Consumer Passion: A confluence of events, including reduced corporate spending, has caused venture capitalists to take another look at a market they once shunned: consumer technology. Should you join

Until recently, David Ladd, a general partner at Mayfield, had never done a consumer technology deal. Enterprise software and telecom were his specialties. But then a young company called Pure Networks caught his eye.

Pure is capitalizing on the advent of the digital home by offering software that makes it easier for consumers to setup and manage their home networks. “The problem is obvious to anyone who has ever tried to share Internet access or printers in the home,” says Ladd, who led a $7 million Series A round in the Seattle-based company in May. “These things are really difficult to make work.” But solving a big pain point wasn’t the only factor that attracted Ladd. “I was looking for a different kind of investment,” he confides.

That should come as no surprise, given the current state of corporate technology. Despite hopeful talk of a tech recovery in corporate America, businesses are still reluctant to make significant purchases. This is clearly seen in the revenue shortfalls of major enterprise vendors, like Peoplesoft and Siebel Software. Even though a new survey by Goldman Sachs predicts that information technology budgets will increase 2.3% this year, many still believe that’s optimistic. Of the spend-

ing that is taking place, most is directed at patches and fixes for existing systems, rather than the implementation of cutting-edge, next-generation technologies.

The consumer technology industry, on the other hand, is a shining star: Its sales will total $101 billion this year-a 4.8% rise over 2003-according to the Consumer Electronics Association. If that’s not enough, market researcher In-Stat/MDR projects that 280 million people will own equipment to make their own media by the end of 2008. Also, the Internet Home Alliance, a technology research organization, says that 26% of U.S. households now have broadband access, compared to 18% last year. And, of course, consumers are turning the home into a digital Mecca. The growing demand for equipment like Wi-Fi routers and digital media servers is igniting an annual market of $150 billion for entertainment products and services, according research firm Parks Associates in Dallas.

Innovation is now being driven by consumers, not corporations, and that shift is having a profound impact on venture capital. After all, the venture world-with the rare exception of the dot-com debacle -has long been about enterprise technologies. Roger McNamee, co-founder of Integral Capital Partners, estimates that about 90% of resources in the venture industry are directed at the enterprise. But with consumers now accounting for an increasingly large chunk of total technology spending, VCs have no choice but to take the consumer seriously.

“The consumer side of what we do is really starting to catch more attention, especially as consumer spending remains strong,” says Larry Marcus, a general partner at WaldenVC who specializes in digital media and consumer technology. “We are certainly getting more inbound calls from other VCs who want to do investments in consumer tech or who want us to take a look at a particular deal with them.” Though it’s difficult to put an accurate figure on the growth of consumer tech deals, Marcus says the quantity and quality of deals has been unlike anything he has ever seen in his venture career.

It was Intel that helped focus attention on the consumer sector earlier this year when it announced its $200 million Intel Digital Home fund. But venture capital firms are hot on the trail. George Zachary, formerly with Mohr Davidow, was recently recruited to Charles River Ventures (CRV). His mandate: to set up a portfolio of “mass-market” companies. Mayfield, too, is focusing more on consumer technologies. Besides Pure Networks, it has made seven other deals in the sector over the last few years. BA Venture Partners is also actively betting on consumer electronics with a series of new investments, including a $51 million financing of Cornice Inc., a Longmont, Colo.-based developer of storage application for portable devices like MP3 players. Mobius Venture Capital, for its part, counts Danger Inc., Wheels of Zeus, Pocket This, and Perpetual Entertainment among its most recent consumer deals. Even Bob Pavey, a partner with Morgenthaler Ventures, said VC firms like his are now branching out into new areas, with consumer electronics near the top of the list.

Knock, Knock

So where exactly are the opportunities? Curt Nichols, a vice president and director of Digital Home Investments for Intel Capital, divides the landscape into two main categories. The first is near-term opportunities that focus on the basic plumbing issues around interoperability and getting all consumer devices-from PCs to TVs to MP3 players-to seamlessly communicate with one and other. Intel’s bets in this area include Digital 5, a Lawrencevill, N.J.-based software maker that allows networked consumer devices to share data, as well as Staccato Communications, a San Diego-based developer of ultra-wideband technology that promises to wirelessly connect numerous devices in the home.

