Out of the swamp: Shedding fins, growing digital feet

Venture capital investment in the Internet is a swiftly moving target, and attention gravitates toward the latest big thing. But statistical perspective reveals patterns: waves of investment in different sectors of the Internet that ebb and flow. Despite periodic setbacks in any given area, over time these waves are carving out a new virtual landform.

Explosive growth notwithstanding, this is evolution, not the Big Bang.

In the early part of the Internet epoch (circa 1995), venture investing focused on software and database companies, which received about twice as much funding as Internet service providers (ISPs), infrastructure companies and business services providers. Fast forward to 1999, and the tables appear to have turned: Investment in business services was double that in software and databases.

But in fact, this change occurred gradually and was a natural outgrowth of Internet development. Such is the case with e-commerce start-ups, which in the first quarter of 2000 raised half as much as during the previous quarter.

Darwin strikes again: Many of them just weren't fit.

Evolution was a recurring theme in the words of Mike Kwatinetz, founding managing partner of Azure Capital Partners, who addressed attendees at the VentureOne Exchange conference, held last month in Boston. Kwatinetz, former global head of Credit Suisse First Boston's equity technology research group and senior software and hardware analyst, is eagerly anticipating--and investing in--the "fourth wave" of Internet technology.

This wave, he portends, will feature online delivery not of physical books, CDs and videos, but of the bytes that comprise them, as well as the devices used to store and replay the data. The climate is ripe for such innovation, he maintains.

Whereas bricks initially battled clicks in the commerce arena, traditional companies seem prepared to embrace the evolution of content-delivery channels.

Not so willing to bet on early adoption? Kwatinetz is the only sell-side analyst rated in the top three by Institutional Investor for each of the past six years-in both hardware and software. For the last three years, he's been the publication's No. 1 Large-Cap Home-Run Hitter for stock selection across the entire market. Let's assume he knows of what he speaks.

Plenty of innovative venture-backed companies are poised to surf the fourth wave, and they'll be taking many "traditional" backers along for the ride.

NetLibrary, based in Boulder, Colo., allows customers to access electronic publications, check books in and out, maintain an online library, make notes and bookmarks, and purchase electronic publications. NetLibrary is backed by McGraw-Hill and Houghton Mifflin, and Simon & Schuster chief executive Jon Newcomb sits on its board. That's in addition to the corporations, individuals and 18 venture capital firms that invested.

DataPlay.com, also based in Boulder, develops miniature optical technology for recording and playing digital and Internet data, as well as distributing digital content for use on portable Internet appliances. The company's investors are individuals, venture capitalists and various electronics corporations, including Toshiba and Samsung.

RioPort.com, based in San Jose, Calif., produces a jukebox application for acquisition and playback of digital audio content from the desktop or the company's own portable appliances. After raising a first round of financing last October, RioPort anticipates closing a second round soon.

San Francisco-based AudioBasket.com, online purveyor of personalized audio content on demand, is also closing a second financing round. DiscoverMusic.com, based in Seattle, Wash., provides music samples and data for use by Internet and traditional music retailers to facilitate the sale of music. Freemusic.com, based in Pasadena, Calif., provides free MP3 files and pays artists via an advertising program. Idealab's chairman and founder Bill Gross is on its board. Even notorious Napster, based in San Mateo, Calif., though embroiled in legal woes, has just completed its second round of venture financing.

And the list goes on.

Venture capitalists, ever on the cutting edge of technology, are obviously believers in online byte delivery. The aforementioned corporations are also in on the action, as is Yahoo, which recently shelled out approximately $200 million in stock for Redwood City, Calif.-based MyPlay, a company that offers online acquisition, storage and management of digital music files.

The public markets, however, are another matter. Beatnik, based in San Mateo, Calif., which develops technologies for online transmission of interactive music and sound, is backed by top-tier venture capitalists and Sun Microsystems, among other corporations. But the company just withdrew its IPO registration.

Liquid Audio, which offers tools and servers for publishing music via the Internet, is backed by Hummer Winblad Venture Partners and Vulcan Ventures; Microsoft executive Jonathan Lazarus sits on its board. Liquid Audio completed its IPO in July 1999, but after rising from $15 per share to as high as $50, it's now trading below $9.

MP3.com, which also went public last July and traded at over $100 on its day of issue, is now trading at about half its $28 offering price. Musicmaker.com, online provider of customized CD compilations, is trading below $2 after the collapse of a marketing pact with AOL. And so on and so forth?

Whether or not specific companies succeed, however, the fourth wave is a distinct evolutionary force.

In the end, the vast majority of literature lovers may be loathe to read eBooks using the Peanut Reader on their Palm Pilots. Those itty bitty DataPlay discs may accidentally be fed into the vending machine, tragically mistaken for yet another state quarter. But as surely as thwarted pen-based computing innovations blossomed in PDAs, the technologies engineered to power fourth-wave devices will develop in multiple directions. And the Internet will continue to evolve.