Cover Story: Internet 2.0 –

Bob Kagle hasn’t been this busy since 1999. In the past three months the Benchmark Capital general partner has led investments in no less than four Internet companies, including an online service that connects attorneys with corporate clients and a Web-based marketplace where you can ship everything from a piano to a horse. And Kagle is just getting warmed up. “I’m looking at four more Internet deals that I just love,” he says giddily. “It’s getting hard to restrain myself, so I think I’ll just have to do them all.”

During the post-bubble years there were only about “four or five firms doing Internet investing consistently,” Kagle says. “Now there are many more. This means rising valuations, shorter periods of due diligence and greater competition for executives. No doubt, we are back at the beginning of those things.”

While Kagle and other VCs actively doing dot-com deals agree that that the sector is heating up, market researchers say they aren’t yet seeing a spike in their numbers. For example, Internet deal volume declined last year and was also down in the first quarter of this year. Still, it’s hard not to conclude that the Internet is hot once again when so many big name firms are jumping into the fray. Here’s a sample of the recent action: Sequoia Capital put $15 million into shoe e-tailer Zappos.com (following its $20 million investment eight months earlier);

Kleiner Perkins Caufield & Byers and Oak Investment Partners co-led a $26 million Series A in online ticket service RazorGator; Morgenthaler Ventures and Venrock Associates teamed on a $5.2 million Series A for online photo marketplace Digital Railroad; and 3i Group and BV Capital invested an undisclosed amount in a Series A for online DVD swapping service PeerFlix.

If that’s not enough, the founders of online payment service PayPal in July launched a $50 million fund focused entirely on-you guessed it-consumer Internet deals.

It may feel like 1999, but Internet investors say it really is different this time around. Back in the 1990s consumers were experiencing the Internet for the very first time. They had clunky dial-up connections, were terrified of giving their credit card numbers to Web merchants and they didn’t have good tools to find exactly what they wanted.

Now more than half of all U.S. Internet users have high-speed connections. The Web is tightly woven into the fabric of their lives. If stuck on a desert island, more Americans would prefer to have the Internet rather than their TV, according to one recent survey. “It’s not so much that VCs wasted $100 billion,” says Allen Morgan, a managing director at Mayfield. “It’s more that we inadvertently financed a mass education program for consumers. Most of these early Internet firms may have failed, but they got people used to the idea that you can do lots and lots of stuff on the Web.”

Today’s Internet startups aren’t the “build it and they will come” pipedreams of 21-year-old entrepreneurs. They have real business models with savvy managers at the helm. They also seem to have real exit opportunities thanks to the established Internet behemoths like Amazon, eBay, Google and Yahoo, all of whom have sizable market capitalizations and are not shy about snapping up innovative startups.

The mantra of the day is capital efficiency-the notion that you can build a great company from start to finish with only a few million dollars, not a few hundred million. VCs have traded in buzzwords like “eyeballs” and “stickiness” for new, serious-sounding ones like “organic growth” and “community.” More importantly, most second-generation Internet companies aren’t getting funded until they see revenue or even profit.

“The biggest difference this time is that we are out of the land-grab mentality,” says Heidi Roizen, a managing director at Mobius Venture Capital, a firm that had its share of dot-bombs. “These companies no longer require $20 million or $30 million right out of the gate. This is no longer about spending tons of money to attract customers, and then flipping the switch and hoping a million people show up.”

Roizen points to InstoreCard as an example of the kind of Internet company worth funding these days. It’s an online service that allows retailers to manage loyalty-marketing programs with consumers over the Web. It is focused on building its business one customer at a time and making sure users have a great experience before introducing new features and expanding the business.

Do Over

Interestingly enough, InstoreCard was founded by Mark Goldstein, an Internet veteran responsible for Bluelight.com, the erstwhile online arm of K-Mart that proved to be a big money loser for Mobius. Roizen says Goldstein is exactly the type of person who VCs want to be leading a next-generation Internet startup. “He is a perfect example of a great entrepreneur who was caught in the downdraft, but who benefited from the experience,” she says. Goldstein’s experience in the trenches-as well as InstoreCard’s rational business model-helped the company raise a second round of $4 million in March from Mobius, Canaan Partners and Outlook Ventures.

