How to reboot a venture firm

Two years ago, Bay Partners was a zombified venture firm staggering around Silicon Valley trying desperately to look alive.

The Bay Partners bleed started in 2005 after firm co-founder John Freidenrich retired and General Partner Loring Knoblauch resigned. Then General Partners Chris Noble and Bob Williams transitioned to part-time roles—at least that was the official word at the time. The move required Bay Partners to renegotiate with limited partners and left the firm severely understaffed. Noble and Williams’ profiles were subsequently pulled from the Bay Partners site. Dino Vendetti jumped ship a few months later to join Formative Ventures.

Neither the current Bay partners nor the former investors we talked to would discuss what caused the departures. A catalyst may have been the poor performance of the firm’s $365 million 10th fund, raised in 2001. That fund has lost more than $4.5 million of the $17 million it invested on behalf of the California Public Employees’ Retirement System, according to a public document. That works out to an annualized rate of return of negative 10 percent. The fund focused on enterprise software, semiconductors and communications infrastructure. So far, the firm has only exited two of the 29 companies the fund backed, according to Thomson Financial (Publisher of VCJ).

Managing General Partner Neal Dempsey, a Bay Partners’ veteran since 1989, could have turned off the lights and gone home. He decided to reboot the firm instead.

Step 1: Bring in Outsiders

Dempsey made Atul Kapadia, who had joined the firm in 2004, a managing general partner. Then he put Kapadia in charge of re-staffing the firm. Meanwhile, Dempsey went hand to hand with the former partners, lawyers and limited partners. He promised the firm would be staffed while Kapadia reached out to his network to hire. “Neal did a fantastic job of shielding us,” Kapadia says. “I had a great opportunity to exercise my leadership because he was insulating me from the other problems.”

Bay added Neil Sadaranganey, a former Stanford classmate of Kapadia, and Eric Chin, who worked with Kapadia in 1999. Then Kapadia reached out to Sandesh Patnam, whom he had known since 2001, to take the roll of CFO, and added Salil Deshpande, with whom he had shared an office at Sun Microsystems.

“I rebuilt this firm from the ground up, brick by brick,” Kapadia says. “I wanted to bring in guys who had as little venture capital experience as possible and had a very confrontational style. That was exactly what we were looking for. I said: ‘Let’s reinvent the wheel because it hasn’t been reinvented for 30 years.’”

Step 2: Add Caffeine

Bay didn’t reinvent the wheel, but it did grease it. The firm’s new general partners were all former entrepreneurs and executives—doers. The firm needed a way to get things done, move quickly through opportunities and make snap decisions.

I rebuilt this firm from the ground up, brick by brick. I wanted to bring in guys who had had as little venture capital experience as possible and had a very confrontational style.”

Atul Kapadia

It had looked at 145 business plans during 2005 and inked seven new investments. That’s slow even for a firm with serious personnel problems. But since Kapadia and Dempsey caffeinated the culture at Bay, things have picked up. It has looked at 910 plans during the last 12 months and made five new major investments.

Part of the change meant putting everything out on the table and looking at it objectively. The partners didn’t need to finger point or kvetch. “The limiteds were concerned because change is never easy in venture capital firms,” says Kapadia. “What resonated with them was the sheer hunger of the team and the very simple operating principles. They felt a new sense of relief that we were not afraid to talk through our losses and our warts.”

The firm also changed the way it looked at opportunities. It started backing earlier stage companies. It dug into Internet deals and started writing smaller checks. The reasoning was simple: The value of new Internet startups lay in customer traction, not intellectual property. You could afford to throw money at startups with crazy ideas just to see if users would bite. “Series A can often be no-man’s-land,” says Deshpande. “It’s wasted money if the site isn’t going to get traction. That’s why we started the seed program.”

Step 3: Create a Game Plan

Bay was racing ahead by 2007 but still had a lot of ground to make up. The firm had taken a bashing in the press the previous year, as various outlets (including sister publication PE Week) carried stories about the departing partners. “Media likes hyperbole,” Deshpande says. “Things are often not as bad or dark as they seem. When you see a star exploding, you’re really looking back into the past. By the time everybody else started talking about [the departing partners], it had already happened and we had moved on.”

