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Back to the future

Late in 2000, as investors were still assessing the damage from the dot-com crash, the venture capital fundraising spigot remained wide open. So when Silicon Valley stalwart U.S. Venture Partners set out to raise $900 million for its eighth and largest fund, it got a rousing reception: In just three weeks, ending in January 2001, limited partners offered up more than $1.5 billion. USVP decided to cap its cash trove at $1 billion and got ready to start putting the money to work.

Late in 2000, as investors were still assessing the damage from the dot-com crash, the venture capital fundraising spigot remained wide open. So when Silicon Valley stalwart U.S. Venture Partners set out to raise $900 million for its eighth and largest fund, it got a rousing reception: In just three weeks, ending in January 2001, limited partners offered up more than $1.5 billion. USVP decided to cap its cash trove at $1 billion and got ready to start putting the money to work.

That's when the markets obliterated any lingering hopes of a speedy tech recovery. Already down more than 40 percent in 2000, the Nasdaq composite index dropped an additional 26 percent in the first quarter of 2001 -- on its way to about 1,450 today, 71 percent off its record high. At the end of March 2001, venture capital returns posted their first-ever 12-month loss -- 6.7 percent, according to Thomson Venture Economics. A host of venture-backed companies, such as Etoys, and, had failed. Fundraising understandably became far more difficult: From $86 billion in 2000, just $6.9 billion was raised in 2002. Taking into account $5 billion returned to fund investors, net fundraising last year was $1.9 billion, the lowest since 1991, according to Thomson and the National Venture Capital Association.

The meltdown leaves USVP in a predicament: It has lots of fresh money to invest in cash-starved young companies, but it won't be easy to parcel out $1 billion in small chunks to start-ups that offer realistic opportunities for high long-term returns. After all, just how many promising new prospects are there when the economy is in the doldrums and large segments of venture capital's favorite target, the tech sector, are contracting -- or even disappearing? With valuations depressed, that $1 billion is either going to have to be spread over far more investments than ever, each requiring time-consuming personal care, or it will have to be doled out in much bigger -- and riskier -- amounts and concentrated in a smaller number of companies. And it will have to do this while the venture capital industry is trying to put to work $80 billion that it has raised but been unable to invest. So much money chasing promising seed investments makes for an extremely competitive environment.

"It's extremely difficult to invest $1 billion in early-stage companies," says John Gabbert, head of worldwide research at San Francisco­based research firm VentureOne. "The math doesn't really work given the current state of valuations, liquidity and financing."

Indeed, USVP is struggling with the math: The eighth fund is only about half invested and is not likely to be fully invested before the end of next year. And with annualized returns running ­16.6 percent, USVP's limited partners worry about the firm's ability to invest the $1 billion wisely. The firm "makes a good point that it takes more money to support your deals with fewer co-investors and over a longer period of time," says Philip Paul, chairman of Paul Capital Partners, a San Francisco­based private equity firm that has invested with USVP since the 1980s. "But they're still on the edge of being too big."

Not unexpectedly, USVP's partners remain confident. "VCs should be in the business boom or bust," asserts general partner Magdalena Yesil. "We're in the business of funding early-stage companies and taking risk. That doesn't change if you're having a bear or bull market."

Fair enough, and 22-year-old USVP is just the firm to put Yesil's conviction to the test. With offices on Menlo Park, California's fabled Sand Hill Road, USVP is a traditional venture capital firm, with a sterling record of making savvy investments and taking a hands-on role in nurturing its holdings to maturity. It has invested in companies like Amgen, Check Point Software Technologies and Sun Microsystems, and it boasts a partner roster full of former corporate executives. USVP's portfolio companies uniformly praise its patience and professionalism.

Perhaps most important, the firm adopted a conservative style after recovering from some setbacks more than a decade ago -- and stuck to it through the late 1990s boom. "Some venture capitalists behaved like they were handing out candies to babies," recalls USVP general partner Irwin Federman. "They'd say, 'Here's your allocation, and we'll take a high management fee and carry.' We could have gotten whatever we wanted [from the 2000 fundraising], but didn't." In 2001 USVP not only turned away $500 million, it also kept its management fee at just under 2 percent, slightly below the going rate. Similarly, Federman has no plans to follow recent fashion and return capital to investors, nor does he expect his limited partners to ask for it.

"Over the years USVP has been one of the more consistent, steady players," says investor Paul. Adds Paul Kedrosky, an economics professor at the University of California, San Diego, and a director at nearby Windamere Capital Ventures, "They can credibly talk the talk."

USVP's partners certainly intend to prove the skeptics wrong. Their annual number of new financings, though down from the late 1990s peak, increased last year to 20, from 12 in 2001. Total new and follow-on financings climbed to $277 million, from $250 million in 2001, as USVP continued to focus on tangible, patentable technologies in health care, semiconductors, software, telecommunications and other areas. Venture Economics ranked USVP fourth in dollars invested last year, behind New Enterprise Associates, J.P. Morgan Partners and Warburg Pincus.

Recipients of USVP money in 2002 included semiconductor manufacturing equipment company Brion Technologies, Internet infrastructure company Caspian Networks and health care technology outfit Core Medical.