Once the plumbing is figured out, Nichols envisions an explosion of new applications and usage models streaming to the forefront. That’s why he is also making long-term bets in companies like Zinio Systems Inc., a Brisbane, Calif.-based company that makes and distributes magazines in digital form, and Vensys, a Copenhagen-based developer of sensors for use in home automation. Nichols also foresees a day when consumers will use broadband connections to download specialized content directly to their TVs, such as a daily yoga video or New Wave French movies from the 1960s.

“Both the basic plumbing and these next-generation applications are not quite there yet,” Nichols says. “But that’s one of the primary reasons we announced our fund. We wanted to inspire entrepreneurs to focus on improving interoperability and ease of use, and we wanted to encourage other VCs to start making investments in this area.”

Ease of use just may be the most critical factor when dealing with consumers. Look no further than the iPod phenomenon for proof. The sleek music player illustrates how a company can make a killing in the consumer market if it designs a product that is truly user friendly. Apple is selling the iPod at Warp speed-at anywhere from $250 to $500 a pop. That’s not a price consumers are normally willing to pay, but in this case price doesn’t seem to matter. That suggests consumers will open their wallets for other technologies as well, as long as they are compelling and easy to use.

Proceed with Caution

Wary VCs may still need plenty of prodding. They have always looked at consumer technology as a hits business with little room for miscalculation. And they have plenty of bad memories of deals gone sour. Remember Scout Electromedia? It made a wireless gadget called Modo that delivered daily entertainment content. It burned through $22 million-a sizable chunk of it from Flatiron Partners-before going kaput a day before a big party celebrating its launch.

VCs are more accustomed to backing companies that only need a few major corporate customers to gain traction in the marketplace and actually turn a profit. But consumer deals often require spending tens of millions of dollars on advertising and branding campaigns to acquire customers one at a time. Moreover, due diligence is difficult because it’s hard to predict how consumers will act. That’s different from corporate deals, in which VCs can get a pretty good idea whether a product will sell by placing some phone calls to a few select CIOs.

Mayfield’s Ladd says that if a deal requiring serious customer acquisition costs crosses his desk, he would toss it away in a heartbeat. But he adds that most consumer deals today don’t look like that. He says many of today’s startups are lowering their customer acquisition costs by forging partnerships with larger players that can promote and distribute their products. The large players are increasingly willing to do this because it makes their job easier, he says.

Take Pure Networks. It recently signed a deal with AOL in which the Internet giant has agreed to push Pure’s software to its customer base. Ladd believes that’s a win-win relationship because it not only dramatically lowers Pure’s acquisition costs, but allows AOL to potentially capture more broadband subscribers by offering consumers a foolproof way to create home networks.

Josh Goldman, CEO of Akimbo Systems, a San Mateo, Calif.-based startup that uses broadband connections to deliver unique content to TV sets within the home, says his company’s partnership model was critical to raising its first round of venture capital this year.

He says that he was blown away by the number of potential investors who were willing to meet with him. The company was able to secure meetings with some 35 to 40 investors over six months before closing its round. Goldman believes that would have been nearly impossible just a few years back. He should know: He was once an entrepreneur-in-residence at The Sprout Group, the venture capital arm of Credit Suisse First Boston. At that time, he says, it would have taken nothing short of a Google to get the partners interested in a consumer technology deal.

“The timing was perfect for us,” says Goldman. “We were no longer out there saying, Trust us, the digital home will really happen.’ We had real validation because all these things were coming together like broadband penetration, home networking and the growing acceptance that PCs and consumer electronics were finally starting to converge.” In the end, Akimbo had offers from multiple top-tier firms but it ultimately decided to go with Kleiner Perkins Caufield & Byers, which led a $12 million Series B round in the company in July. Kleiner was joined in the round by Series A investors Draper Fisher Jurvetson, Sprout Group and Zone Ventures. In addition, Kleiner Partner Will Hearst joined Akimbo’s board as chairman.

John Dougery, a managing director at BA Venture Partners, was an early believer in consumer technologies. Starting in 2001, he noticed an interesting trend. Namely, corporate buyers, who used to be the ones driving innovation, were now being supplanted by consumers, who where greedily gobbling up the latest and greatest electronics devices. That’s when Dougery decided to shift his focus away from semiconductor and hardware deals in favor of consumer deals.

