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Venture capitalists sail turbulent waters into 2001

Venture capitalists are still flush with cash, but they have become highly skeptical of most business plans and don't think many start-ups are worthy of their money.

Got an idea for a hot wireless company sure to take Wall Street by storm? It won't impress Bruce Crocker.

An Israeli entrepreneur pitched just such a plan to the Menlo Park, Calif.-based venture capitalist about two weeks ago. Despite having a solid business plan and a strategy to wring revenue from advertising, the founding partner of the overseas start-up left Crocker's office with little more than a handshake--and no promise of venture funding.

Year in
review special report "I liked the guy and thought he was bright and capable," said Crocker, managing director of Polaris Venture Capital. "But I just couldn't get over the fact he had an ad-based model. If this conversation had taken place last year or 18 months ago, I would have had a lot more optimism and likely taken it to the next stage."

The story is the same at scores of venture firms from Silicon Valley to tech hubs in Israel and India: Venture capitalists are still flush with cash, but they have become highly skeptical of most business plans and don't think many are worthy of their money. For example, Polaris made nearly 20 investments between April and September, but it is likely to fund only five start-ups in the fourth quarter.

The sustained downturn in U.S. stock markets, combined with Wall Street's waning affection for initial public offerings, marked a sea change in the venture capital sector. The last several months of 2000 are a stark contrast to the late '90s--a time when virtually any technology company with a half-baked business plan could weasel funds out of giddy investors.

Investors poured nearly $51 billion into funds managed by U.S. venture firms during the first nine months of this year, up 40 percent from the $36.6 billion raised during all of last year, according to industry researcher VentureOne.

But the amount of money venture firms invested in information technology companies declined in the third quarter, as venture capitalists severely reined in their funding for e-commerce companies and other tech start-ups.

"It seemed like anything with e-commerce or the Internet in their business plan was capable of getting funded earlier in the year," said Stewart Gross, senior managing director of New York-based Warburg Pincus. "And now we're entering into a very cautious environment."

Venture capitalists are not necessarily closing their wallets. Although most venture firms are private companies and do not have to divulge their assets, many insist that they have ample cash to dispense. But they are far less apt to fund a brand-new company or listen to a business strategy that does not have a proven track record.

In the third quarter, U.S. venture firms spent 75 percent of their overall funding on companies that had already received at least two rounds of funding. Before that, they were more likely to fund companies in the first stages of financing, according to VentureOne.

VCs venture abroad
They are also far less likely to listen to a business strategy from a group of entrepreneurs in the United States.

Experts say 2000 will go down as the year when venture firms, especially those concentrated in Silicon Valley, tuned in to global opportunities. Many venture capital firms tested their strategic instincts in places such as Brazil and India, where governments extended capital gains tax breaks to overseas investors.

See 2000 timeline Many saw opportunity in Europe, which is becoming an easier place to do business across national boundaries because of the 1999 introduction of the new standard currency, the euro. Others looked at any company based outside the United States, where the bearish stock market was making it difficult to wring profits out of any investment.

The percentage of venture capital firms that are planning to enter Europe or already have a presence there grew to nearly 10 percent in the second quarter this year from 4 percent in the same period in 1998, according to VentureOne.

"Europe is as large and diverse an area as the United States, yet venture investment is less than a third of what it is in the United States," said Steve Harmston, European research director for VentureOne. "There's tremendous opportunity in Europe right now. The euro has made the region a more homogenized financial area, the markets are consolidating, and there's a number of moves afoot to reduce investment gain taxation."

Warburg Pincus, which has offices in Europe, Asia and Latin America, has noticed a slight increase in competing venture firms overseas.

"We're beginning to see people put their toes in the water by putting a person or a couple people in outpost offices," Gross said. But he noted that it will take time for these firms to broaden their overseas funding efforts, given that they have to learn the local culture and gain acceptance by the native companies.

Asia in particular is attracting a greater share of venture capital after a long recession that stifled entrepreneurship throughout the '90s. Many Asian nations are trying to reverse their reputation as hostile places for foreign-based businesses. For example, Hong Kong is giving financial support to start-ups and changed regulations to ease the path to an IPO.

"Countries in Asia look at how the U.S. high-tech machine has powered the economy and they don't want to be left in the dust," said Andy Kau, a general partner with Walden International Investment Group.

The number of business plans from Indian companies submitted to Walden has increased fivefold this year, while the number from Malaysia has increased more than fourfold. Meanwhile, the of American business proposals submitted has grown a relatively anemic 25 percent to 50 percent, Kau said.

Few venture capitalists predicted the sharp downturn in the U.S. stock market, and many are hesitant to be overly bullish about 2001. Many predict that the venture market will be strong--but not as scorching as in the late '90s or in the first half of 2000.

"A lot of venture firms that came in on the dot-com gold rush got burned," said Sasha Talebi, research director for VentureOne. "I don't think we'll see a doubling of the money raised next year."

Changes afoot
Many say that 2001 is likely to see a shakeout in the venture niche itself. During the late '90s and in the first half of 2000, the promise of huge returns lured prominent executives, Wall Street analysts, business professors and regular folks to become venture capitalists.

An article in Fortune magazine in November called this new breed of investor "the venture capitalist next door." Now that the lure of quick riches has disappeared, experts say many are likely to return to their former professions.

Business plans are also likely to revert to their previous cycles. With prompting from venture capitalists and an eager market for IPOs, many companies, such as TheStreet.com and Pets.com, went public before they could hire key executives and solidify long-term business strategies--let alone post profits. Many venture capitalists say the IPO market of 2001 is likely to be populated by older, more established companies.

"Companies won't go from start-up to IPO in two years," Kau said. "It'll be more like four to six years, and they'll need to focus on creating longstanding businesses."

As for the next hot segment, many venture capitalists are betting cautiously on wireless and Internet infrastructure companies. Some are even hopeful about a rebound for the moribund e-commerce niche.

"E-commerce, broadly defined, continues to be an important investment theme," said Warburg Pincus' Gross. "From our perspective it's a global world, and we're unlikely to invest in a company in Asia that isn't globally competitive."

News.com's Rachel Konrad contributed to this report.