It may have been the drone of the earlier speechifying, or the narcotic effect of the prime rib entrees, but it was not until Mike McNeilly stepped to the podium that the audience at the Los Altos Golf & Country Club shook off its torpor and listened up.
McNeilly is a tall, barrel-chested man with a booming voice and the self-confidence that comes from having made a few thousand investment pitches in his career. He is also a member of Silicon Valley aristocracy, having founded the illustrious high-tech company Applied Materials in 1967 and remained an active investor since.
On this occasion his audience was the Band of Angels, among the most distinguished investment groups in Silicon Valley. Comprising scores of wealthy entrepreneurs who deploy their own money to nurture new high-tech ventures, the Band meets once a month to hear investment pitches and trade stories from the venture capital trenches. Lately, socializing has been more of a draw than investing, the valley having been the epicenter of one of the great investment bubbles of all time. And yet the Band has survived.
By the time McNeilly took a laser pointer in hand, his audience had heard an hour of rather dreary programming: a too-long speech by State Treasurer Phil Angelides proclaiming the resilience of a California economy; an investment pitch by a broadband company called ManyStreams ("If there's anything unique or proprietary about this deal, they haven't mentioned it yet," one listener groused); and a pitch from a group proposing a private bank that left it unclear whether they were trolling for investors or customers.
But McNeilly got the room's attention. His pitch was for NanoSpin, a company developing a new way to deposit microscopic copper wiring on silicon wafers, an increasingly exacting step in semiconductor manufacturing. His slide show was laced with chemical symbols and schematics of semiconductor chips, as well as assurances that Dow Chemical, Intel and IBM were prepared to finance NanoSpin's scientific discovery with millions in research and development funds. He was offering the Band a $500,000 piece of the action, and from the vigorous technical and financial questions that followed, it was clear that he had touched a nerve.
This was hard-core technology of the kind that had made Silicon Valley famous, not the Internet frenzy that had made it infamous. After two years of dot-coms, of kids without a day of operating experience giving investors a half-hour to put up or shut up, of vacuous new-economy concepts like "mind share" and "eyeballs" and "first-mover advantage," of start-ups that hadn't generated a dime of profit projecting they'd be worth $20 million next year and $100 million the year after, it was a hint of how this region's future might look like its past. One could feel a fresh breeze sweep the room.
I first became acquainted with the Band of Angels in 1996, when it was a few months old. The Silicon Valley craze was well under sail. Start-up companies were going public at an amazing rate, years ahead of where they would be in a more rational era. The region was awash in money. Venture capital firms were raising nine-figure grubstakes from institutional investors, and public investors wanted in on the party. "If you couldn't make money in the venture business in the last two years," said Jack Carsten, one of the Band's founders, at the time, "you should find another business."
By then the boom already appeared to be mature--how much higher could things go?
But 1996 was merely a taste of things to come: The technology bubble would raise Silicon Valley to worldwide attention, turn middle-aged engineers and youthful MBAs into storied millionaires, then bring them and the rest of the stock market crashing down even faster. So now, nearly seven years on, it seemed time to see how the Band of Angels had fared.
Things had changed, large and small. The group's membership swelled from 60 to 180 during the bubble, and finally eased back to about 120. In the bear market many members saw their net worth suffer what was charitably called a "haircut," but these were genuine long-term investors. Few suffered the devastating losses of novice individuals investing for the first time at the market peak. The downtown Palo Alto restaurant where the group originally held its dinners had been torn down for a dot-com's office building. The dot-com had failed and the new building was vacant: bubble and bust in microcosm.
But the most important change was in the business model of angel investing. Traditionally, venture capital financing is done in stages. Inventors or entrepreneurs start by raising seed money, say $100,000 to $500,000. Their sources, including family, friends and angels--well-heeled individuals who put up $10,000 to $50,000 each--are their bank accounts and credit lines. The seed round covers a few months of preliminary tinkering. Eventually the entrepreneur must return to the well. Round B, or the first "follow-up" round, might be $1 million. The sources now include established venture capital firms--"VCs" in local parlance--that are backed by institutional investors such as pension funds and corporate research departments, as well as some of the original investors who hope to preserve their stakes by keeping the venture alive. There might be several more rounds, ideally at higher prices as the company grows. Eventually the company gets acquired or stages an initial public stock offering through which the original investors are bought out (at a profit, they hope).
There's a symbiotic relationship, therefore, between angels and venture capital firms. The latter need angels to get start-ups off the ground, and the angels need the firms to fuel their companies' later growth. In the wake of the dot-com crash, however, that relationship has broken down.
