Venture capital - withering and dying

MR. RICHARD THOMPSON and Mr. Larry Braitman made a fortune on Flycast Communications, an Internet advertising services company they founded in San Francisco in 1996 and sold about three years later to CMGI for $689 million.

It was a classic tale of success in the Internet age, and the two men decided - in the peculiar vernacular of the Web - to leverage their success at starting Flycast by creating a venture capital firm to finance other new technology businesses.

Just as the 20th century gave way to the 21st, they opened Signia Ventures in San Mateo, Calif. Mr. Thompson, 47, and Mr. Braitman, 43, put up $50 million of the money they received for Flycast and started to pour it into new companies.

Now, less than two years after opening, Signia Ventures' office is closed, its Web site blank and its phones unanswered. Mr. Thompson said he and Mr. Braitman had decided not to raise money from outside investors or invest in new deals until the market comes back, maybe next year.

As Mr. Thompson and Mr. Braitman symbolised the Internet boom of the 1990s, so they also came to illustrate the venture-capital bust that has rattled investors from the Bay Area to Boston - a bust that is hurting even venerable firms such as Kleiner, Perkins, Caufield and Beyer.

During the Internet bubble, dozens of speculators started to compete with established venture capitalists, using cash raised from rich people and big institutions to finance Internet start- ups or small biotechnology companies - then hitting jackpot after jackpot by selling stock in those companies to insatiable investors. Ted Dintersmith, a general partner at Charles River Ventures, a 30-year-old firm in Waltham, Mass., compared it to a baseball game where``suddenly they moved the fences in to 125 feet''from 330 or more.``There were a lot of pop-ups that suddenly were home runs,''he said.

Today, the fences that venture capitalists are swinging for might as well be 550 feet away. With some market indexes off 50 per cent or more and with uncertainty growing after the terrorist attacks on September 11, investors have become much more discriminating. That has made it nearly impossible for venture capitalists to use the stock market to cash out of their speculative investments. So far this year, 29 venture-backed companies have tried initial offerings, compared with 252 in 2000. There are also fewer mergers and acquisitions.

As a result, Even Kleiner, Perkins, based in Menlo Park, Calif., and other established firms have slowed the pace of their investments after watching an unusual number of their companies go bust in the last two years.

Venture capitalists, once the celebrated rainmakers of the new economy, now seem adrift. Elbow deep in troubled deals, they are pruning their portfolios, closing companies whose prospects are dim and concentrating instead on the handful that they think can survive a long downturn. The few investments they are making are usually in traditional software and health care.

In turn, the innovative technology sector, which had been the engine of growth, has been throttled back, and many promising but risky companies are either dying from lack of cash or hibernating until the market recovers. That is not good news for the economy. Last year, companies financed with venture capital since the 1970s accounted for 5.9 per cent of the jobs in the U.S. and 13.1 per cent of economic output, according to a study by the National Venture Capital Association, a trade group.

Venture capitalists point out that their business is cyclical and that they have been through down cycles before, as when a boom fuelled by personal computer makers and suppliers limped to a halt in the late 1980s. But at the peak of the PC boom in mid- 1983, venture capital under management was just $10.8 billion. Now, more than $200 billion is under management, so a downturn's magnitude is much greater - and the reverberations felt more widely.

Venture capital investors themselves - entrepreneurs like Jim Clark and Michael Dell and athletes like Wayne Gretzky and Andre Agassi, not to mention pension funds and endowments - are seeing their capital shrink and their profit distributions dry up. Cash and stock payouts from these funds fell more than 80 per cent in the first six months of the year, compared with the same period of 2000, according to Venture Economics, a firm that tracks venture capital.

As their returns shrivel, limited partners are growing disenchanted with what some call excessive management fees. Ominously, they are sometimes balking at their commitments to put more money into funds.

Venture capital funds lost 18.2 per cent, on average, for the 12 months ended June 30, according to Venture Economics, while Internet-specific funds were down 27.7 per cent. The triple-digit returns, on paper at least, that venture capitalists were promoting as recently as last year have melted away.

