Playing God : Orange County Venture Firms Control Millions of Dollars. They Can Make--or Break--High-Tech Dreams

Bob Hoff shudders at the notion that his job lets him play God, but the business plans that flow into his Irvine office are like prayers sent to heaven.

As a partner in one of Orange County’s largest venture capital firms, Crosspoint Venture Partners, Hoff has the power to breathe life into embryonic high-tech companies, providing them with the cash they desperately need to grow up and become the next Microsoft, Intel or Netscape.

But cold Darwinism rules the high-tech universe, and the vast majority of prayers go unanswered.

“I see 350 prospects a year,” said Hoff, 43. “I look real close at 20, and do maybe two investments. That’s the reality of this business.”

The story is the same across the San Diego Freeway at Brentwood Associates, where Roger Davisson and the other partners in the firm passed over 560 proposals last year in funding just 15 companies.

At both firms, fewer than one in four applicants even gets an invitation for an interview, which is why two entrepreneurs who walked through Hoff’s door on a recent fall morning had already beaten some very long odds.

Wearing monogrammed shirts and nervous faces, the men set up twin laptop computers on a conference room table and prepared to spend the next two hours making what is simply known as “the pitch.”

The men, Mike Arrigo and Karl Karlsson, hope to start an Internet news service, one that gathers stories from hundreds of sources, then bundles special packages for subscribers with specific interests, such as cardiovascular medicine. To make it work, they need a lot of financial help.

“What I’m looking to get out of this is a $500,000 bridge loan and $3 million down the road,” Arrigo said when Hoff had stepped out to make a call. “I see Bob as the kind of guy who can help with that.”

He can. The question is whether he will.

Nationwide, venture capital firms are poised to invest more than $6 billion in young companies this year, topping last year’s mark by about $1 billion and even surpassing the totals of the booming late 1980s, according to VentureOne Corp., an industry research firm in San Francisco.

The bulk of that money continues to pour into Silicon Valley, the center of the venture capital universe. But Orange and Los Angeles counties are on a pace to receive about $280 million, well ahead of last year’s supply.

Venture firms are essentially intermediaries that collect money from corporate pension funds, university endowments and other institutional sources, and then plow it into young companies that have the potential to grow rapidly.

In exchange, the venture firms get a sizable stake in the companies they back, often 20% or more. So if the company does take off and ends up selling stock to the public, the venture firm simply sells its stake and cashes in.

“Venture capital really thrives on swinging for the fences,” says David Gleba, chairman of VentureOne.

For entrepreneurs like Arrigo, 37, and Karlsson, 31, that means they’ve got to toss up a very fat pitch to get Hoff interested in their company, called NewsMakers.

Hoff, a thin man with bushy hair parted down the middle, took his seat at the head of the conference table, flanked by Arrigo, Karlsson and their laptops.

After some strained banter meant to ease the tension, Arrigo and Karlsson plunged in. Clicking through computer screens showing Hoff outlines of their plans, they recited all the phrases designed to get a venture capitalist like Hoff licking his chops.

“The first wave has been the Internet access providers,” Arrigo said, referring to the wave of Internet companies, such as Netscape, that have become Wall Street darlings this year. “We think the next phase is content. We add value to content. We think we can make two plus two equal eight or nine.”

The meeting went smoothly for the first hour, as Hoff nodded in agreement with various pieces of the plan, and occasionally tossed out questions about competitors, contracts and revenue sources.

But as the meeting drew to a close, the overeager Karlsson started to press too hard, interrupting Hoff, digging for a commitment, and dropping not-too-subtle hints about other funding sources that he said were already lined up.

Growing visibly annoyed, Hoff tried to offer some encouragement to the entrepreneurs without raising their hopes too high. “I’m very interested,” he said. “But I’m not a you’ll-get-a-check-next-week guy.”

Oblivious, Karlsson pressed harder. Doesn’t “the fact that we’re already profitable mean something?” he asked.

Hoff, squinting his eyes in disbelief, snapped back, “What kind of question is that?”