He was intrigued by a couple of powerful yet underappreciated changes in the market. First, he realized that consumer electronics was no longer controlled by a small coterie of dominant players-players that typically shunned third-party technology and were incredibly hard to sell into. The market is now full of upcoming Chinese, Taiwanese and Korean vendors who were more than happy to integrate third-party technologies into their offerings. This prompted Dougery and his partners to lead the financing of a startup called Xceive to the tune of $10.5 million. Xceive, based in Santa Clara, Calif., makes chips that it says will improve the image quality of TVs and other consumer devices, like MP3 players, camera phones and other handhelds.

Dougery and his partners also noticed that technologies from fields whose markets were shrinking, such as telecommunications and personal computing, were now being applied to consumer electronics. That realization led the firm to invest in Cornice, which recently raised an impressive $51 million. Basically, Cornice has taken old hard drive technology and refashioned it into a compact, low-cost storage element for portable devices like MP3 players. It’s similar to the technology used in Apple Computer’s wildly popular iPod. “There is a renaissance taking place today in consumer electronics,” says Dougery. “Prices are falling, markets are easy to enter, and innovation as a whole is exploding.”

Paul Kedrosky, Distinguished Fellow at the William J. von Liebig Center for Entrepreneurism at the University of California, San Diego, has a slightly different take on the situation. “Consumer deals still make GPs nervous, but they understand this is a place where they have to have some investments,” he says. He adds that if VCs stick to enabling technologies, it’s possible from them to remain in their comfort zone. But if they go all the way down the path and try to do deals that touch the consumer directly, they may be at much greater risk.

Danger, Will Robinson

Gary Rieschel, managing director at Mobius Venture Capital, is braver than most. His firm recently led a $37 million Series D round in Danger Inc., a maker of handheld devices that serve as both cell phones and email devices. It’s a deal that would make most VCs turn pale: Danger has raised a total of $114 million to date and it’s in a very competitive market. It’s key product competes against the Blackberry handheld sold by Research in Motion (RIM) and a growing number of similar consumer devices. Working in its favor, Danger has licensed its technology to cell phone giant T-Mobile, which has successfully marketed its T-Mobile Sidekick to the instant-message-crazed teen set. The next-generation device, the Sidekick II, is getting strong reviews from tech pubs and will hit the market in the fall.

Rieschel maintains that the consumer has always been the holy grail of the tech industry. “What is happening is that all the real interesting innovation is moving from the PC to all these edge devices in the home,” he says. And as products like PCs, digital cameras and mobile phones now standard in most homes, technology is firmly engrained in consumers’ lives. “Just look at the progression from Web browsers to instant messaging to using your phone to take photos,” he says. “The numbers are so vast in the consumer sector that it just takes a little momentum to create this huge opportunity wave.”

When we spoke with Rieschel in late July, he had just offered a term sheet to a startup that helps consumers manage and share their digital media. Though he did not disclose the name of the company, he said the technology would allow consumers to centralize all their content on one device-sort of like a server for the home-and then distribute that data, whether it’s a word document, a video, a photo, or a music file, to any other device on any other network.

Rieschel, for one, believes the consumer technology market is just getting started, and that it will continue to grow unabated for the next five to 10 years, providing plenty of opportunity for venture-backed companies to make their mark.

Others, however, aren’t so sure. After all, consumers are not like corporations. They are not willing to suffer through painful change management and reengineering sessions just to implement a new technology. If consumers can’t figure it out in half an hour or less, they may decide it isn’t worth the trouble.

Another factor to consider is that consumers may pull back their spending due to concerns about the economy, just like corporations. That, in fact, happened in June when U.S. consumer spending suffered its biggest decline since Sept 11, 2001, according to the Commerce Department.

Still, CRV’s Zachary is a firm believer in the future of consumer technology. Since he joined the firm six months ago, he has looked at more than a hundred companies and is close to pulling the trigger on his first deal. “Consumer technology is a long-range opportunity that is still largely overlooked by the venture capital community,” he says. “The digital lifestyle is no longer just some kind of afterthought. There are millions, no billions, of people for whom technology is integral to their lives. As a VC, that’s where I want to be active.”

Tom Stein is a freelance writer based in Silicon Valley. He specializes in writing about startups and venture capital. He may be reached at tom_stein25@yahoo.com.