USVP's investment amounts remain undisclosed, but as indicated by its co-lead role in a $120 million Series D round for Caspian that closed in February 2002, the firm is growing more inclined to make bigger, later-stage deals to accelerate deployment of its capital. "We usually end up putting $10 million to $20 million into a company, except for a couple of cases that will be several times this," notes Yesil.

The firm's emphasis on recruiting partners with hands-on operational, technological and financial experience works well in today's marketplace. "To be a successful fund, partners need that mix of skills," explains Jonathan Silver, head of Core Capital Partners in Washington, D.C. "You can get away without operating experience when the markets are going up. When the markets are going down, there's a premium on operational experience to help entrepreneurs."

All 15 USVP partners have operating experience; two are Ph.D.s, one is an M.D., and about half have run companies. Federman, a general partner since 1990, was CEO of semiconductor maker Monolithic Memories for nine years before merging it in 1987 into Advanced Micro Devices, where he served as vice chairman. Yesil, who joined USVP in 1998, co-founded CyberCash, an Internet payments company that is now part of VeriSign; Geoffrey Baehr was chief network officer at Sun Microsystems before jumping to USVP in 2001; and Arati Prabhakar, who also joined in 2001, had previously directed the microelectronics technology office at the Defense Advanced Research Projects Agency and served as director of the National Institute of Standards and Technology.

The partners' knowledge and experience predispose them to be patient and flexible. In 1998, for example, USVP anted up $1.1 million to seed CryoVascular Systems, a Silicon Valley company that was developing a low-temperature angioplasty technique. When CryoVascular scrapped its original business plan in 2001, USVP injected $5.7 million in three subsequent financing rounds, most recently in February 2002.

"They were supportive and willingly served as advisers as we completely changed the direction of the company," says Jeff Gold, CryoVascular's president and CEO. Instead of offering coronary applications, which is a highly competitive marketplace, he explains, CryoVascular decided to focus on the wide-open market for noncoronary applications, such as blood vessels in the leg. "It was a complete strategic flip-flop, but today there's no question that it was borderline brilliant," he says.

USVP's cautiousness kept it away from the worst excesses of the dot-com era. "We were wondering why we were looking so stupid for a while, and we missed some quick flips," says Winston Fu, a Burmese-born general partner with a Ph.D. in applied physics from Stanford University who focuses on communications, semiconductors and optical components. "But we just didn't see the business models working long term," adds Fu, who at 37 is USVP's youngest partner.

The antics of the bubble era also nagged at Federman. "When we started to see pictures of VCs on magazine covers and someone paying to have breakfast with a VC, I said, 'There's something wrong here,'" he recalls. (Federman is referring to a widely publicized 1999 incident in which entrepreneur Mark Hernandez paid Draper Fisher Jurvetson partner Steve Jurvetson $4,400 for the chance to pitch his business plan over a breakfast at local landmark Buck's Restaurant in Woodside, California. The pitch missed the mark, and the money went to charity.)

Despite these misgivings, USVP did get scalded by the tech mania; it wrote off $20 million in Internet investments in its $278 million Fund VI (1998), for example. Although it rejected most dot-com business plans, it accepted widely quoted and now-discredited estimates that telecommunications bandwidth would continue to expand for several years at annual rates of 100 percent. Among other busts, the firm invested in Centerpoint Broadband Technologies, which was formed in 1999 to develop optical networking systems for telephone companies. Centerpoint, after having raised some $200 million in venture financing, declared bankruptcy in 2002. "Our mistake was not to follow the derivation of our poor view of dot-com retailers," says Jonathan Root, a USVP general partner specializing in medical technologies.

USVP was able to contain the damage because it usually worked with co-investors -- a risk-sharing strategy that lost favor at the height of the tech hysteria. Explains Root: "Our investments are rooted in the knowledge of individual partners, who are generally conservative individuals. We focus on companies with core technologies and platforms that are proprietary." One example is Raven Biotechnologies, a South San Francisco­based start-up that is using proprietary stem-cell lines to create antibodies for treating a variety of cancers.

Says partner Baehr, who specializes in the information technology area and is eyeing opportunities in wireless networking and grid computing: "Our thought process is to identify a specific market need and a method to satisfy it, assess the quality of the management team and then the technology. We try to differentiate ourselves by finding people who can apply new ideas to a new space or marry two technologies that are diverse -- such as using a genetic algorithm for wireless security systems."

Of course, USVP's patient approach can backfire. In 1998 it invested about $1 million in Valicert, a Mountain View, California, developer of software for secure business collaboration over the Internet. In 1999 USVP facilitated Valicert's merger with another portfolio company,, which led to an initial public offering in July 2000. Post-IPO, USVP held onto some 1.3 million shares, or 6 percent, of Valicert, down from 15 percent when it went public. But Valicert's shares, which peaked at $25.24 on September 21, 2000, had fallen to 43 cents on February 18 -- when Tumbleweed Communications Corp., a Silicon Valley messaging technology company, agreed to acquire Valicert for $14.3 million, or 56 cents a share. "We're not great timers on public stocks, are we?" says USVP's Yesil, a Valicert director.


