Cover Story: VCs Hone In On Products, Profitability –

Sex no longer sells.

Okay, maybe it still works for lingerie or motor oil, but certainly not for entrepreneurs in need of private equity dollars.

Venture investors argue that the fast-food salad shaker days of pitching Powerpoint slides and a dream are over, with due diligence now increasingly focused on companies with tangible products that have already received positive feedback from potential customers. It is old-school venture financing, they say, and it doesn’t look to get any less restrictive in the foreseeable future.

;Sex appeal is not enough any more,” said Erel Margalit, managing partner with Jerusalem Venture Partners, during a recent panel discussion in Boston. “You need to prove that you can achieve long-term sustainable differentiation.

What this throwback philosophy has created is an investment atmosphere where early-stage transactions are increasingly rare. Since 1995, approximately 24% of all institutional venture capital disbursements made into U.S.-based companies were categorized as early-stage or startup deals, according to our VentureXpert database. But in Q3 2001, that figure was down to 18%, and as of mid-December the early-stage/startup portion of VC investment for Q4 was hovering around 10%.

Just last month, TL Ventures fired five of its Austin-based investors following the voluntary departure of office founder Bob Fabbio. Bob Keith, managing general partner with Wayne, Pa.-based TL Ventures, said the Austin team was built around Fabbio’s interest in seed-stage companies, whereas TL Ventures generally prefers to back firms with a bit more maturity. Without Fabbio, senior management at TL Ventures saw no compelling reason to maintain the practice.

On its face, the move toward later-stage deals isn’t alarming or surprising. Many limited partners are happy to see their VC funds exercising more caution, and from a cost perspective a Series B or C deal is hard to pass up: Given the nose-dive in valuations last year, investing in a proven company with real products and customers can be almost as cheap as buying a piece of an unproven start-up.

But despite all that, there’s a growing concern in the marketplace that this stage shift could get too pronounced. What will happen in 12 to 24 months when the growing glut of expansion- and late-stage investors encounter some inevitable failures? Just as important is the question of what happens to the early-stage companies that do manage to receive venture capital in today’s market. Specifically, will they need to accelerate their product development and commercialization efforts in order to raise expansion-stage capital? If so, will technological innovation be sacrificed?

;For what was a $10 million pre-money in the old days, you can now get a so-called Series B deal where the company’s product is known to exist, it’s been in beta and there’s an almost-complete management team,” said Bill Elkus, founder and managing director with Clearstone Venture Partners. “This change in valuation has given VCs the choice of choosing more defined transactions, or lowered valuations for the risks they take. It’s more rational investing, but if too many VCs [shift away from early-stage investing]… that situation may not be sustainable.

Late the Great

Not surprisingly, many VCs interviewed for this story weren’t comfortable acknowledging any preference for late-stage deals—even when the statistics seemed to indicate otherwise. But a few firms willingly admitted the shift, reasoning that it’s simply good business.

Take Martin Gagen, an 18-year private market veteran who currently oversees the U.S. investment group of 3i Group PLC. His generalist firm manages more committed capital than any other private equity firm in the world, and he acknowledges that it has recently begun a noticeable shift toward later-stage opportunities.

;Yes, we’ve definitely been doing more later-stage [deals] than we had been doing,” he said. “The price for companies with revenue and full management teams and clearly identified customers and an existing market is much more attractive today than it was in 1999 or 2000.

In 2000, 3i Group invested approximately $290.38 million into 41 early-stage and startup companies. That commitment represented 10.6% of the total capital 3i Group put to work that year, with the number of deals comprising 18.7% of the 219 completed financings. In order to find a comparable deal completed this year, however, one must go all the way back to August. None of the 20 companies that received $144.62 million worth of 3i Group’s capital from September through mid-December qualify.

And those figures are for 3i Group’s entire global operation, not just the downtrodden domestic arena. Gagen noted that the later-stage shift could become even more pronounced globally as the European and Asian markets catch up to the current economic suffering in the U.S.

