A desert wind blows down Sand Hill Road

FT Invest

By Paul Abrahams and Caroline Daniel

Just 18 months ago, venture capitalists were on the covers of business magazines, feted as the world’s cleverest men. They appeared to have discovered the Midas touch, achieving astonishing financial results: in just two years Benchmark Capital managed to generate a return of 100,000 per cent on its $6.7m investment in eBay, the online flea market. Greed overtook fear. During 2000, investors provided the American venture capital industry with nearly $100bn in new funds. Even in Europe, they gave venture capitalists a record $11bn.

These days, many of the internet-related magazines have closed, and venture capitalists have become more media shy. The trophy plaques triumphing the initial public offerings (IPO) of their companies are looking increasingly like embarrassments. Leading Silicon Valley companies as diverse as WebVan, the online grocer, and Exodus, the web-hosting group that once had a market capitalisation of $48bn, have filed for bankruptcy protection. Ariba, a business-to-business e-commerce company which once had a higher value than General Motors, now has a market capitalisation of just $450m.

The euphoria of 2000 on Sand Hill Road, the capital of the world’s venture capital industry in the heart of Silicon Valley, had already long dissipated before the attacks in New York and Washington on September 11. The collapse of the Nasdaq share index, down 70 per cent from its March 2000 peak, has almost completely halted the flow of “liquidity events” – the mergers and acquisitions and initial public offerings that provide an exit for those investing in venture-backed companies.

“Frankly, 2001 has been a nuclear winter,” says Alex Mendez, a general partner at Storm Ventures, based in Palo Alto. The National Venture Capital Association (NVCA) estimates that the combined value of mergers and acquisitions involving venture capital-backed companies in the US during the first half of the year, was just $9bn and the amount raised through initial public offerings was just $1.7bn. That compared with $67bn through M&A and $24bn through IPOs during the whole of 2000.

“Is there a bottleneck of exit opportunity? Absolutely,” says John Thornton, general partner at Austin Ventures, an early-stage Texas-based venture capital firm. “There are virtually no IPOs and hardly any trade sales. The only other alternative is for entrepreneurs’ companies to go out of business.”

The pitiful flow of mergers and acquisitions has been particularly disappointing. Take the communications industry. “By the end of August last year, there had been 75 acquisitions or deals involving communications companies with an average size of $1.7bn. This year, so far, there have been just 24, with an average size of $475m,” explains Mr Mendez.

About 70 per cent of those deals involved just six companies: Cisco, JDS Uniphase, Corning, Lucent, Alcatel and Nortel. Although Cisco is still doing a few deals, most of the rest of those companies have little or no interest in making acquisitions. Some are just fighting to survive, and may even be acquired themselves.

“Look. Nobody wants to do deals when they are laying staff off 10,000 at a time,” says David Spreng, managing partner at Crescendo Ventures in Palo Alto. Besides, says Philip Sanderson, a general partner at Walden VC in San Francisco, most acquisitions just do not work, so why do them in a down period? “There’s still a lot of carnage out there,” he adds.

As for the IPO market, the appetite of investors for technology-related offerings has yet to recover from the binge of the late 1990s. “Anybody who bought IPOs has been badly burnt. Most public funds are way under water,” says Christopher Nawm, a partner at Technology Crossover Ventures in Palo Alto.

Many believe the venture capital industry is facing a liquidity crisis of prodigious proportions. The amount invested in US venture-backed companies leapt during the late 1990s, from just $12bn in 1997 to $89bn in 2000, according to PricewaterhouseCoopers (PwC). The NVCA reckons the peak was almost $100bn. About two-thirds of the money available globally was earmarked for technology investment, according to Keith Arundale, European business development and venture capital leader for technology, at PwC.

“Clearly, there was massive over-funding in the late 1990s. There was just too much money pouring into the industry which was then simply misallocated,” says Jean Paul Ho, managing director of Crimson Ventures.

“Quality control went out the window,” says Jim Seaberg, a principal at McKinsey, the strategic consultants. “Investment in venture capital groups outpaced the rate of new patent applications by nearly three times,” he explains.

“People were not just setting up dotcoms for food, but dotcoms for dog food, and even Scottish terrier dog food,” says Bruce Dunlevie, a general partner at Benchmark Capital.

In December 1999, people were doing 10-year discounted cash-flows on companies without revenues, says Mr Nawm. “Companies went to market that weren’t businesses – they were at best features or products, not companies,” he explains.

Even those groups with serious business models will struggle because of excessive competition, warns Mr Ho at Crimson Ventures. “Venture capitalists were funding 20 different start-ups in a single space,” he adds.

