Tech Industry

Venture capitalists recovering from dot-com scare

Though venture capitalists say their business has undergone a significant chill, they agree that the drop in temperature is unlikely to threaten--and may even improve--the overall health of the industry.

Adam Zong could almost taste the money.

He had just wrapped up a presentation to a potential investor and was told that a check for $1.5 million--enough to propel his young company, NovaEx.com, into the next stage of development--would be sent his way in the next day or two. During the plane ride back from Phoenix to his home base in Philadelphia in early April, Zong felt "elated" and made plans to hire several senior managers and programmers.

The next day, the Nasdaq composite index plunged more than 300 points. And the day after that, Zong no longer had $1.5 million coming his way. "The investors got really spooked and backed out," he says.

Over the course of the next several weeks, technology stocks in general--and Internet stocks in particular--experienced a spectacular descent. The Nasdaq lost 40 percent of its value, and many companies lost much more. The effects of the decline hit especially hard in the venture capital arena, an industry where sky-high valuations and the dot-com excitement had fueled a meteoric rise.

Several months later, these effects are still rippling through the VC world and through the many companies that depend on VCs for their growth and survival.

Though venture capitalists and entrepreneurs say the VC business has undergone a significant chill, they agree that the drop in temperature is unlikely to threaten--and may even strengthen--the overall health of the industry.

"I think it's a completely healthy development," says David Schlessinger, the founder of retailers Encore Books and Zany Brainy, who oversees an investment portfolio of both Internet-related and more traditional businesses. "Too many of us, frankly, weren't holding companies to a high enough standard when it came to things such as quality of management, the relevance of the business and the potential for profitability.

"If a change in the market means that now real businesses will rise to the top, then I couldn't be happier."

The allure of eye-popping returns
The tremendous bull market for venture capital can be roughly dated to the launch of Netscape in 1996, which put Sand Hill Road, the home of VC, on the map. In all, nearly $150 billion in venture capital has flowed into businesses in the past five years. The past two years have been especially kind to venture capital. In short, everything came together: a wave of high-tech and Internet ideas, tons of venture cash, and receptive financial markets that made exit strategies a snap.

Some estimates place the number of venture capital firms at close to 1,000. Venture capital funds carry war chests filled with hundreds of millions of dollars--and a growing number total $1 billion or more. Even well-established companies, some of which had dabbled in venture capital to expand their business lines or to get in on new technologies, were not able to resist the allure of eye-popping returns. Lucent Technologies, Nokia and Chase Manhattan Bank, to name a few, launched venture funds as pure profit plays.

Not surprisingly, a huge portion of the venture capital investments made during the past several years went to technology-related companies. In fact, PricewaterhouseCoopers estimates that all but about 9 percent of the venture money invested in 1999 went to tech firms.

John Taylor, research director at the National Venture Capital Association, says that although second-quarter figures are not yet available, venture-capital funding looks to have booked its best numbers ever during the April-June quarter.

A strong second quarter would continue an impressive string of records. Venture capital investments reached an all-time high of $48.3 billion in 1999, an increase of more than 150 percent over 1998's total, according to the NVCA and Venture Economics. In the first quarter of 2000, the trend continued, as venture capitalists invested $22.7 billion in more than 1,500 companies.

Taylor says that the fallout from this spring's "tech wreck" may not show up in industry figures immediately. However, plenty of anecdotal evidence points to a considerable shift in approach by venture capitalists. "We're hearing that there are two factors at play in the market right now," Taylor notes. "First, venture capitalists are telling us that they're keeping some powder dry so that if the IPO market stays tight, they're ready to contribute more money to their companies, essentially adding another pre-IPO round.

"Second, with valuations less stratospheric, many deals are more attractive to venture capitalists, because instead of getting, say, 20 percent of a company for $5 million, they can get 35 percent of the company." Zong, of NovaEx, said his April setback forced him to reevaluate his fund-raising strategy but didn't deal his company a fatal blow. NovaEx is a business-to-business online exchange for natural products such as nutritional supplements and personal-care items. Zong has expanded his network of contacts in attempts to raise $1.5 million to $2 million and has hired financial advisers to aid in the search.

"There's no doubt that the current market has affected the ability of entrepreneurs to negotiate with VCs on the valuation of the company," Zong says. "Many people like me have to be careful about giving up too much of the business to get financing because our decisions are evaluated by other investors who come in later. It's a real dilemma."

Letting go of the bottom of the barrel
"The world certainly has changed, but for our purposes, not necessarily in a negative way," says Christopher Gatti, president and chief executive of Living Strategies, a Bala Cynwyd, Pa.-based elder-care planning, placement and management company.

Indeed, the factor that closed some financing doors for his company in the past has recently opened doors.

"We had plenty of investors tell us they liked our company and our plan but that they weren't interested in us because we weren't a pure Internet play, and that's what they were looking for," Gatti says. "Over the past few months, they've become interested again.

"It just makes a lot of sense for the business to drive the financing. It's really not that difficult to figure out which businesses have a good chance of making it, which are long shots, and which ones never should have gotten any money in the first place.

"I think VCs are going to let the bottom of the barrel die, and they'll bring the middle of the barrel along to let them play out and see where they go," he says. "And the real good stuff will always be there."

David Schlessinger, the entrepreneur and investor, says the market downturn has refocused many investors on sound investment principles--a positive development for both investors and entrepreneurs.

"Most compelling for me personally are CEOs who know their businesses...As investors, of course we know to look for strong management teams, solid business models, a unique market niche and scalability.

"A few months ago we got a reminder about just how important those things are."

 
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