Sensing that the meeting was unraveling, Arrigo tried to grab the reins. He scolded his partner--”Karl, he doesn’t have a crystal ball”--and repeated Hoff’s earlier comments, showing that at least one guest had heard the host’s message.

Minutes later, Arrigo and Karlsson slinked out of the office, aware they let things get out of hand. After the visitors had gone, Hoff offered a surprisingly charitable assessment of the meeting.

“That’s as good as they go; they answered all my questions,” he said. As for Karlsson, Hoff said simply: “He’s very smart but talks too much.”

Hoff’s firm is currently trying to raise some cash of its own. Venture firms get most of their money from institutions, since few individuals can afford to part with a couple of million dollars. The money is allocated to specific funds, which are structured as limited partnerships.

Venture firms usually have to repay investors within 10 years or so, so when one fund winds down, partners have to raise money for the next.

Hoff recently spent a hectic week darting up and down the East Coast, hitting up potential investors. He met with representatives from the AT&T; pension fund, the Yale University endowment, the Pfizer Pharmaceutical pension, the Liberty Mutual, Kemper and John Hancock insurance funds, the Harvard University endowment and others.

“By the 16th presentation on Friday, you’re drinking a lot of coffee,” Hoff said. “But you’ve got to get psyched up for it. We’ve got to keep making them feel this is a good investment.”

That can be a tough sell when the economy is down, as it was in 1991. But these days, with the stock market hitting new highs every week, and with high-tech start-ups like Netscape fetching billions of dollars in their initial public offerings, the money is flowing into venture firms at a swift pace.

For Hoff, who hopes to raise about $80 million for the newest fund, the job of raising money is made even easier by the fact that Yale and others have invested in previous Crosspoint funds and profited handsomely.

Crosspoint invested about $60 million through its 1988 fund, Hoff said, and by the end of this year will have returned more than $109 million to investors. “In 1983, we were a new team and [raising money] took a lot longer,” Hoff said. “But now we’ve made money for these people.”

Of course, successful venture capitalists also make plenty of money for themselves.

The firms generally collect annual management fees equal to 2% of each active fund. That means if Crosspoint raises $80 million for its new fund, investors will pay the firm $1.6 million per year for the life of the fund. That money will cover Crosspoint’s rent, six-figure salaries for partners and other expenses.

The partners also get a hefty cut of the profits. Under the most common arrangement, the venture firm distributes 80% of the profits from a fund back to institutional investors. But partners split the other 20%.

Within a few years, Hoff expects Crosspoint’s 1988 fund to have yielded a $140-million profit, meaning he and the other four partners in the firm will each get about $5.6 million.

All of which helps explain why Hoff has a $485,000 house in Irvine. Davisson, who enjoys a similar arrangement at Brentwood, has a $1.3-million home in Capistrano Beach.

The venture capital process can be a slow one, often taking weeks or even months, depending on how hot the company is and how many other venture firms are interested.

Every business plan that arrives is logged into a computer and looked over at least once. Almost all have “hockey stick” revenue projections, Hoff said, referring to the charts included in most plans that show sales soaring within a few years.

But venture capitalists like Hoff are looking for a few key ingredients, including an experienced management team and a booming target market. Plans that show promise in these areas prompt an invitation to the entrepreneur to come in and make a pitch. Once that test is passed, the venture firm digs in, checking the entrepreneurs’ references and contacting potential customers.

Every month or so, Davisson and the other Brentwood partners gather at the company’s eighth-floor conference room in Irvine, like venture capital gods meeting at Mt. Olympus to weigh the fates of entrepreneurial mortals.

Sitting around a sunlit table on a recent Monday morning, they ran through a lengthy list of prospects.

The five partners in attendance were a remarkably homogeneous group, with sharp suits, bright ties and short hair. Four of the five have MBAs from Stanford, and you could almost hear the BMW keys jangling in their pockets.

