Feature: Keiretsu Comedown –

Peter Sisson was a golden child of the Internet era. While working as a securities analyst at NationsBanc Montgomery Securities Inc. in 1998, he dreamed up a business plan for selling wine online. Before Sisson could say chardonnay, he landed a meeting with venture capitalist John Doerr, a high-profile partner at Kleiner Perkins Caufield & Byers and arguably the king of Silicon Valley.

Doerr loved the idea and promptly handed over $46 million, instructing Sisson to grow the business, called Wineshopper.com, as fast as he could. The new wine merchant leased sprawling office space in San Francisco’s hippest district and hired like mad. The office was outfitted with the latest accessories, including $350 ergonomic chairs for every employee. Wineshopper.com even spent $15 million on an advertising campaign it never launched. Not surprisingly, Wineshopper went bankrupt.

Today, the 30-something Sisson has started a new business called Mixonic.com Inc., which sells customized CDs over the Internet. He is funding the company with unemployment checks and the proceeds from selling a piece of land in the California wine country. For him, venture capital and its attendant excesses has lost all appeal. Crammed into a single room, Sisson and his six employees now conduct their work on plastic lawn furniture. “We delight in being frugal,” he says. Would Sisson ever return to John Doerr and Kleiner Perkins for money? Not likely. “Now I’m able to run my company the way I want to.”

Sisson’s tale speaks volumes about Kleiner Perkins and its brand of venture capital. Sure, nearly all venture capital firms were guilty of fostering a mercenary environment in which the fast-buck Internet IPO became more important than creating innovative, long-term businesses with real technological merit. But, says one observer, until quite recently, everyone in the venture industry-from limited partners to entrepreneurs to investment bankers to other VCs-believed that Kleiner Perkins was the “school of sober second thought.” Kleiner was the one firm you could count on to see past the short-term trends and ferret out the real winners. It was not supposed to get caught up in the general craziness of the day and make the same irrational investments as everyone else.

But it did. Over the past few years, Kleiner pumped hundreds of millions of dollars into dozens of now-deceased startups. Limited partners are starting to complain about Kleiner in a way unthinkable a few years ago, and are particularly worried about several new partners, including Tom Jermoluk, the former chairman of one of Kleiner’s biggest failures-Excite@Home.

Moreover, the once-legendary Kleiner keiretsu-the firm’s Japanese-inspired philosophy of creating loose, interlocking networks among the hundreds of companies in its portfolio-is in tatters, with Exite@Home now viewed as the perfect example of its downside.

Back in School

Kleiner is learning what recession-hobbled Japan discovered a decade ago: Keiretsu can kill you. The kind of corporate back scratching fostered by a keiretsu may allow one company to piggyback on the success of another, but it can also lead to false growth and stock bubbles. Doerr himself came close to conceding this point. On a bright July morning last summer at the Fairmont Hotel in San Francisco, Doerr, who declined to be interviewed for this article, stood in front of an audience of technology leaders and politicians and admitted he had been wrong. “I’m here today with something of an apology,” he began. His much hyped and oft-quoted statement that the Internet was “the largest legal creation of wealth in the history of the planet” was, as it turns out, dead wrong. More like the largest legal “evaporation” of wealth, he conceded. On that dazzling San Francisco day, what Doerr may really have been saying was that Kleiner Perkins-the most hallowed, mystique-cloaked VC firm of all time-wasn’t all it had been cracked up to be.

How did Kleiner Perkins come to be the VC industry’s gold standard in the first place? Since its foundation in 1972, the firm had exhibited an uncanny knack for identifying promising yet little-known technology startups and transforming them into market-defining giants. Among its most notable successes are Sun Microsystems Inc., Compaq Computer Corp., America Online Inc., Amazon.com Inc., and biotech behemoth Genentech Inc. Moreover, Kleiner Perkins helped put the optical networking industry on the map in 1999 when two tiny companies it had championed-Cerent Corp. and Siara Systems-were acquired for a jaw-dropping $8 billion and $4.3 billion, respectively. All told, Kleiner has invested in hundreds of ventures that have resulted in the creation of more than 250,000 new jobs, $100 billion in revenues, and $650 billion in market capitalization, according to the firm’s internal statistics.