;The U.S. always leads these trends,” he said. “You’re finally now starting to see some people in Europe and Asia move away from early-stage into later-stage as they realize that the problems here are quickly moving there.

For his part, Gagen recently hired Sandy Miller, a co-founder of Thomas Weisel Partners, as a managing director in charge of later-stage investments. Since that early November news, Miller has already taken board seats with late-stage portfolio additions PlaceWare Inc. and Appshop Inc.

Meanwhile, other venture firms are trying to have it both ways: maintaining their early-stage credibility while admittedly adventuring into uncharted late-stage territory.

One example is Polaris Venture Partners, a firm known for providing initial venture funding to companies like Akamai Technologies Inc. and Paradigm Genetics Inc. While the Waltham, Mass.-based investment house has no interest in setting aside its early-stage mission, it does hope to begin taking advantage of attractive later-stage opportunities.

;We aren’t moving away from what we’ve traditionally done, but we are adding something new,” said Alan Spoon, a managing general partner with Polaris and the man charged with leading the new effort. “The opportunity of investing in good companies with reasonable valuations has presented itself, and we don’t want to let that pass us by.”

Jerusalem Venture Partners (JVP) is another convert, with Margalit recently proclaiming a newfound affinity for PIPE deals and other forms of creative financing options. Most recently, JVP participated in a reverse merger of sorts for portfolio company Cogent Communications Inc.

While calculated stage shifts by firms like 3i Group are largely responsible for the venture industry’s overall move away from early-stage investing, there are also extenuating circumstances that have helped to move the mountain.

When the Internet boom began molding rich venture capitalists into filthy rich financial seers, the private equity market quickly found itself playing host to an influx of forty-niners disguised as investors. Never mind that the obscene returns of new money firms like Benchmark Capital were based on investments made before Time Magazine knew who Jeff Bezos was; everybody wanted in, and the CMGI Inc.’s of the world began devoting billions of dollars toward nascent venture capital operations.

Today, however, companies like CMGI provide little more than names for football stadiums and fodder for vindicated skeptics. This reduction in the available early-stage capital pool has also been augmented by the hasty retreat of countless leveraged buyout firms that also chose to try their hands at early stage-VC.

Despite the trend, not every firm is moving to late-stage deals. Consider Generation Capital Partners, a New York-based private equity firm with approximately $325 million under management. Historically, Generation Capital has pumped almost all of its money in later-stage deals, including a handful of leveraged buyouts. But with the changing investment landscape, the firm is now making a strategic move to early-stage investing.

;We felt there was an opportunity right now to invest in some very basic technologies which can be productized at a later date,” said Peter Campbell, a partner with Generation Capital. “A lot of people have gone too far the other way in needing to know the ROI before investing.

Like many other venture firms still looking at early-stage deals, Generation Capital plans to slightly over-fund its new portfolio companies so that they won’t be forced to rush their products to market. It also plans to keep a very close eye on burn rates.

;Some of the technologies these companies are developing are very complex, and people need runway time to develop them correctly,” Campbell explained.

Market sources say such clear thinking, however, has become pervasive only within the past few months.

Early-stage IT companies that raised first rounds of funding in early 2001 are fast realizing that they need far more than alpha testing and vague market interest in order to secure outside investors on Series B deals. Indeed, such companies generally need to have completed a substantial portion of their beta testing, have specific and enthusiastic customer feedback and proof of manufacturability.1 Many didn’t feel that same burden a year ago.

The Problem with Mega Funds

One issue that makes early-stage investing problematic is the omnipresent issue of the venture capital mega-fund. When early- and balanced-stage firms began raising their $1 billion-plus babies, many wondered aloud how any of these firms could justify participating in a Series A funding.

;A lot of what’s happening in the market today represents some of the problems associated with the mega-funds,” agreed Larry Kubal, a founder and managing director with Labrador Ventures, which still maintains its seed- and early-stage focus. “There has definitely been some migration of those funds… and our yearly increases in deal-flow may be partially due to that.