The opportunity to hit the nitrous came in May, when Facebook opened its code and allowed developers to build applications. Senior Associate Angela Strange thought it might be interesting to create a program to target Facebook applications. The team dove into the code, pulled it apart and kicked it around. The verdict: Facebook had built a viable platform. The partners let Strange run with the idea. She teamed up with Deshpande to start AppFactory. The mandate, as Deshpande puts it, was to “take it to the next level and make our deals even more micro, even smaller than our typical seeds.”

Step 4: Spread the News

Bay hired public relations firm Porter Novelli to blast the business press with releases about the firm’s new program in July. Pundits weighed in on both sides of the program. Some thought it a genius move poised to take advantage of the burgeoning social medium. Others opined that the firm would be sorry when Facebook stole developers’ ideas and crushed the nascent startups. Either way, people were talking about Bay Partners again. That resulted in even more business plans coming through the door.

The firm looked prescient when Facebook itself copied the AppFactory idea in September, announcing a $10 million fund focused on application developers. Facebook partnered with Accel Partners and The Founders Fund to launch FBfund. Deshpande says the program validates Bay’s AppFactory.

But the real validation came in October, when approached Bay about starting a similar program for developers building apps around its platform. It turned out that the software-as-a-service (SaaS) giant maintains an internal list of the 50 or so strategic companies that are developing on its platform. “We came to know that six of them were our investments,” Deshpande says. “They saw the success of our AppFactory announcement and saw some of the deals we were doing and it just made sense for both sides.”

Positive change is sometimes easier when there’s already lots of change going on.”

Salil Deshpande

Bay partnered with Salesforce to commit $15 million over three years to early stage startups using the company’s application platform to develop services. Each initial investment will range between $500,000 and $2 million. Bessemer Venture Partners also joined the investment keiretsu with a $10 million commitment. Salesforce is providing advisory services to the venture firms.

Bay has been working with startups looking to build applications based on Salesforce for at least two years. It has seven startups in the SaaS space and they’re doing well, Deshpande says. Eloqua, a Toronto-based maker of automation software, is booking revenue in the tens of millions, and recently closed a $23 million round of venture financing at a significant increase in valuation, he notes.

Bay isn’t done with platform plays just yet. Deshpande says to expect another platform-oriented investment program soon, but he declines to specify the sector.

Step 5: Plan for the Future

With deals rolling in and a refurbished reputation, the management at Bay is now looking down the road. Dempsey is still actively investing, albeit at a slower pace. Kapadia is managing day to day operations.

The firm has all but jettisoned under-performing investment sectors such as communications infrastructure equipment in favor of Internet deals and emerging cleantech opportunities. Its platform plays—Facebook for consumer applications and Salesforce for business apps—are driving deal flow.

With an eye toward the future, Bay is looking for investment associates and another syndication partner for its Facebook AppFactory program, Deshpande says. He would not specify what company or firm might be tapped.

For now, Bay has managed to turn a meltdown into an opportunity for evolution. “Positive change is sometimes easier when there’s already lots of change going on,” Deshpande says.

Still, there’s no guarantee that the application platform strategy will be successful. The firm has committed less than a tenth of its fund to the Facebook and Salesfoce initiatives. It will be very difficult for that little amount of money to move the dial. Worse, it may suck up too much of the partners’ time and attention.

Bay will face competition from several camps. Companies such as Slide and RockYou have built their entire business around creating and marketing Facebook applications such as slide shows. Not to mention Facebook’s own investment program. In Salesforce applications, Bay will have to contend with Emergence Capital Partners, which specializes in SaaS investments and has just started investing out of a $200 million second fund. Emergence has a close relationship with Salesforce, since it was a seed investor in the company.

It may be years before the restructured Bay Partners sees returns from its new directions. The firm will have to execute on its core investment thesis and get the early stage investments of its predecessors out the door if it expects to successfully raise another fund.