During pauses in the meeting, their chatter offered a glimpse of their upscale lifestyles. “Oh, I found a good web site for wine auctions,” said one. Another, lamenting the prospect of visiting a company in Pennsylvania, asked plaintively, “Why can’t it be Kauai?”

By the end of the two-hour meeting, the partners have picked over 114 potential deals, passing on all but a few.

For those plans that get a go-ahead, the firm and the entrepreneurs start negotiating a deal. Usually, the partner who arranges an investment in a company will take a seat on that company’s board of directors, and, for the next several years, play a significant role in major decisions such as hiring executives.

The selection system is far from foolproof. Of the 27 companies Crosspoint invested in through its 1988 fund, 10 have been money losers, 10 have been winners, three continue to show good potential and four will at best break even, Hoff said.

But venture capitalists don’t mind sinking money into losers as much as letting a big winner get away. “The most painful experience,” Davisson said, “is having missed a really good one.”

In the late 1970s, Brentwood passed on a couple of entrepreneurs “who were talking about developing a hormone or some kind of drug,” Davisson said. “We just couldn’t get excited about it.”

A few years later, those entrepreneurs founded Amgen, now the biggest biotechnology company in the world, with annual sales of $1.6 billion.

For entrepreneurs who can’t get venture capital, there are alternatives. Many entrepreneurs tap their savings, borrow from relatives or take out mortgage loans. Others start by doing consulting work and gradually shifting into product development. That is the way AST Research Inc., the giant Irvine computer maker, got its start.

There are also thousands of wealthy individuals, often called “angels,” ready to take a chance on a young company. The trick is finding these people, but there are services, such as the Accelerate program at UC Irvine’s School of Management, that specialize in linking entrepreneurs with private investors.

These kinds of deals outnumber venture capital investments by 100 to 1, according to some estimates, and hark back to the birth of the venture capital industry in the 1940s, when Laurance Rockefeller and other multimillionaires sought a more systematic way to put small chunks of their fortunes into speculative investments.

The industry was barely a blip on the economic radar until 20 years ago, however, when the high-tech economy started to boom. Venture capital was a perfect funding mechanism for high-tech start-ups, which require deep-pocketed investors that can afford to back risky ventures and are able to wait patiently, hoping that a few years of research will yield a blockbuster product. As early venture firms started reaping huge profits, others sprang up quickly.

In fact, the market got so overheated in the late 1980s that there were as many as 20 venture capital firms in Orange County, Hoff said. The lean economic years that followed thinned Orange County’s ranks to about six firms today, but they are larger, more prominent players.

The amount of money flowing into the industry has risen in recent years, fueled by waves of hot new technologies. First there was the biotechnology boom in 1991 and ’92. Then that gave way to multimedia and telecommunications in ’93 and ’94.

The Internet is the latest craze, and initially, that helped lift the prospects for Arrigo and Karlsson in their efforts to get some money from Crosspoint.

But, as it turns out, another news service called Individual Inc. has already been started in Massachusetts. In fact, the company recently sold 10% of its stock to Microsoft Corp., which also agreed to make Individual’s service available through the new Microsoft Network.

Given the presence of that competitor, Hoff now says the odds that Crosspoint will invest in NewsMakers are 50-50. In the meantime, he has agreed to invest in another company that develops sites on the Internet’s World Wide Web.

Asked whether he believes he gets to play God, Hoff winced. “I suppose that’s true to an extent,” he said. “But in the end I can’t be romantic about it, or think about God or anything else, because I’ve got to return 18% per year to the AT&T; pension fund, or when I go back to New Jersey next time they’ll shut the door.”

Reflecting on it a moment longer, he offers another difference between him and the Almighty.

“We make mistakes,” he said. “We had those 10 losers in the 1988 fund. If I was God I’d make them all win.”

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Ventura Tales

Venture capital investment has nearly doubled in the United States since 1991.

(see newspaper for chart)

In billions

1995: $6.000 (projected)

Source: VentureOne Corp., San Francisco

Researched by GREG MILLER / Los Angeles Times