Headquartered on Silicon Valley’s fabled Sand Hill Road in Menlo Park, Kleiner Perkins is surrounded by many other top quality venture firms, including Mayfield Fund, Sequoia Capital, Accel Partners, Benchmark Capital, and New Enterprise Associates. But no other VC firm has quite the same magnetism and star power as KP. It was said that a single phone call from John Doerr was enough to entice even the best business executives away from corporate America and into a Kleiner-backed startup.

Indeed, back in the bubble days, Doerr convinced the likes of Roger Siboni to pack his bags and quit his post as head of KPMG’s $3.6-billion-a-year consulting operation to run enterprise-software startup E.piphany Inc. Despite Kleiner’s reputation as being somewhat arrogant and domineering, the very best entrepreneurs flock to the firm and desperately covet its money.

Seal of Approval

“Having Kleiner behind you is like the Good Housekeeping Seal of Approval,” says one Kleiner-funded entrepreneur. “When you sign on with KP you get the whole package, from access to other companies in their portfolio to top talent. The Kleiner name instantly distinguished us from the rest of the pack. It legitimized our company and gave us the credibility to do serious business development deals.”

But the bloom may finally be off the rose. In the venture capital universe, you’re only as good as your latest fund. And Kleiner’s latest reads like a who’s who of dot-com disasters. The two sectors in which the firm invested most heavily are the Internet and communications, each of which in recent years grew tremendously, crested, and finally crashed. Kleiner Perkins gambled almost half-46%-of its money on these two sectors, according to Venture Economics, a research firm owned by VCJ parent Thomson Financial.

Kleiner invested $618 million in 75 Internet companies for an average of $8.2 million per company, and it invested $524 million in 57 communications companies for an average of $9.2 million per company. The Internet sector, specifically consumer Web sites, was the first of Kleiner’s two favorite sectors to bottom out. In the Internet bust, Kleiner lost, among others, Kibu.com, a Web site aimed at teenage girls, and Homegrocer.com, which was acquired by now-bankrupt Webvan Group Inc. in a $1.2 billion, all-stock deal.

Kleiner, with its strong emphasis on broadband equipment and services-it lists 30 such companies on its Web site-continues to lose big in the communications sector. Three of the 11 broadband services companies listed on Kleiner’s Web site are defunctExcite@Home, Rhythms Netconnections Inc., and 360networks Inc. — and two others are struggling badly, including XO Communications Inc. and Wildblue Communications Inc. Outside investors recently said they would prop up XO on condition it successfully restructures its balance sheet. Wildblue Communications, which hopes to become a satellite Internet service provider by 2003, filed to go public in 2000 then scrapped those IPO plans last year. Other broadband failures include Broadband Office, which filed for bankruptcy in May 2001, and Geocast Network Systems, which went belly up in February 2001.

Band on the Run

The once-booming and now-crumbling broadband services market bodes ill for a dozen other Kleiner investments. Numerous industry watchers predict that the shaky broadband sector can only bring fresh wounds in 2002 for Kleiner-backed startups.

Other failures include Web-site management firm Logictier Inc., telecom consulting company Valiant Networks Inc. and electronic publishing house Themestream Inc., to name a few. Of course, Kleiner is not alone in its mistakes. But never before has the firm had such a spectacular string of flameouts. “At one point, all venture firms thought they were going to be the next KP, but they turned out to be impostors,” says a manager at a leading endowment that invests in a number of venture capital firms, including Kleiner Perkins. “Now we’re starting to wonder whether KP itself isn’t also an impostor. That’s something we just don’t know anymore.”

Kleiner, for its part, declined to comment for this story. While Kleiner partners are always eager to talk with the press about successful companies in their portfolio, they almost never discuss the overall activities of the firm itself.

The Faustian bargain

An inside look at investments like Wineshopper.com reveals the extent of Kleiner’s problems. Former Wineshopper CEO Sisson admits to entering into something of a Faustian bargain when he accepted $46 million from Kleiner in the spring of 1999. At the time, all he had was a decent business plan, a makeshift office, and a modest dream. “Then I got all this money and was told I’d have to build the company instantly,” says Sisson.

