The Near Death of Early-Stage Investing –

This is how slow early-stage investing is these days: Not only has Intel Capital begun inviting Silicon Valley’s venture capitalists for breakfast-time crash courses on emerging technologies, it even flew a handful of European investors to Russia to meet scientists there.

The situation has left Intel Capital President Les Vadasz exasperated. “I have never heard, Gee, there is too much market risk here,’ as much as I hear it now,” Vadasz says. “I find that extremely frustrating. That is what the world of venture investing is about.”

The problem isn’t that there’s a shortage of interesting ideas or entrepreneurs, adds Intel Capital Vice President John Miner. “There are a lot of people willing to invest in the very, very early seed stage-angels and that sort of thing,” he says. “But in the A round the bar has been raised so high. Everyone has gotten so conservative. The B rounds and the C rounds are just an exercise in negotiation more than anything else. The A round is the big challenge.”

Despite its best efforts (it made 23 Series A deals in the first quarter), Intel Capital hasn’t been able to single-handedly pull early-stage venture investing out of its slump. During the first quarter of 2003, venture capitalists invested $365.7 million in 79 seed- and early-stage companies, in contrast to $1.25 billion invested in 256 new companies in the same period last year.

Biotechnology, health care and life sciences deals still lag behind information technology deals, while the number of non-high tech deals is growing (see Cover Story, page 18). Investors completed 55 new IT deals valued at $302 million in the first quarter. They spent $48.8 million on 13 new biotech and health care companies and another $14.6 million on 11 new non high-tech deals. Wireless startups continue to pull in new funding, as do medical technology companies (see story, page 31). But for the investors still struggling with the bad investments made in the past two years, there’s a new caution in early-stage investing, illustrated by the increased interest in investing in mature companies that have never before raised a round of venture capital.

Take Mythic Entertainment of Boston, which raised nearly $32 million from TA Associates in March ($20.2 million in equity/$11 million in sub debt). Mythic develops medieval role-playing games for the Internet’s King Arthurs. It’s an 8-year old company that sells the world’s 15th most-popular computer game, “Dark Age of Camelot: Shrouded Isles.” It raised its first round of venture capital to try to improve its position and create new content-delivery technology-not to get its business off the ground.

Similarly, Hotelevision of New York closed its first round of venture financing after five years in business. The company, which supplies premium cable TV channels to upscale hotels, closed a $15 million A round in March from WS Investments of Princeton, N.J., Hotelevision feeds cable programming into 133,000 rooms in 375 hotels nationwide through partnerships with chains like Hyatt Hotels, Omni Hotels and Wyndham Hotels & Resorts. This round of financing is enough to bring 200,000 systems into hotel rooms by the end of the year and to add another 100,000 by the end of next year. The company is already generating revenue, and this round of capital is what it needs to kick it into cash-slow positive territory.

Mythic Entertainment and Hotelevision are A rounds on paper but not in spirit. Both are mature companies with large numbers of customers, name recognition, cash flow and experienced management teams. For that reason, they are low-risk investments that don’t require the heavy lifting normally associated with A rounds: productizing a technology, convincing a founder he or she doesn’t have the chops to be CEO, actually finding a CEO, setting up sales channels, and on and on.

By their actions, VCs currently aren’t willing to put all of that time and energy into a Series A deal unless there are other factors that mitigate the risk-like a potentially huge market. With the continuing buzz about Wi-Fi (the 802.11 wireless standard), VCs are much more willing, even eager, to plunk their money down. Seven of the Series A deals done in the first quarter were related to wireless technology, from software to power systems to network equipment. Collectively, they pulled in $34.2 million for an average of $4.9 million apiece.

Intel’s high-profile “Unwired” campaign marked the launch of its first 802.11-enabled wireless chipset (named Centrino) in January, while McDonald’s announced in March that it had wired dozens of its restaurants for mobile Internet users. Developments like these should drive both entrepreneurs and investors to fill out the wireless landscape with Wi-Fi hot spots, improve user interfaces and add complementary technologies like software-defined radio. The problem is, very few VCs are stepping up to fund those cutting-edge technologies.

Seed-stage investors like ITU Ventures in Los Angeles say they aren’t seeing any competition when they invest in technology startups. ITU closed six deals in the last six months and has another two in the pipeline, says Chad Brownstein, a managing member with the firm. “Early-stage investing means a lot of work and a lot of risk,” Brownstein says. “Most investors are mitigating that by doing later-stage deals, but it’s the best time to be investing in startups in the last 10 years. It’s the strongest depth of management, and there’s great opportunity emerging from the research labs. “

While the A-round reticence works in favor of firms like ITU, it’s a thorn in the side of firms like Intel Capital, which has a policy of always co-investing. Its charter obligates the firm to invest alongside a syndicate of traditional venture capitalists. When those firms pull out of the market, Intel cannot invest and loses its eyes and ears into the world of emerging technologies.

Other corporate venture arms that are stepping in to fill the void left by traditional VCs include Chevron Texaco, EDS and Siemens Venture Capital. All three invested in new deals in the first quarter.

Large, diversified venture firms like Mohr Davidow Ventures and New Enterprise Associates (NEA) also stepped in to fund new deals. NEA has said more than once that it sees the current downturn (and resulting decline in startup valuations) as a big opportunity to get into hot new startups at very low prices.

Others, like Meritage Equity Partners of Denver, have announced new programs that allow the firms to invest smaller amounts than usual. Meritage manages a $475 million family of funds that invests in communications startups. Companies funded by Meritage’s FastStart program, for example, go through a less rigorous due diligence process than Meritage’s other portfolio companies. The fund will invest up to $1 million in each FastStart company, then requires those companies to hit milestones before funding a full Series A round. So far, Meritage has funded four of its five FastStart companies through A rounds, says Stephanie Smeltzer, a vice president with the firm.

Still, the problem remains one of perception. Investors are scared-they’re taking heat from their limited partners after making so many write-downs. They’re worried, some say, that their performance will come under public scrutiny and that has forced them to invest with more caution.

Intel Capital’s Vadasz, for one, believes that some firms that have been spending a lot of time with their 1999 and 2000 portfolio companies will soon start to re-focus their energies on new deals when it becomes clear that older companies just aren’t going to pay off. “I think people are realizing that there is only so much that the investment community is going to get out of the investments that were made two or three years ago,” he says. They’re realizing that “if you put 100% or 10% of your time in that investment, the results are not going to change that much, because you invested at a very high level.”

Until there is a collective capitulation over the investments that are bogging down portfolios, the drought of early-stage deals promises to continue.