A key difference in starting an Internet company today vs. five years ago is that startup costs are significantly cheaper. James Lussier, a venture partner at Norwest Venture Partners, says the business plans he sees these days are much more feasible than before. “Running a state-of-the-art e-commerce site a few years ago required 80 engineers and a fully customized system,” he says. That’s no longer the case thanks to low-cost Linux boxes, open source software and off-the-shelf systems. As a result, Internet startups can burst out of the gate faster and cheaper than ever.

As an example, Lussier cites Mercora, a legal music network composed almost entirely of music that resides on people’s computers. The company, founded in 2003, has raised just $5 million in venture capital from Norwest-considerably less than the tens of millions required by first-generation music sites-and it has no plans to raise additional capital. In short, the company’s main mission is to get money from subscribers, not investors. That, in itself, is a major step forward for Internet startups.

When it comes to recruiting customers, Mercora is being very frugal. Or, in the parlance of the day, very “capital efficient.” It is relying on record companies to reach out to the Mercora user base. It is engaging in guerilla marketing tactics such as affiliate programs with like-minded sites. And it is betting on a fanatic community of loyal users to refer the site to friends and spread the word (dare we say it?) virally. All in all, Lussier says, the cost per customer is not only reasonable but is justified by the company’s revenue stream.

“Capital was once used as competitive weapon by Internet startups,” says Mark Hilderbrand, a general partner at Onset Ventures. “The logic back then was that huge amounts of money were needed to build the next generation of household brands, like Colgate and Tide.” The object of the game (whose rules were largely written by VCs) was to dump all available capital into building a premier brand, whether it was eToys, Pets.com or a site that matched the buyers and sellers of bulk chemicals. “Now it’s all about aggregating demand and building communities that can sustain organic growth, sometimes without spending any capital at all,” Hilderbrand says.

Too Efficient?

But does this new-found frugality come at a cost for venture capitalists? After all, some of these new Internet companies are so capital efficient, they don’t need any venture capital. When VCs were nursing dot-com hangovers, a whole generation of Internet companies learned how to get profitable all on its own. “It’s amazing how many unknown Internet companies there are doing anywhere from $10 million to $100 million,” observes Lussier of Norwest.

Increasingly, when these companies do accept VC financing, it’s not because they need it, but because the founders see it as a way to put money in their own pockets. For instance, when Internet advertising firm Fastclick raised $75 million in a Series A late last year, about half of it went directly to its two founders, who had already left the company (see “Can VCs Cash In When Founders Cash Out?” VCJ, May 2005).

“This used to be an absolute no-no in the venture capital world,” says Kagle. That’s because entrepreneurs who use venture capital to line their own pockets have less skin in the game and may not be as motivated to succeed. These days, however, Kagle is willing to let it slide. That’s understandable, considering many of the firms he is looking at are actually turning a profit. “Many of these entrepreneurs couldn’t raise money before because no one would touch them,” he says. “They just put their heads down and learned how to fend for themselves.” As a result, Kagle believes much of the risk is now removed from these investments. “We can put in genuine expansion capital, while still getting the benefits of an early stage investor,” he says

Some VCs are willing to fund Internet companies from scratch, but they do so cautiously. In late 2003, Jason Goldberg approached Ignition Capital with Jobster, a second-generation employment site that leverages social networks to go beyond the likes of Monster.com and Careerbuilder.com. Intrigued, Ignition agreed to pay Goldenberg a stipend to build out the team and get customer validation before committing funding. Ignition liked what it saw and invested $2.5 million last spring. Jobster went on to raise another $8 million led by Trinity Ventures early this year.

“The idea was to not do 1999 all over again,” says Goldberg. “The key is not just having a great idea, but a great business. We were able to come back to the VCs with 32 name-brand customers paying to participate in our pilot program.”