“I had to hire 150 employees within six months, build an infrastructure, and do everything lickety-split. Honestly, I was looking at a ten-year time frame for achieving financial rewards. But VCs push you to grow bigger, faster. They’re just concerned about having some kind of liquidity event or going public. That was the conventional wisdom at the time.” When the stock market started to head south in April 2000, Kleiner decided that Wineshopper no longer made sense and declined to give it any more money. “When you’re instructed to spend, spend, spend, you just assume there will be an infinite source of capital,” says Sisson. “I didn’t know the money could be shut off so suddenly and disastrously.”

In the past, at least, the secret of Kleiner’s success was its rock-solid network, say people who have observed the firm closely. Entrepreneurs and executives who work with Kleiner on Startup A are eager to come back and work with the firm on Startups B and C. But if a phone call from Doerr no longer carries the weight it once did, and if top quality talent no longer bangs down its door, then the fabled keiretsu philosophy falls apart.

Does that mean the Kleiner mystique is on the wane? Just ask Paul Wahl. In the winter of 1998, he was the president of software giant SAP America Inc., and one of the most respected technology executives on the continent. For years, hundreds of other companies had tried to lure him away, but he always resisted-at least until he got a call from Kleiner Perkins and Benchmark Capital, who together were funding a new security startup called TriStrata Security Inc. They wanted Wahl as their CEO. And Wahl, dazzled by the attention of these all-star VCs, finally succumbed to temptation. “The VCs on the TriStrata board were very prestigious,” says Wahl. “These were very smart people, and I figured they wouldn’t waste their time and money with this company if they didn’t see big potential.”

Not Ready for Prime Time

In retrospect, Wahl says the wool may have been pulled over his eyes. “Everyone was a little too optimistic,” he says. “Overall, I was surprised by the quality of due diligence. I soon discovered that the technology wasn’t really ready. Also, some of the board members were just lending their name, rather than offering up their time and thinking through what the technology could really do.” After a bitter and sometimes contentious year, Wahl left Tristrata and took a job with CRM software maker Siebel Systems Inc., where he now serves as president and chief operating officer.

Would Wahl consider heading back to a Kleiner startup and working with VCs again? “If I got the same golden phone call tomorrow, I wouldn’t listen,” he says. “I think it’s much harder for any VC to call up executives and get them to join a startup. There are too many examples of good ideas that have not materialized into sustainable business models. I believe most VC ideas are half-cooked.”

Of course, many people still have tremendous faith in Kleiner. Joseph Horowitz, former CEO of bankrupt Kleiner investment Geocast Network Systems Inc., says Kleiner provided his company with “world-class sponsorship and a platform of legitimacy that helped Geocast recruit bright employees.” Horowitz believes that Kleiner’s reputation and aura have not suffered, even though the firm has lost plenty of companies in the downturn. “Top VC firms are smart, know how to build companies, and had long-term success before the recession,” he says. “These firms will survive slumps in the startup market, even if a few of their portfolio companies don’t.”

Gary Steele, CEO of Portera Systems Inc., a Kleiner investment since 1998, believes a depressed economy is when top-tier venture capital firms show their value. He says Kleiner has continued to invest in each of Portera’s subsequent rounds, including the most recent financing of $16 million in August. “In challenging times, Kleiner sticks by their entrepreneurs,” says Steele. “We knew they would stick with us no matter what happened. I think they have gained ground in terms of stature.” But, adds Steele, “we still have to execute to show we’re worth continued support.”Entrepreneurs like Steele say they were attracted to Kleiner because of its vaunted, highly emulated keiretsu. In a perfect world, the keiretsu would allow startups to cross-pollinate, form strategic relationships and benefit from each other’s services. In reality, however, the Kleiner keiretsu is coming under fire for being a sloppy practice in which loyalty to the group is more important than making sound business decisions.

“Portfolio companies have less in common than we like to believe,” says Gary Rieschel, executive managing director of Mobius Venture Partners (formerly Softbank Venture Capital). “The idea that you can create some kind of entity where the sum is greater than its parts just doesn’t make any sense.”

