Venture industry gets sex education

When David Brown went looking for venture money to finance the expansion of his startup he heard the same thing over and over again from VCs: “Great idea. You should go with this, but we can’t have any part of it.”

Brown’s company, Sun River Systems, makes the HeatSeek adult Web browser and content management system. His software allows users to download pornography and store it in a partitioned section of a PC’s hard drive that can only be accessed through a password.

“There were a lot of VCs backed by pension funds and universities and they sometimes have a hard time backing anything in the adult world,” Brown says. He’s quick to point out that he doesn’t operate a porn company. “We’re actually a software company,” he says. “We can help this particular industry and its users help protect their families.”

It’s an argument that, at least so far, has fallen on deaf ears. Although Brown’s software could have applications outside the sex industry, such as protecting sensitive defense-related materials on Army laptops, VCs have yet to bite.

There were a lot of VCs backed by pension funds and universities and they sometimes have a hard time backing anything in the adult world.”

David Brown, Founder, Sun River Systems

Prudish PennSERS

VCs appear to be reluctant to do such deals for fear that they would upset their LPs. That’s a safe assumption if the LP happens to be the Pennsylvania State Employees’ Retirement System. “Although the fund sponsors we work with certainly do seek to maximize returns, they are sensitive to the issues that may surface if they were to make investments in such industries,” says Robert Gentzel, a spokesman for PennSERS. “It wouldn’t be good for their reputation, or ours.”

Other LPs won’t even talk about it. Big university endowment managers, such as those at Princeton, declined to comment. And the Church Pension Group—which manages pensions for Episcopal clergy and is a limited partner in Sequoia Capital’s eleventh fund—did not return messages seeking comment.

“The large universities are petrified of having students barricading themselves in the endowment office,” says Paul Kedrosky, a venture fellow with Ventures West Management in Vancouver, B.C., and a professor at the University of California, San Diego.

Although the fund sponsors we work with certainly do seek to maximize returns, they are sensitive to the issues that may surface if they were to make investments in [adult] industries.”

Robert Gentzel, Spokesman, PennSERS

There seems to be an implicit agreement between general and limited partners on how exactly to approach a startup that expects to make money from adult content: You’re allowed to invest if the company is one step removed.

“Everybody knew PayPal was running huge payments for the [sex] industry, but since they weren’t actively running the service, it was OK,” notes Kedrosky. “It’s one of those weird things that nobody talks about but everybody knows.”

A recent example of a venture-backed company that makes money indirectly from adult content is TwistBox Entertainment. Spark Capital invested $12.75 million in Los Angeles-based company last fall. TwistBox—via its Waat Corp. subsidiary—signs exclusive mobile distribution deals with adult entertainment purveyors, such as Vivid Entertainment Group and Girls Gone Wild producer Mantra Films, then pushes that content to cell phones and other handsets via agreements with more than 60 major mobile carriers. Spark says its funding of TwistBox didn’t prompt any complaints from its limited partners.

Angels with dirty minds

We have a little bit of a puritanical attitude in Silicon Valley that can be hard to shake.

Phil Schlein, Venture Partner, U.S. Venture Partners

Rather than risk offending LPs, some VCs are putting their own money to work in adult-related companies that look promising.

For example, JimmyJane, which makes sex toys, raised $1.1 million in late 2006 from individual venture capitalists Tim Draper, another undisclosed partner from Draper Fisher Jurvetson, and Phil Schlein, a venture partner at U.S. Venture Partners. (DFJ and USVP did not invest.)

JimmyJane, based in San Francisco, sells a premium line of gold and platinum vibrators along with sensual candles, silk and suede blindfolds, body jewelry and fragrances. “I can’t even tell you what a challenge it was to get people to understand what we were doing when I only had a few sketches,” says Ethan Imboden, the company’s founder. “But we have reached a scale now and a level of dialogue with consumers that investors really understand.”