Allen Morgan of Mayfield is convinced that some of the Internet companies that failed were actually good ideas and good businesses that just came along too early. He would love to have another crack at Offroad Capital and BigStep, two Mayfield portfolio companies whose assets were auctioned off during the nuclear winter. “People just weren’t used to some of these ideas,” he says. “Plus it was really hard for customers to have a satisfying experience with dial-up connections.”

In fact, Morgan says some of his most recent Internet investments look a lot like short-lived companies from the 1990s. One such investment is Pluck, which raised $8.5 million for Mayfield and Austin Ventures last October. Pluck’s software is an add-on to standard Web browsers and helps users retrieve, organize, share and publish information. Sound familiar? It should. “The whole notion of subscribing to a content feed is back to the future,” says Morgan. “This idea goes back to a company called PointCast. The difference this time around is we have better networks, bigger bandwidth and more educated users-not to mention hundreds of thousands of active bloggers who are now designing their own content streams.”

History Never Repeats …

While VCs learned a lot from the bubble, some will undoubtedly make the same mistakes again. You’d think, for instance, that they would have learned that funding umpteen online pet food companies wasn’t a very good idea. But in the wake of Google’s IPO, they started pouring money into search companies of all shapes and sizes. At last count, there were at least 16 venture-backed search companies, and probably just as many ad-serving startups. “VCs are the biggest flock of sheep you’ll ever come across,” admits Kagle.

Paul Kedrosky, who teaches entrepreneurship at the University of California at San Diego, isn’t convinced that VCs have stopped looking for a quick buck from Internet deals, especially since there are plenty of examples of Internet investors doing just that. Before online photo-sharing site Flickr got snatched up by Yahoo for a rumored $35 million it was limping along with about $600,000 in angel money.

“Since Flickr was bought, VCs have stars in their eyes,” Kedrosky says. “They think they can fund an Internet company for under a million bucks and then get it bought by Google or Yahoo at a massive premium. Already, we are starting to see some next-generation Internet companies that are solely being built to flip.”

One company that leaps to mind is Dodgeball.com, a two-person startup acquired by Google in May for an undisclosed sum. Dodgeball, a service that fuses social networking with text messaging, has no ostensible business model, but that didn’t seem to bother cash-rich Google. This begs the question: Will we soon see a flurry of investments in companies with no money-making potential other than their likelihood of getting acquired by an Internet behemoth?

The Bubble era notion of betting on ideas rather than real businesses has not been completely eradicated. The spate of investments in social networking companies like Friendster the past few years attests to that fact. Indeed, Kagle, who invested in Friendster, told VCJ at the end of 2003 that his goal was to “figure out a way to harness [Friendster’s fast-growing user base] in terms of the economics.” That process appears to have been more difficult than expected. In May, 3-year-old Friendster brought aboard its third CEO and laid off five of its 55 employees, as competitors like Redpoint Ventures-backed MySpace.com surpassed it in popularity.

All the Rage

Even if social networking, search and Internet advertising deals are overdone, VCs will always be attracted to the segment du jour. These days, blog-related startups are generating a lot of heat, with a reported $6.5 million infusion in Technorati led by Draper Fisher Jurvetson and a $10 million investment in Six Apart led by August Capital.

“The VC game works best when you fund a few sprinters and not the whole Boston Marathon,” insists Kedrosky. “But you have tons of venture firms that think they can all build the next great ad network. That is all wrong. Yet that kind of stuff cheerfully goes in the venture world. I don’t think it will ever change.”

The simple truth is that, in the beginning, Internet investing got hyped beyond reason, with expectations outstripping reality. It then hit a rough patch and fell dramatically out of favor. But after a period of sober reflection, these investments have clawed their way back to respectability-and rationality. Going forward, Internet deals will be just like those in any other sector. There will be great investments and there will be terrible ones. But surely there won’t be $100 billion worth of terrible ones. At least, let’s hope not.

Tom Stein is a Silicon Valley freelance writer who specializes in writing about startups and venture capital. He may be reached at