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Planting fewer seeds

In the wake of the dot-com bust, venture capitalists are not funding as many start-ups as they used to.

In the wake of the dot-com bust, venture capitalists are not funding as many start-ups as they used to.

By Justin Schack
December 2000
Institutional Investor Magazine

The wilder the party, the worse the hangover. That seems to be the lesson being recited all over Silicon Valley these days, as investors, entrepreneurs and bankers come to grips with the end of one of the headiest speculative booms in the history of the financial markets.

At the Internet mania's apex, even the most woeful business models found eager investment dollars (remember "teen community" Thirsty.com and online appointment scheduler Jacknabbit.com?). But now woozy venture capitalists are far more guarded with their investors, money. According to San Francisco research firm VentureOne Corp., $24.5 million in seed-stage venture capital went to only 16 start-ups during the third quarter. That's off a whopping 81 percent from the $130.2 million that was sprinkled among 66 seedlings during the same period last year (see graph).

For a number of reasons, most venture firms recently have preferred to fund companies in later stages of development. One major priority has been to ensure that existing portfolio companies didn,t run out of cash. Several companies that went public during the past two years, including E-Loan and Drkoop.com, have gone back to venture investors for private equity infusions, usually at a discount to their already depressed public valuations. Many other companies have had to delay or shelve IPOs altogether, and yet they continue to need capital.

Venture capital has always been subject to cycles in which investors migrate to earlier-stage deals during times of strong economic growth, but favor later-stage investments when things cool off. "There's really no theoretical explanation for it," says Joshua Lerner, a professor of finance and entrepreneurial management at Harvard Business School. "But when there's less exuberance about the economy, people tend to move into later stages."

One simple reason may be that investing in better established companies generally involves less risk. Seed investors often perform the most-critical due diligence. And later-stage companies at least have a few quarters of operations after initial funding on which to base projections about financial performance.

During the third quarter, for example, San Francisco,based Crosslink Capital made venture investments only in its existing portfolio companies. The firm sees early-stage deals gradually becoming more attractive, as lower public market valuations bleed into the private markets. But for now the problem remains finding profitable or near-profitable companies with solid business models. "We,re very cautious now," says Anthony Brenner, a partner who handles venture investments at Crosslink.

To be sure, no one is sounding the death knell for tech entrepreneurs just yet. Although statistics showing the level of seed investment before 1999 aren,t readily available, venture capitalists say that today,s activity, though diminished, bests that of the early and mid-1990s.

"Sure, there's been a slowdown," says Ira Ehrenpreis, a partner in Palo Alto, California, venture firm Technology Partners. "But these levels are still at huge multiples of historical levels. Even though the investment pace has declined slightly this year, there are still lots of opportunities out there."

Indeed, in recent weeks Technology Partners has participated in the initial funding rounds of two companies: FreeRein, a Bellevue, Washington, provider of mobile technology systems for businesses; and Palo Alto,based Netliant, which helps companies design communications networks online.

What's more, the Internet boom and bust created a network of entrepreneurs who got rich before the bubble burst and are now financing their peers, new ventures. These angel investors may step in where traditional venture firms are backing off. "There is a lot of seed funding now taking place outside of VC groups," notes Harvard's Lerner.

That alternative funding, and a renewed sense of sanity in Silicon Valley, may be just what it takes to get investors and entrepreneurs partying again, albeit not so rowdily.

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