VCs turn off the tap on funding

It's no secret that the stock market downturn has forced venture capitalists to look skeptically on wild-eyed entrepreneurs.

But as the downturn approaches its first anniversary, venture capitalists' skepticism is spreading to more mature technology companies in their portfolios--evidence that the sustained downturn has become wider and deeper than many investors had presumed when the stock market took a dive in April.

Partners at several blue-chip venture capital firms said at a bearish investment management conference Thursday and Friday that they had severely reined in second- and third-round funding for adolescent companies. That indicates that the stock market downturn has not only dented demand for newly public companies, but it has also stymied investment in more established companies that were aspiring to go public in the next 18-24 months.

More ominously, the same venture capital firms that are slashing middle-stage funding are also demanding far greater stakes in portfolio companies, particularly those in the highly volatile Internet and software niches. That signals that even the venture capital community--the most high-risk investor category--is approaching the battered technology industry with an extra dose of caution.

"There are a lot of entrepreneurs who don't get it yet--that the bar is now really, really high," said Chuck Robel of San Francisco-based Hummer Winblad Venture Partners. "They come in and say they need $50 million or $60 million, and we're skeptical right from the beginning."

Robel provided a stark example of how times have changed since the stock market correction of April 2000:

An entrepreneur with a strong track record, solid business plan and a concrete management team might have promised $300 million in revenue in exchange for a $30 million investment and a 15 percent ownership stake in 1999 or early 2000. Hummer Winblad was likely to buy into that vision and grant the funding, Robel said.

VCs: Less for more
Today, Hummer Winblad would likely presume the exact same company could bring in revenues of only $50 million--roughly one-sixth of what the entrepreneur dreamed possible. And instead of forking over $30 million for a 15 percent stake, Robel said, Hummer Winblad would now likely squeeze out $12 million and demand a 30 percent stake.

Robel also said that a Hummer Winblad portfolio company that would have received a second-stage round of funding for $100 million one year ago is likely to receive as little as $20 million today.

"That's the way it is now--if you can even find a venture fund to do a follow-on round," Robel said Friday morning at the Association for Investment Management and Research (AIMR) conference. "'Brutal' would be an understatement when it comes to how the venture capital community has changed its idea of how to value these companies."

Robel said it is common to see second- or third-round funding slashed by 75 or 80 percent. Even the most optimistic venture capitalists at the AIMR conference said entrepreneurs should expect middle-round funding that is, at best, half of what it would have been a year ago.

Most agreed that the market for initial public offerings would remain dry in 2001--and possibly for as long as the next three years.

One venture capitalist said companies in their second- and third-round of financing are perhaps more at risk in 2001 than new companies. Venture firms typically give companies a relatively small amount of funding to start--say, $20 million--and then dole out bigger awards in the second round, and bigger still in the third round as the company prepares to make its Wall Street debut.

"The most early stage investment is the least risky for the VCs because there's usually less money involved," said Jim Dorrian, general partner of Crosspoint Venture Partners. "If you took your money in 1999 or 2000 and you're coming up to your next funding round now, it's not at all certain that you'll even get anything. And if you get anything, you're looking at what looks more like series A funding...We see some of our companies looking at series B and C funding rounds facing very, very difficult times. We're in a tough year."

Rampant pessimism
The pessimism of venture capitalists mirrored a surprisingly negative mood at the annual AIMR conference. In contrast to typical tech conferences, where speakers tout the industry and predict a stunning comeback, candid AIMR speakers presented PowerPoint presentations with subject titles such as, "What went wrong?" and "Financial Shenanigans" of Internet companies.

"We wanted this to be a brutal, honest, tough discussion of the bloody carnage that has happened over the last year," said moderator Berge Ayvazian, president and CEO of The Yankee Group. "We wanted to find out who to blame, what happened, what we can learn, how to prevent it from happening again."

To a rapt room of about 150 investment executives, Martin Fridson of Merrill Lynch said the Internet boom of the late '90s and 2000 will go down in history as a silly fad similar to other trendy investment boondoggles. Fridson and others compared the boomlet with the tulip frenzy of 17th century Holland, in which gullible investors paid the equivalent of $300 for a single bulb, to the railroad boom of 1824, whose bubble burst spectacularly in 1873.

Howard Schilit, president for the Center for Financial Research & Analysis in Rockville, Md., also used a series of slides to blast Internet companies for their "aggressive" accounting methods, which Schilit labeled decidedly unethical. Schilit criticized such common practices as shifting current income to later periods, shipping goods before a sale is finalized or boosting income with bogus, one-time gains.

Like many speakers at the conference, Schilit berated analysts and boosterish executives who tried to persuade Wall Street that the New Economy needed an entirely new set of accounting methods. He poked fun at accountants who used such metrics as "eyeballs," market share, page views and revenue gains instead of solid profits.

"Many sell-side analysts believe the current accounting model is antiquated, even though it's been around for 500 years," Schilit said. "Whether the books are about an Internet or software company or a railroad company of 100 years ago, the accounting model is robust enough to handle all types of businesses. There ain't nothing wrong with it."

Pointing fingers
Frank speakers also assessed who was to blame for the massive stock market devaluation, which has erased more hundreds of billions of dollars in market capitalizations in the past year.

Lawrence Haverty Jr., senior vice president of State Street Research, said the stock market losses for AOL, Yahoo and Amazon alone have erased $300 billion in market capitalization since March of last year. By contrast, Secretary of the Treasury Nicholas F. Brady testified in Congress in 1990 that the savings and loan bailout of the 1980s cost taxpayers at least $89 billion and possibly as much as $130 billion.

In assessing the damage, speakers pointed fingers at investment bankers, day traders, Internet company executives, accountants and forecasters who touted wild gains in the number of Internet users. But no institution received more blame at the conference than the venture capital industry.

Dorrian didn't shirk responsibility when asked whether the venture capital community was at least partially to blame for taking too many companies public too quickly and creating a delicate bubble for investors. After a long pause, he said he felt some personal responsibility--and that the current belt-tightening of venture funding is a result of the bubble's bursting.

"I'm not saying there was anyone out there who was intentionally packaging stuff that was valueless and sending it down the pipe looking for the highest bidder," Dorrian said. "But clearly a frenzy developed...and you moved quickly to exploit it.

"The real thing was the Nasdaq became a venture capital market, and there was a chain of people involved: VCs, investment bankers, the market itself," Dorrian said apologetically. "People didn't know three or four years ago whether companies would be valued the way they were. The trust in the business model was probably the biggest sin."