Draper did not respond to requests for comment. Schlein, who sits on JimmyJane’s board, says he made the investment because, “People are much more open and aware of their sexuality and ways to enhance it.” He adds that he is optimistic about the startup’s international appeal. “Europe is way ahead of us,” he says. “They’re just more open about these things. We have a little bit of a puritanical attitude in Silicon Valley that can be hard to shake.”

Public markets are not receptive to IPOs [from sex-related companies], so these companies end up looking like more of a cash flow business than a capital gains business.”

Venky Ganesan, Managing Director, Globespan Capital Partners

Some VCs say they aren’t interested in sex-related investments because exits are so difficult—not because they are prudes. “Exits in this market are not well defined,” says Venky Ganesan, managing director of Globespan Capital Partners. “Public markets are not receptive to IPOs, so these [sex-related companies] end up looking like more of a cash flow business than a capital gains business.”

Go big or go home

Others say they would be open if an adult-themed company meets classic VC criteria. Says Stewart Alsop, co-founder of Alsop-Louie Partners: “I’d like to think that we would review any investment the same way—how great is the entrepreneur and how big and important is their idea?”

David Stern, a venture partner at Clearstone Venture Partners, says his firm hasn’t invested in adult-specific startups, but is open to companies that might use the market as a launching pad.

“We were the A or early round investors in Overture and PayPal, both of whom derived a large amount of revenue from sin businesses online, namely adult entertainment and gambling,” Stern says. “Had either of those businesses come to us as an adult entertainment search engine or adult entertainment payment mechanism for the Web, we wouldn’t have funded them—not because of their content, but because we like businesses with big, broad, game-changing ideas and entrepreneurs who can see beyond any one vertical segment.”

Moving beyond the vertical segment of adult content is more difficult than it looks. Consider Guba. The video sharing site, which scrapes Usenet directories for content it can then package and make searchable, once received the majority of its page views from people who used it to search for pornography. It was a good business for more than half a decade and made the company profitable. But CEO Tom McInerney wanted to work more closely with Hollywood, so he spun out Guba’s porn business as a separate business in April 2006. Bad idea. Just nine months later, Guba’s page views had plummeted by nearly 80% and McInerney stepped down as CEO.

David Brown of Heatseek has no illusions about where his bread is buttered. “I think the adult market is absolutely the most lucrative—that’s why we’re pursuing it first.” When business is good, as it is for Brown, you can fund growth with sales instead of equity.

SEX IS BIG BUSINESS

TOYS & NOVELTIES

The Miami Herald estimates that adult novelty industry, which includes everything from edible panties to vibrators, has annual revenue of $1.5 billion. Some 46% of U.S. residents have confessed to using sex toys, according to a 2004 study conducted by condom maker Durex. Similarly, in some European countries, the usage ranges from 30% to 50 percent.

WEBSITES

Some analysts estimate that the online adult content market is valued at roughly $50 billion. ComScore Media Metrix says that in June 2006 there were 64.8 million unique visitors to websites it has identified as “adult sites” category. Adult websites hold at least 11 spots among the 500 most trafficked online destinations tracked by Alexa. The highest ranking adult site is Adultfriendfinder.com (ranked No. 77 among all Internet companies), followed by Pornotube.com (No. 195) and Nastydollars.com (No. 207), whose catchphrase is “porno guys that care.” To put those numbers into context, those three adult sites garner more Web traffic than the likes of Skype (No. 236), Slashdot (No. 244) and Monster.com (No. 298).

STRIP CLUBS

Americans spend more money at strip clubs each year ($2 billion) than on Broadway Musicals ($705 million) according to Eric Schlosser, author of the 2003 book “Reefer Madness: Sex, Drugs, and Cheap Labor in the American Black Market.”

CONDOMS

The total U.S. market for condoms was $398.3 million in 2005, up 2.8% from 2004 according to market research group Packaged Facts.

Source: Reporting by Alexander Haislip