder of Exodus Communications. Crescendo also invested in Lumenare, a provider of dynamic remote lab services for testing and provisioning by vendors and service providers.

“We like being arms suppliers; We like providing infrastructure that [other companies] can leverage,” Fox says.

Wireless equipment is another green-field opportunity, according to Dalton, because it has a lot of similarities to the wireline business in 1996 and 1997. The switch from analog to digital networks and the addition of new data-capable spectrum worldwide create a need for cutting-edge, third generation infrastructure.

Historically, wireless equipment providers were few because they had to build every piece of the system-radio chipsets, chassis and software. Now, component players and system integration will allow entrepreneurs to build a wireless company without ever having to see a radio, Dalton says. “Companies that three years ago would have developed a box now sell a chip and sell it at much higher margins,” he says. “It’s all about accelerating products through the sales channel.”

According to Irwin, businesses built around improving the quality, throughput and bandwidth of wireless transmission form another intriguing area. “In RF you can’t make a new pipe—how do you get more bits through that spectrum?” Irwin says. “That’s an incredible opportunity.”

Comeback?

With the IPO market still in the doldrums and constant evidence of a capital spending slowdown by carriers, VCs don’t expect many home runs to be hit in 2001. But the fact that “exit values” are down does not mean there is no room for achieving a decent return on capital.

Exit values are coming down, but so are valuations, Fox says, giving VCs a larger stake in a more rationally valued business. “You have to assume a more normalized exit value. Lower valuations increase the prospects of achieving the returns that we want.”

At the same time, of course, VCs won’t be in any rush to put dollars to work—especially if limited partners sour on venture capital and look elsewhere for investing vehicles.

For VCs the trick to smart investing will remain the same: Get in early, evolve the business plan, fix the weaknesses and eventually hope for a liquidity event. But with liquidity events few and far between, it could be a while before the capital markets revive and the good times return. In the process, however, it’s not unthinkable that some opportunities will be missed.

“It’s much more sane, but it’s a little too extreme,” Fox says. “Good companies have been suffering along with more marginal companies. The pendulum has swung too far back.”