NEW YORK-The bad news, according to Jerry Newman, senior managing director of Bear, Stearns & Co. Inc., “is word of a 50-to-75 percent decline in new venture capital investments” so far this year.
The good news is “there probably is in the neighborhood of $100 billion (in venture capital) available to entrepreneurs today that did not exist in the early 1990s,” said Kevin Maroni, managing general partner of Spectrum Equity Investors.
Spectrum, which focuses on early through late stage investments in telecommunications services and infrastructure providers, recently completed raising $2 billion for its fourth fund. In the past, it has made private equity investments in companies including American Cellular Corp., Illuminet Holdings Inc. and Jazztel.
Maroni was one of five venture fund managers who participated June 12 in a discussion, which Newman moderated, at Bear, Stearns’ Technology Conference.
From 1995 through 2000, the internal rate of return on venture capital investments “spiked up off the charts” compared with the 15 previous years, Maroni said.
“A lot of entrepreneurs thought they’d discovered electricity, and a lot of us were struck by lightning. The cost of capital was infinitesimal. Now it’s substantially higher but more rational,” he said.
“Things have moved more slowly in the last six-to-nine months than in the prior 24. Lately, the pace has picked up but on a more rational basis.”
The pressure to get deals done in the recent venture capital feeding frenzy made “time our enemy, but now it is our friend because we can take time to evaluate companies,” said William J. Marshall, a partner of VantagePoint Venture Partners and former director of Bear, Stearns communications technology strategy.
VantagePoint, which focuses on early stage investments, has $2.5 billion under management. Its strategic investors include IBM Corp., JDS Uniphase Corp., Level 3 Communications and Nortel Networks.
The issue of strategic investor participation raised more negative than positive comments from panelists.
“If Lucent is a strategic investor in a company, will Alcatel or Siemens buy from it? You need to make sure strategics are not on the board (of directors) and that you limit their information rights,” said Loring Knoblauch, general partner of Bay Partners.
Bay Partners focuses on early stage companies developing new technologies for networking, wireless communications and software. In Knoblauch’s view, strong early-stage companies don’t need strategic investors to guide them, but they do need financial investors to back them.
“We’ve seen a lot of strategics dump a lot of stock on the market right after the company went public to help their own balance sheets. But that’s bad for the new IPO company,” said Mark Dzialga, partner in General Atlantic Partners L.L.C.
General Atlantic, which has $4 billion available for investment, focuses exclusively on information technology and telecommunications businesses.
Weaker companies are falling by the wayside, partly due to a self-destructive impulse in recent years to “price goods on the margin,” said Michael Krupka, managing director of Bain Capital, which has $12 billion in assets under management. However, the stronger players left standing can expect to receive more for the goods or services they sell, provided their prospects for remaining in business look good upon close scrutiny.
Sales cycles for start-ups have lengthened a bit compared with recent years “when large companies bought technology without a lot of due diligence about how they were spending their money,” he said.
“Now, a lot more large companies want to talk to us about the stability of smaller companies because they have been burned by a fair number of companies that are no longer there.”
In today’s environment, it has become necessary to cull the weakest companies in order to focus on those with the best prospects for eventual success, Marshall said.
“So many science projects were funded in the last several years, but we are seeing an increase in quality deals and our belief is the market is coming back,” he said.
“Right now, we are focused on our current portfolio (of investments), some of which we will freeze dry, others put out for valet parking and some set adrift.”
There has been an accompanying shakeout among venture capitalists, panelists said. Those remaining are returning to the status quo of the late 1980s by requiring their stakeholders to remain financially committed to new ventures they invest in until those companies are profitable. Those that back out prematurely lose their equity stake under these “pay to play” rules.
“Companies with troubled characteristics fall into two buckets. The first are either technologies masquerading as products or products masquerading as companies, and are likely candidates for mergers,” Krupka said.
“The second group has some traction but needs a longer runway to be successful, and venture capitalists need to `incentivize’ their CEOs to make sure this happens.”
Marshall described the problem with chief executive officers of venture-backed telecommunications services start-ups in the recent heyday this way: “We created crack addict CEOs who didn’t use their equity properly, exceeded their debt limits and couldn’t service that debt in turbulent times. They also built up monstrous (cash) burn rates, didn’t throttle back and then wouldn’t throttle back because they became addicted to employee head counts.”
The reality check under way today is welcome, he added.