The vast majority of the companies that were funded during the boom will not survive. There is simply not enough cash available. “If you look at the number of venture-backed companies in the US and the amount of additional funds they will need to reach profitability, then there is a $40bn to $80bn shortfall. That is a liquidity crisis,” says Mr Thornton. This is challenged by the NVCA, which claims that much of the money made available last year has not been committed.

But most venture capitalists believe that there is an impending crisis, one that can only intensify. “If there was a tough environment before the World Trade Center crisis, then it has got even worse,” adds Mr Thornton.

“We are looking at huge capital destruction and human tragedy,” warns Mr Nawm at Technology Crossover Ventures.

The hope of new money coming from IPOs any time soon is remote. During the peak, between 1998 and 2001, the average time between foundation and liquidity event was a stunning 2.2 years. “It could be that companies go to market not after 12 to 18 months, but need a path of three to four years,” warns Brad Koenig, managing director of investment banking at Goldman Sachs.

Groups that go to market may need a number of years of sustained profitability, but at the moment, there are none that meet that profile. “We are looking at the possibility of three or four years with no funds raised,” warns Mr Ho.

For the moment, venture capitalists are trying to salvage their investments, cutting costs, rationalising management teams, even merging the companies in which they have invested.

“It’s like these venture-backed companies are crossing the desert. The question is how big their canteen of cash is and how far the desert extends. A lot just won’t make it,” says Mr Mendez.

Raising new capital from late-stage investors is fraught. “Late-stage investors are in shock,” says Rosemary Remacle, a general partner at Sevin Rosen in Palo Alto. With the prospect of an early exit remote, valuations have fallen drastically – creating so-called “down-rounds”, forcing early-stage investors to accept massive dilution. “There are late-stage companies going for early-stage valuations, sometimes even below their cash value,” says Mr Ho at Crimson Ventures.

And venture capital groups will themselves start to fail. “A lot of venture companies are running into a wall with their portfolios,” says Shahan Soghikian, a partner at JP Morgan Partners, a late-stage investor. They are increasingly rationing capital, making fewer new investments, but using increasing amounts of cash to prop up existing investments. Many venture capital groups will not be able to raise new capital.

“This year, venture capital companies will start to die. They will simply run out of cash,” says Tae Hea Nahn, a general partner at Storm Ventures.

“Half of the venture capital companies out there will not survive. It will be a slow death, but they just won’t be able to raise more funds,” agrees Mr Spreng at Crescendo Ventures. A few, such as Octane Capital Management, have closed their venture capital operations and returned their remaining cash to investors.

In Europe too, there is pain. But if the sudden increase in investment during the late 1990s was less pronounced than in the US – just $11.5bn was invested in 2000 according to PwC – so the downturn has been less dramatic.

“European companies are still investing in areas such as wireless technologies, interactive television and internet security. There have not been the spectacular levels of investment in Europe and it is not as mature as the US,” explains Mr Arundale at PwC.

“The mood is one of extreme caution, but it is still a good time to invest because valuations have fallen so much. 2001 could be a far better year in terms of returns than 1999,” he says.

Industry faces an identity crisis

The amount invested is expected to return to the levels of 1999, when about $6bn was invested in technology companies in Europe, adds Jacques Garaialde, managing director of Carlyle Europe Venture Partners.

“It’s a very difficult market, made more difficult by recent events in the US. A number of people have just stopped to digest and have halted investments,” admits Jo Taylor, managing director of UK technology at 3i, the European private equity group.

“It has made it harder to assess revenue visibility, especially for orders with US corporates. You need to be quite brave to invest. A number of companies we are likely to back in the next six months are likely to see their revenues go down.”

As for Asia, just $3.7bn was invested in venture capital in 2000. This year will be worse,” says Mr Ho at Crimson Ventures, which specialises in the region’s companies.

There is little doubt that both the structure of the venture capital industry and the way venture capital companies are managed will have to change. “The industry is going through an identity crisis,” says Lucy Marcus, managing director of Marcus Venture Consulting in the UK.

“Many venture capital groups, if they were pitching to their own company, wouldn’t invest in themselves. But now their own investors are demanding greater professionalism,” she says.

“Venture capital companies must learn how to leverage their expertise in information technology, human resources and even travel budgets to maximise the entrepreneur’s efforts as well as the venture capital groups’ returns,” says Mr Spreng, at Crescendo Ventures. “They must institutionalise the knowledge in the company, rather than it being stuck in the partners’ heads.”

What is clear is that the glamour surrounding the venture capital industry in general and Silicon Valley in particular has dissipated. It will be a long time before it recovers and many moons before a venture capitalist graces the cover of a business magazine for the right reasons.


1 October 2001

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