Second Thoughts

Rieschel, after embracing the concept for many years, now believes a keiretsu can cause more harm than good. There are plenty of others who agree with him. Many pundits blame the whole Excite@Home debacle on the Kleiner keiretsu. Before the two companies merged, Internet portal Excite.com and broadband access provider @Home were both in Kleiner’s portfolio. Sources say Kleiner played in instrumental role in forcing the two firms together, even though they were incompatible from the start.

“You had a third-rate portal company on one side and broadband service provider that was far from profitable on the other,” says one observer. “It’s not hard to see how that deal got screwed up.” Cynthia Brumfield, president of research firm BroadbandIntelligence Inc., concurs the merger was a terrible idea. “The value that Excite brought to the table was negligible,” she says. “But Kleiner wanted the deal done, so it got done.” According to reports, Kleiner envisioned the combined company as “AOL on steroids.” Instead, the company lost focus and alienated its customers and partners. Excite@Home is now auctioning off its remaining assets and is set to shut down on Feb. 28. Meanwhile the Kleiner keiretsu, though weakened, lives on.

There’s a joke that the only thing harder than getting money from Kleiner Perkins is trying to give it to the firm. LPs would still prefer to put their money with Kleiner than almost any other firm. Clint Harris of Grove Street Advisors is not an investor with Kleiner, but he would sure like to be. “Kleiner has an unbelievably good franchise, and they know how to use that franchise effectively, especially in terms of generating deal flow and getting high quality entrepreneurs and CEOs to go back to them three and four times,” he says.

Publicly, most of Kleiner’s LPs say that they are thrilled with the firm. They don’t want to be branded as troublemakers in the industry and denied entry into any future funds. But privately, many of these LPs are starting to grumble. “It’s hard to know what’s going on inside Kleiner,” complains one limited partner. “I have no idea how the firm is managed.”

In particular, LPs are worried about several new Kleiner partners, including Tom Jermoluk and Ray Lane. “What LPs really invest in is partners,” says Darlene Mann, a VC with Onset Ventures. “If there are changes in the partnership, then LPs change their view of that firm.”

Lane Change

In fairness, Lane is less of a concern than Jermoluk. Previously, Lane was Larry Ellison’s right-hand man at Oracle Corp., but left the company in the summer of 2000 after a public falling out with his boss. Lane was largely credited with pulling Oracle from the brink of disaster and transforming the brash young software company into a technology blue chip. Many believe his deep management skills and operational expertise will be valuable assets to Kleiner startups. Others, however, question his commitment to the firm, especially since he has a personal net worth in the nine figures and has stated he wants to spend more time with his family.

But the real wild card is Jermoluk, who joined the firm after serving as chairman of Excite@Home. “This is AWESOME,” trumpeted John Doerr in a Kleiner press release in May 2000. “The KP team is thrilled that Tom is joining us. Tom’s management experience, technical expertise, raw smarts, good will, and proven leadership… will be invaluable to KP ventures.”

Today, Doerr is surely eating his words. Jermoluk’s aggressive and arrogant management style was widely seen as a key factor in Excite@Home’s demise. “Tom Jermoluk has to be a source of embarrassment for KP,” says Paul Kedrosky, a professor of business at the University of British Columbia who specializes in venture capital. “His work at Excite@Home was pretty much the poison pill strategy for taking down the whole dot-com industry.” Kedrosky adds that KP has suffered other losses under the tutelage of Jermoluk, including Kibu.com, a company he championed and that burned through nearly $22 million in seven months before finally having to be shut down. “I’m not sure Jermoluk, Lane or any of the new partners have the same stuff as Kleiner legends like John Doerr and (optical networking wizard) Vinod Khosla,” snipes one rival VC.

Another bone of contention among limited partners is management fees. Kleiner, like all top-tier VC firms, last year raised a billion-dollar megafund with an annual management fee rumored to be as high as 3%. That means the firm collects $30 million per year strictly in operational fees, regardless if it returns money to investors or not. As elsewhere in the VC community, Kleiner’s dozen-odd senior partners are spreading the lion’s share of that money among themselves, even though they are largely sitting back and just trying to salvage existing portfolio companies, complain limited partners. “It’s clear I may not get a return on my latest investment,” says a Kleiner limited partner. “I really would like them to change the terms of the agreement we signed a year ago.” Unfortunately, that’s not likely to happen. While lesser firms are starting to reach out to their LPs by dropping management fees and cutting the size of their funds, Kleiner is far too proud to do the same, according to industry observers.