That is especially true of the newcomers - the investment bankers, corporations and entrepreneurs who jumped into the venture business when it was hot. Even the established firms have not been spared.

Most vulnerable are funds that were raised and invested at the height of the bubble, in 1999 and 2000, when 70 per cent of all high-technology venture capital for the last two decades was invested. The competition for deals was so fierce that venture capitalists virtually threw money at start-ups, many of which had no clear plan for making money. Some venture capitalists also invested large amounts in companies that were about to sell stock, in hopes of quick profits when the stocks started trading; that aggressive strategy cost them dearly when investors turned their backs on such shares.

That is not to say that all venture investments made in the last few years were bad. It is still too early to calculate performance in such young funds, and one big hit could more than compensate for many duds. But the sheer volume of deals and the high valuations at which they were made all but assure that the crop of venture capital funds invested in the last few years will be among the worst-performing ever.

Money is also available to companies with new ideas. One is Groove Networks, a maker of software that helps a company's employees converse electronically and share documents instantly with suppliers and customers. Partly on the reputation of its founder, Ray Ozzie, the creator of the Lotus Notes program, Groove raised $54 million earlier this month from Microsoft and Accel.

But many venture firms need to clean up their mistakes. While a lot of investments have already been written down - some to zero - people in the industry say a number of firms are still carrying deals on their books at older, inflated values.

That is already apparent on the fringes of the business, which swelled to more than 1,000 firms at the end of last year, more than twice as many as in 1995. Fewer corporations invest through venture capital arms started just a few years ago, and``incubator''firms that invested in, advised and sometimes gave office space to start-ups are less accommodating.

Despite a handful of closings, many venture firms are unlikely to start boarding up their airy offices on Sand Hill Road in Palo Alto, the Park Avenue of venture capitalists. Venture funds are set up as limited partnerships to last at least ten years. So even if there is no new activity at a firm, venture capitalists can linger for years on management fees - typically 2 per cent annually - without generating a dime in profits.

Instead of closing quickly, venture firms in trouble are likely to become unable or unwilling to raise funds, and to have their star performers leave for better opportunities.

For now, the law of the venture jungle may be survival of the fattest. Venture capitalists who have raised $1 billion or more in recent months will have a better chance of surviving the slump. This year alone, nine firms raised at least that amount. That should see them through the next couple of years; most do not expect to try to raise more money until 2002 or 2003.

Despite the capital raised in the last few years, some firms burned through cash like reckless start-ups, investing hundreds of millions of dollars in a matter of months. New Enterprises was the bubble's most prolific investor, backing a total of 122 deals in 1999 and 136 in 2000, according to VentureOne. As a result, New Enterprises and others are going back to investors to raise annex funds - also called bailout funds - to keep their investments afloat.

Firms seeking to raise more money may find a less-than- enthusiastic reception. The downturn and the undisciplined investing of the past are testing the ties between venture capitalists and their investors. Some venture capitalists have sued limited partners who threatened to default on capital commitments, which they promise upfront and pay over several years. Although that is rare, Jonathan Axelrad, a lawyer at Wilson Sonsini Goodrich & Rosati in Palo Alto, said the rate of limited-partner defaults was``unprecedented.''The firm, he said, is handling several such cases.

Some investors, meanwhile, complain privately about the fees charged by venture capitalists. In a 10-year, billion-dollar fund, operating costs alone can be $200 million. On top of that is the``carry,''the portion of profits that venture capitalists receive - as much as 30 or even 35 per cent. More than a few limited partners have concluded that their interests may be at odds with those of the fund managers.

Low returns and high fees are leading many big pension funds and endowments to consider reducing their investments in risky businesses like venture capital.

As one endowment manager explained:``So many of our firms raised a lot of money ending a year ago and have not come back since the world changed. Some we are worried about.

When they do come back, we will give it a hard look and may choose to end the relationship.''

Amy Cortese

New York Times

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