Some such firms ramped up their investment staffs to catch up with their burgeoning fund size, but not even those efforts were able to stem the outgoing tide of early-stage investing. Of the 34 U.S.-based venture capital firms that have ever raised $1 billion-plus funds, just four have actually followed their fund close with an increase in disbursements to early-stage and startup companies: Baker Capital (1.24% before 2000, 89.35% after, as of mid-December), Softbank Venture Capital (11.06% before 2000, 20.97% after), Accenture Technology Ventures (11.23% before, 30.55% after) and Warburg Pincus (9.47% before 1994, 12.44% after).

Some of the more notable decreases came from New Enterprise Associates (48.95% into early-stage/startups prior to 2000 mega-fund close, 25.19% after, as of mid-December), Benchmark Capital (62.28% before 1999, 34.15% after), U.S. Venture Partners (38.09% before 2001, 21.06% after) and Westin Presidio Capital (30.25% before 2000, 15.56% since).

Entrepreneurs Under The Gun to Deliver

Even young companies that meet and surpass the tougher guidelines can’t always count on obtaining an expansion round of capital.

Quantum Vision Inc. is a Mountain View, Calif.-based company that produces cathode tubes for large-projection television sets, thus creating high-definition-type quality at a much lower cost. It needed just $1 million to begin product manufacturing, having already received initial backing from such investment firms as El Dorado Ventures.

;They’ve got Mitsubishi knocking on the door, everybody lined up [and] they’ve got patents out the wazoo,” said Damir Perge, founder and chief executive of Futuredex, which helps start-ups find venture capital. “By getting to the production level, the customers would finance the next stage; but they could not get it because the market’s contracted.

The lesson many entrepreneurs are learning from companies like Quantum Vision is that they need to accelerate their time to market so they don’t get left a day late and $1 million short.

;The speed to execution has definitely gone up,” said John Pilitsis, chief executive and president of CyOptics Inc. “I’m on the board of a company that couldn’t get a VC to talk to us six months ago because we didn’t have our product ready yet and the value proposition wasn’t clear. Now, we’ve gotten there and we’re about to close a major round.

He added that many expansion-stage investors are tying capital commitments to certain product-based milestones.

While such fiscal caution is sure to increase venture fund returns and sate nervous limited partners, it remains to be seen whether shortened product cycles will cause some important technological innovations to be glossed over.

;What I’m pushing entrepreneurs to do is come up with fundable business plans where they really focus hard on certain milestones and getting products into customers’ hands early. This does not mean that companies should push product development at all costs,” said James Furnivall, partner with Canaan Partners. “But you should limit what you spend money on to what is really important – like getting one or two really strong customers rather than spending a lot of money on marketing.

Change is a Good Thing

There are no absolutes when it comes to predicting future financial market conditions, but there is growing concern that the venture industry’s forward-leaning direction could trigger negative repercussions for years to come.

The most pressing lesson taught in this school of pessimistic thinking regards what happens when flight from early-stage deals eventually catches up to expansion-stage deal-flow. Venture capitalists are hardly role models for the supply-and-demand set, but that most fundamental of capitalist principals should not be ignored out of convenience.

;I think you can really compare this to yields on a bond curve,” said Clearstone’s Elkus. “Many of the early-stage investors are being attracted to Series B investments because of the decrease in valuations.

The problem is that those who make that shift are not paying attention to the speciousness of their own motivation. If the supply-and-demand balance is thrown too far out of whack, expansion- and later-stage players will find themselves competing for a limited number of investment opportunities.

Paul Gompers, a Harvard Business School professor and co-author of The Money of Innovation, isn’t too worried. Although he is aware of the drop-off in early-stage funding, he believes that too many companies received funding in the past without enough thoughtful due diligence.

;Entrepreneurs will always say there is too much fiscal discipline being exercised, but a lot of them were lulled into thinking that they could get just about anything funded,” he said. “This change is a good thing; and if a company has a good business model and an interesting technology that makes sense, it will probably find a way to get funded.”

Contact Dan Primack at: