Venture Capitalists Show the Risk Can Be Worth It

The fare was veal, quail and exquisitely braised tuna, the subject was a possible new treatment for chronic hepatitis, and in an upstairs room at a restaurant here in the heart of high-technology country, C. Budd Colby was fielding questions like a tennis champ getting peppered with shots.

“There are a lot of companies working in this field,” said one interrogator. “‘What do you have that will get you ahead of them?”

“What will happen to your business if a successful hepatitis vaccine is found first?” was the next question. “How good is your patent protection? . . . How do you know this will work? . . . Who has paid for the research so far?”

Finally, Colby--who has a doctorate in genetics, is a pioneer in the cloning of interferon and and is chief executive of a tiny start-up company hoping to develop a treatment for a disease afflicting 100 million people around the world--closed the discussion.

“We’ve got a cutting-edge technology, really exceptional professional talent and a really big health problem,” he said of his company, Cura Pharmaceutical.

It was a grueling encounter in a deceptively urbane setting, a fine dinner followed immediately by the third degree. Entrepreneurs like Colby submit to it--indeed, clamor for an invitation--for one reason: The audience at this once-a-month session represents as much as a half-billion dollars of investable capital on the hoof.

This is the Band of Angels, a society of 60 dues-paying current and former Silicon Valley executives, retired entrepreneurs, bankers and others helping find young companies worthy of their money.

The group takes its name from a term widely used in the venture financing business for individuals investing their own money in high-risk enterprises, usually in chunks of $50,000 to $200,000 per investor. From them an entrepreneur with an intriguing idea can raise as much as $1 million at a shot--often enough to finance the technical studies, market surveys and prototype developments to get a company up and going.

The angels also exemplify a phenomenon that has supercharged the economy of Silicon Valley for much of the ‘90s: The high-tech community is awash in money.

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The business of venture capital--private partnerships and well-heeled individuals investing in speculative companies in the hope they will grow into successful, stock-issuing enterprises--has never been better. Over the last two years, start-up companies have been funded at a record pace and have been issuing public stock at record prices.

This in turn has provided those early backers, known as venture capitalists, or “VCs,” with record levels of returns. The funds invested in venture partnerships by institutional investors have returned 35% to 60% a year since 1994.

“If you couldn’t make money in the venture business in the last two years,” said Jack C. Carsten, a former Intel Corp. executive and a founding member of the Band of Angels, “you should find another business.”

High-tech’s river of green has been fed by a historic surge in demand for commercial technology, coupled with a persistent enthusiasm for high-tech stocks on Wall Street. Initial public offerings of stock by 203 venture-backed companies last year brought in a record $8.2 billion.

What is striking about this freshly minted wealth is the speed at which it is being put to work nurturing new ventures, the development of more technology and the creation of jobs. A large share of the about $15 billion to $20 billion in venture capital raised nationally in 1995 came from former entrepreneurs financing the next generation of high-tech pioneers as they were financed themselves.

“I firmly believe that anyone who’s made a lot of money at this should plow it back into the system,” said Rodney Perkins, a Band of Angels regular who earned his grubstake from three high-tech start-ups dating back to 1981.

Venture financing is not merely individual, however; it’s also institutional. Big investors such as pension funds, university endowments and insurance companies, themselves so flush with bull-market gains that they could never deploy all their holdings via conventional liquid instruments such as stocks and bonds, put a record $7.4 billion into venture pools last year.

With institutional enthusiasm for venture investments at an all-time high, the major venture firms have pulled out all the stops to “get it while the spigot is open,” said a report by Asset Alternatives, a Wellesley, Mass., research firm. Registered venture pools have ballooned in size to an average $80 million, up from $50 million in 1990. Some major firms are raising investment funds of $250 million or more.

“These are the ‘good old days’ of venture capital,” said Roger McNamee, an industry analyst at the Menlo Park firm of Integral Partners.

Indeed, many in the business are wondering if the latest bull cycle in venture has not already ended. Two ferocious drops in the technology-heavy NASDAQ stock average this year--most recently a 13.6% pullback between its all-time peak June 5 and Friday’s close--have forced as many as 100 small companies to suspend plans for initial public offerings of stock.

Since these offerings, called IPOs, are the means by which venture capitalists cash out their investments, the sell-off could sharply reduce investment returns, slowing the pace of new investment in the field, even if only temporarily.

That would be a concern because venture capitalists--whether angels or managers of institutional partnerships--are the financiers of the new economy, planting seeds they hope will sprout into the Netscapes, Sun Microsystems and Microsofts of the future.

“Look at the list of industries that venture has financed in this country,” said Kipling Hagopian, principal of the Los Angeles-based venture firm Brentwood Associates.

“Overnight package delivery--FedEx was venture-backed. Microcomputers, microprocessors, computer-aided design, biotech. . . . If we didn’t have an institutionalized venture capital industry, we wouldn’t have started up all these industries.”

Moreover, as jobs in America’s traditional manufacturing industries succumb to global competition, the new venture-backed sectors are emerging as the engines of job growth.

“The U.S. is having a growth push because of the access to capital of new entrepreneurs,” said Michael E. Tennenbaum, a Los Angeles-based former senior managing director at Bear Stearns & Co. who recently formed his own financing firm.

Most of those entrepreneurs are in California. This state hauled in the lion’s share of venture largess last year with $2.27 billion raised in 437 deals--almost one-third of all the venture activity in the United States.

Even more telling, nearly 75% of all California deals took place in the Silicon Valley.

Why there? The answer says much about the history and nature of the venture business.

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One factor is geography. In the 1930s a cadre of gifted engineers who would form the nucleus of an entrepreneurial critical mass started to appear on the Stanford University campus.

Among them were William Hewlett and David Packard, who met as Stanford freshmen, learned engineering from that university’s legendary Fred Terman, and in 1939 established the perpetually innovative and market-savvy company bearing their names in a Palo Alto garage.

“Silicon Valley started as an accident,” said William H. Davidow, a former Intel executive who is now a principal in Mohr, Davidow Partners, a large venture firm. “But what sustains it is a process, a very informal process of relationships between banks, VCs, PR and law firms.”

(It’s no accident that many of the country’s biggest venture capital firms can be found along a single quarter-mile stretch of Sand Hill Road in Menlo Park, all within walking distance of each other and within sight of Stanford University’s landmark Hoover Tower.)

Business failure is not only tolerated here, it is often celebrated as an expression of entrepreneurship.

Many of the most successful entrepreneurs in the region flirted with ruin more than once: here a misjudged market, there a technology not quite ready for prime time. Most venture capitalists keep Rolodexes full of executives who are “between companies,” using them as consultants to scrutinize new ideas or step in to lead inexperienced entrepreneurs around the potholes of company management.

“This is a closed-loop economy, where the destruction of a company lays the groundwork for the creation of five more,” said Ruthann Quindlen, a partner at Institutional Venture Partners, one of the leading venture capital firms. “Among this pool of talent, there’s no stigma to being in a failed company just because an idea fails.”

Overseeing and financing this process often demands a technical background and years of management experience. This is nothing like New York investment banking, where millions can be made restructuring a company’s balance sheet. To make millions in the venture business, you have to build.

“I couldn’t even join this business today,” said Brentwood’s Hagopian, one of the senior figures in the field. “The prototype VC today has a physics or engineering degree, an MBA, and worked up to 20 years for a high-tech company. He’s steeped in the market.”

The process starts at the seed stage, with groups like the Band of Angels. That group’s regular monthly dinners upstairs at Palo Alto’s Chantilly II restaurant agglomerate not only capital, but talent and experience.

“This is a senior group. They’re mature, they’re knowledgeable, they’re bloodied, they’ve been through the wars,” said William F.X. Grubb, head of a software start-up company who followed Budd Colby to the podium at the mid-July dinner. “I tell you, when I sat down among them I was pretty intimidated.”

Entrepreneurs trying to snow this gathering with an unrealistic financial projection or a glib dodge about their product’s capabilities are almost sure to find someone in the room who knows the business better than they do.

Semiconductors? Former executives of Intel Corp. attend in packs. Biotech? Rodney Perkins, professor at Stanford Medical School, founder of the $160-million Collagen Corp. and an established biotech veteran, is perched in the front row, armed to the teeth with genial but unmistakably penetrating questions.

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And what some members don’t know about a prospective investment, another is sure to tell them.

“The strength of this group is that we can rely on each other,” Carsten said.

In Colby’s case, he needed $2.5 million to continue the next phase of research and development. For the chance to buy a troupe of hepatitis-infected chimpanzees and test his product on them, he was willing to sell one-third of his company and he received a commitment from a few intrigued listeners to meet with him later for a follow-up lunch.

The acquisition of seed financing is only the beginning. Before the average high-tech enterprise can sell stock to the public, there will be three or four more rounds of venture funding, each larger than the previous and representing a progressive dilution of the founder’s stake in his or her own company.

Each round, however, also means a greater commitment by the venture backers to the company’s success. The price they exact is measured not only in dollars, but in attention. For venture capitalists are notoriously intrusive. Silicon Valley simmers with the resentments of inventors and entrepreneurs whose venture backers kept them on a short financial leash while peering over their shoulders at every step.

“We’re not simply buying stock and then asking somebody to send us a report every quarter,” Hagopian said. “Every venture-backed company gets two or three or four venture capitalists on its board. The entrepreneurs may not always like that because they think some venture capitalists are dumb. But the reality is that when you have stockholders who are really interested, they’re going to make sure you don’t deviate from your plan too far before they bring you back to where you’re supposed to be.”

“The VCs hold all the cards,” said Paul Matteucci, chief executive of Mpath Interactive, a venture-backed start-up company that will soon market a program allowing strangers to play action games with each other over the Internet. “They have the money, and time is on their side.”

On the other hand, he says, “these guys know how to build. Even entrepreneurs who can afford to do it themselves should get professional VCs for their connections, their network, their investor discipline.”

For all that, venture-backed companies do fail with regularity. Sometimes a bad idea can bring down a whole industry. Partners at the major venture firms still wince over the pen-computing debacle of the mid-1980s, when they poured tens of millions of dollars into a technology that promised convenience for computer users on the go but never approached marketability at a rational price.

“They charged up that hill together and fell off the cliff on the other side,” said Russell G. Snipes, principal of Venture One, a San Francisco-based investment research firm.

Almost every major venture firm financed a portfolio of pen-computing companies. AT&T;, IBM, Microsoft and Apple all scrambled to license or develop the hot technology, which allowed commands and text to be entered onto a computer screen by stylus, rather than by keyboard or mouse.

But within a few years, almost all of the pen-computing start-ups were defunct, the technology never having worked well enough to attract customers.

Venture professionals are still trying to draw lessons from the fiasco. One problem the episode exposed was the venture community’s insularity; while the venture capitalists were busily persuading each other that pen-computers were the next home run, no one noticed that the technology was a hit nowhere but on Sand Hill Road.

Some fear that pen-computing reflects earlier venture manias and presages others looming on the horizon.

Moreover, they say, even if pen-computing were a workable technology, too many companies were being backed--just as too many disk drive companies were funded during the personal computer mania of the early 1980s and too many Internet applications are receiving backing today.

“Two hundred people are trying to develop the perfect Internet application,” said McNamee of Integral Partners. “A lot is getting done, but there’s no chance they’ll all be successful.”

The counter-argument is that most of America’s growth spurts have taken place on the heels of investment manias: Sometimes the financiers bet wrong on industries, sometimes they bet right.

“In every sector where we invest, there are three or four companies that dominate a particular market,” said Michael Moritz, a partner at the venture firm Sequoia Partners, in a typically unemotional appraisal. “The rest are road kill.”