Further irking LPs: Not only are Kleiner’s private companies in trouble, so are many of its publicly traded holdings. Kleiner companies that went public became industry leaders and made investors piles of money. Today, many of its publicly traded companies are staring Nasdaq’s delisting officers in the face. This ugly turn of events not only hurts Kleiner’s reputation as a company builder, it hurts the firm’s limited partners who often hold onto the shares of KP companies for an extended period. Internet consulting firm Viant Corp., for instance, now trades at about $1.50 per share, down from a high of $60. Meanwhile, application service provider Corio Inc. is hovering at just over $1, e-learning firm Lightspan Inc. is also at a buck and change, while Internet software firm Calico Commerce Inc., which once traded as high as $70 per share and had a market cap in the billions, was just acquired by PeopleSoft Inc. for a paltry $5 million.

The Thrill is Gone

And then, of course, there is Excite@Home, which is now bankrupt after once having been worth billions of dollars. “Overall, almost every VC firm went overboard,” says a Kleiner limited partner. “The question is: did they go so far overboard they have bankrupted their reputation and themselves?”

In Kleiner’s case the answer is both yes and no. Yes, the firm has gone overboard and yes its reputation has been considerably sullied. “For the first time, everyone now sees that the Kleiner guys are human like the rest of us,” says professor Kedrosky. “John Doerr doesn’t really have the ability to transmute base metal into gold.” Still, in the long run, no one is ready to bet against the firm. To Kleiner’s immense credit, it is remarkably good at spotting-and riding-new technology waves before anyone else. Kleiner was the first firm to invest in the Internet, in optical networking and in Java technology. It even created a $100 million Java Fund in 1996, and managed to return four times that amount to investors, according to various reports. “Kleiner was way ahead of the game with the Java Fund,” says Dick Coburn, director of Java and XML technologies at research firm IDC. If there’s an important new technology on the horizon, many investors still believe that Kleiner will be the first to find it-and capitalize on it.

One area where the firm hasn’t been able to capitalize is Europe. Starting in early 2000, every Silicon Valley venture firm worth its salt expanded overseas. Buoyed by sky-high self-confidence and a belief in their own infallibility, VCs abandoned the notion that they should only do deals within their own backyard and set out to conquer foreign markets. Kleiner was no different. Together with management consulting firm Bain & Co. and private equity firm Texas Pacific Partners, it launched Evolution Global Partners, headquartered in London.

The Kleiner partners committed millions of dollars of their own money to Evolution, according to sources. Like much else recently, the project has been a painful lesson in bull market extravagance. The Evolution mandate: to develop e-commerce businesses in Europe, Asia, Latin America and the United States in partnership with leading global corporations. But the fledgling firm never really found its footing. Evolution managed to make three investments. But last November the firm released most of it employees, shut down the London office, and relocated to Silicon Valley with a single partner.

“We decided to focus mostly in the United States because we found that U.S. corporate partners are more ready to look at venture capital as a way to extend their reach and brand,” says Steve Savignano, Evolution’s sole remaining partner. But critics argue that Kleiner, along with its Silicon Valley brethren, thought it could blithely march into Europe and automatically attract the best deal flow. That never happened, say the critics, mostly because firms like Evolution underestimated the complexity of the European market and overestimated their ability to adapt.

After so many years of uninterrupted prosperity, Kleiner Perkins started to believe its own press clippings. When everyone keeps telling you how smart and perfect you are, it’s hard not to agree with them. “I used to feel sorry for those guys at Kleiner and the incredible standards they had to measure up to,” says Stewart Alsop, a general partner at New Enterprise Associates. “They were treated like gods for a long time and now they have crashed back to Earth. It turns out they really are human beings like the rest of us. Kleiner Perkins is still a great firm with lots of superior investors, but it’s comforting to know they put their pants on one leg at a time.”

Tom Stein is a freelance writer who covers the Silicon Valley VC scene. This story originally appeared in Investor Dealers Digest, a VCJ sister publication, on Feb. 11.