USVP FORGED ITS CHARACTER AND LONG-TERM strategy after coming through a boom-and-bust cycle of its own. Founded in 1981 by Bay Area venture capitalist William Bowes, USVP got off to a roaring start with home-run investments in Amgen, the biotechnology giant that Bowes created as a venture capitalist in 1980, discount clothier Ross Stores and Sun. But by 1990 the venture industry was experiencing its worst slowdown to date, and USVP started to come apart at the seams. Two partners fell ill and retired. Three others were forced out. A couple of the firm's funds had tanked, and limited partners were irate. "They took our management fees and screwed us," complains one investor, still angry 13 years later. "They raised a fund, bought homes in Palm Springs and played golf."

But USVP cleaned up its act. Bowes, still active today as founding partner, brought in Federman and Philip Young, former CEO of medical instruments maker Oximetrix, to reform the partnership. The firm recruited partners with expertise in semiconductors, software, networking, communications and biotech. Federman, a shrewd yet grandfatherly 67-year-old, emphasized teamwork and professional courtesy. "Collegiality was being lost in the industry in the '90s and during the bubble," he says. "You can't be Janus-faced. If you're discourteous to one another, you're not going to have a genteel face to the outside."

The shift in investment focus and management philosophy paid off. USVP funds IV, V and VI, begun in 1994, 1996 and 1998, respectively, posted annualized internal rates of return as of last September of 71.7 percent, 30 percent and 12.2 percent, according to Among the big winners: Advanced Cardiovascular Systems, now part of publicly held Guidant Corp.; Israeli data security vendor Check Point Software; and voice recognition systems pioneer Nuance Communications.

The less impressive returns of more recent funds are pretty much in line with those of competitors of similar size and vintage. USVP VII, for example, a $606 million fund raised in 1999 and now 69.5 percent invested, is showing an annualized loss rate of 24.1 percent, which is worse than the ­16.6 percent of the $1 billion USVP VIII. The firm says that the sector breakdown of the eighth fund approximates that of its entire portfolio: communications, 28 percent; health care, 24 percent; semiconductors, 14 percent; software (enterprise and technical), 18 percent; wireless, 9 percent; and storage and computer systems, 7 percent.

Still, USVP's overall performance remains top-drawer. Since 1987 more than half of the companies USVP has invested in, including those from its younger funds, have achieved liquidity, either through IPOs or mergers -- an unusually high percentage for that period, according to VentureOne.


AS EXPERIENCED AND SAVVY AS USVP IS, THE billion-dollar question remains: Can it -- or anyone -- efficiently and profitably invest so much capital? USVP is making a straight-out bet that venture giants like Accel Partners, Charles River Ventures and Kleiner Perkins Caufield & Byers have hedged. All have cut planned billion-dollar funds by hundreds of millions in recent months, saying they can't prudently invest so much money in such hostile conditions.

The toughest challenge is low valuation. USVP typically puts $2 million to $7 million into initial investments. At today's valuations it would have to make about 70 initial investments plus numerous later-stage co-investments to fully allocate its $1 billion (and account for nearly $200 million in management fees over ten years). Federman reckons that Fund VIII is on track to make 67 investments and to be fully committed by year-end 2004.

That would be three and a half years since the fund's start, much longer than bubble-era time frames. Even at that pace, says Sanjay Subhedar, a general partner at Storm Ventures in Palo Alto, California, USVP is investing too quickly, taxing its partners' ability to pay the necessary attention to start-ups. He predicts that USVP will "eventually drift to more later-stage investing." Yesil denies that there is any drift, saying that USVP has been consistently making 90 percent of its investments in early-stage deals.

USVP contends that its current pace -- averaging 1.5 deals per year per partner -- is manageable. "We're on a good, sustainable rate," says Steven Krausz, a general partner since 1985. He notes that the number of general and venture partners has grown to 15 from eight in 1996. Over the same period USVP's capital has more than tripled, and valuations -- despite their sharp drop -- remain above prebubble levels.

More important, USVP views today's depressed market as an ideal investment opportunity, affording greater access to entrepreneurial talent at lower costs. "Some VCs are returning money not because they can't deploy it but because they're saddled by managing too many old companies," says Federman. "It's only common sense -- it's better to invest in the Nasdaq at 1,100 than 5,000. You have to believe there's a return on this investment, or there's no industry."

Even the skeptics grant that USVP's track record and operating know-how make it one of the few firms capable of pulling off this trick. "Because of their historical success and the vast amount of experience they have in their investment team, USVP has great prospects of continuing its outstanding returns," says VentureOne's Gabbert.

"The single biggest risk is that purely financially oriented investors will withdraw support at pivotal times, leaving a company unfinanceable," says Gary Morgenthaler, a general partner at Morgenthaler Ventures in Menlo Park, which has co-invested with USVP on numerous occasions. "When times get bad, the guys at USVP figure that this is just another problem, and problems are solvable. They're very consistent investors."

Their limited partners can only hope that consistency pays off in a treacherous environment.