Still, there is a widespread concern that the inflow of cash means that too much money is chasing increasingly speculative deals.

“We see some wonderful business and technology opportunities ahead, but I do feel that maybe too much money is available,” said Les Vidasz, head of the internal venture unit at Intel. “Lots of deals are being talked about at ridiculous valuations.”

Business plans and speculative concepts that were unimagined--and unimaginable--even two years ago have lately been finding backers willing to bet millions of dollars at a shot.

“Every deal we are turning down is getting done somewhere else,” said Geoffrey Y. Yang, a partner at the top-line venture firm Institutional Venture Partners. “It used to be that a much higher percentage of deals you thought didn’t deserve to get funded, didn’t get funded.”

Some people contend that the big firms are overpaying for the hot deals and neglecting important smaller ones. In part this is a function of the hands-on aspect of the business. Firms with, say, $100 million to invest must parcel it out in chunks of $2 million to $5 million at a shot so the sheer number of deals to oversee remains manageable.

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The smallest or most speculative deals are increasingly left to angels, who are more disposed to invest in deals where an injection of $50,000 to $200,000 can turn an idea into a company.

What unnerves some venture professionals is how closely today’s environment resembles that of the last big venture shakeout, in the mid-1980s, when the market for high-tech initial public offerings snapped shut like the jaws of a crocodile.

“VCs were investing like drunken sailors and spreading themselves too thin,” Hagopian said. “Everyone was going public within 12 to 36 months. They loaded up the pipeline” with deals preparing for the offerings.

With the closing of the IPO window, scores of companies were left stranded with huge capital needs and no source of funding. “We got utter gridlock,” Hagopian said.

Venture returns stayed flat for two or three years, awaiting the next burst of enthusiasm. In some sectors, such as biotech, the hangover lasted even longer.

The specter of that period has reemerged this year with the blunting of the market’s taste for high-tech initial public offerings in recent months.

Still, the continual germination of new ideas and new companies has continued unabated. The vigor of the process is visible in the Band of Angels, which this month completed its first $1-million deal.

It can be seen at the offices of big venture firms such as Institutional Venture Partners, where Yang acknowledges the parallels between today’s atmosphere and that of 10 years ago but says: “This cycle feels different. There’s so much quality, so much change in technology. I’m trying really hard to turn down deals. I’m trying to hate them. But I have a real hard time hating them.”

And it’s visible at Mpath Interactive, where Matteucci leaves off tweaking his company’s software to ponder the size of a market that won’t even exist until his company’s program hits the Net in another month.

“In two years, we’ll know if we have something,” he said.

Meanwhile, the venture community has backed him with $11.9 million in financing to find out.

“But everything they fund on Sand Hill Road is like that, the unknown,” he said. “Because things that are known don’t need venture funding.”

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Nothing Ventured...

* Total U.S. dollars invested

Total annual venture capital invested hit its fifth consecutive record in 1995 by rising nearly 50% over the previous year’s.

(please see newspaper for full chart information)

1995: 7.4 (in billions)

* % of venture dollars invested in 1995, by industry group

Nearly half of all venture funds in 1995 were invested in the information technology sector, including computer hardware and software and Internet companies. About a quarter was invested in biotechnology and other life science ventures.

Life sciences: 24%

Non-technology: 30%

Information technology: 46%

* State percentages of total amount raised in 1995

California dwarfs all other states in the amount of venture capital raised, with Massachusetts a distant second. The two states’ dominance of the field is expected to persist through the end of the century.

Note: Percentages don’t total 100 due to rounding.

Illinois: 5%

Texas: 5%

Massachusetts: 10%

New Jersey: 10%

California: 31%

All other states: 40%

* Companies receiving initial venture funding

The number of U.S. companies receiving venture financing for the first time shot up to 445 last year, a 56% increase over 1994.

(please see newspaper for full chart information)

1995: 445

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Where Venture Capital Is Raised

California and Massachusetts remained hotbeds of venture financing in 1995.

(Please see newspaper for full chart information.)

Source: Venture One Corp.