"For a few seconds in 1996, the environment was truly favorable for angels," says Art Reidel, one of the earliest recruits to the Band of Angels. "Not today."
Reidel is 52 but looks much younger, like a grad student at an engineering school. After receiving his degree from MIT in the late 1960s, he worked as an engineer and programmer in the high-tech corridor of Boston's Route 128. By a series of "career accidents," as he puts it, he then moved into high-tech investing. Now he is running Pharsight, a venture-backed start-up that organizes clinical trials for pharmaceutical manufacturers.
The problem with angel investing today, he explains, is that venture capital firms, still recovering from the dot-com crash, have withdrawn from the financing market. "The whole angels model was based on attracting follow-up money at attractive rates. The whole idea that if you did a reasonable job you could count on further rounds, that just went out the window. No one expected that the follow-up money would completely dry up."
"My job is to keep this group together," says Hans Severiens, 73, the presiding spirit of the Band of Angels and the master of ceremonies at most of its functions. Like many of his friends and partners, the Amsterdam native and former investment banker oscillates between hopefulness at the future of the market and resignation at what happened to his investments. From his office in Menlo Park, Severiens recalls the environment of earlier days and how they inspired him to found the Band.
"The boom started with the Netscape IPO," he says, evoking a mythical moment of Silicon Valley history. The initial public offering of Netscape Communications in August 1995 opened the world's eyes to the riches to be plucked from backing high-tech start-ups. Netscape's product was a browser, first developed in the graduate school of the University of Illinois, which allowed users to view Web pages graphically on their computers. The company had never made a profit and was destined to be outmaneuvered in the browser market by Microsoft. But it was backed by James Clark, who, as the founder of Silicon Graphics Inc., boasted solid entrepreneurial credentials. Netscape shares nearly doubled in price on the first day of trading, valuing the tiny company at $2.6 billion. "This was the start of the whole thing of 'put up your money and two years later you're a multimillionaire,' " Severiens says.
The Netscape IPO stood out as an anomaly. Many investors remembered lessons from the 1987 stock market crash. Good companies had trouble finding investors, and individuals with money to invest had trouble unearthing promising companies.
Severiens and Carsten, old friends from some joint investments, recognized that they knew plenty of wealthy former executives who might jump at the chance to help out a new generation of entrepreneurs if they could rely on a support group. "The society of Silicon Valley is a society of engineers," Severiens says. "They're not the types to become art collectors in retirement. They like the game, being involved. I thought maybe they'd like to continue to have some involvement with start-ups."
Along with Fred Hoar, a prominent public relations man, Severiens and Carsten buttonholed candidates to join. Reidel, who had done deals with both, got invited to lunch, only to discover that his hosts were determined to goad him into contributing his knowledge and experience to the group. "The gist was, 'If you're going to roam about the valley starting companies, you should be part of this thing,' " he recalls.
By early 1996, "we were in place, we were ready and we had a good format," Severiens says. The group would meet monthly for dinner at Chantilly, a continental restaurant in downtown Palo Alto. Promising entrepreneurs would be invited to make a presentation if they passed an initial test--find a Band member who would be willing to act as a sponsor, perform a round of "due diligence" by inspecting the company's books and prospects, and back that with an investment pledge.
There were three pitches per dinner, wedged in among the socializing and an all-cholesterol main course.
"One of us would be the ringleader for a deal," Severiens says. "One criterion for being a member was that you should have enough contacts to bring in a couple of deals every couple of years, and you should be putting your own money in. These people wouldn't stand much for being jerked around."
The group mirrored establishment Silicon Valley. The semiconductor and computer hardware industries were most represented, with large contingents of engineering executives from companies such as Intel, Hewlett-Packard and Sun Microsystems. Anyone pitching to this group got subjected to rapid-fire interrogation by a pitiless audience: "Who's your competition?" "How good is your patent protection?" "How do you know this will work?" "What if someone gets into this market before you?" Project a PowerPoint slide with a chemical formula or physical equation on the wall, and a half-dozen members would wield sharp pencils to check your math on their tablecloths.
But the supplicants kept coming--eager to reach an audience that might represent a half-billion dollars of investable capital. Within months, the original band of 12 had doubled in size. By mid-1996, membership had reached 60. Soon there was a three-month wait for an opening to make a pitch. The Band's renown grew beyond the borders of Silicon Valley. The Chantilly dinners became a stop for any reporter writing about high-tech; by 1999, Severiens estimates, there were 20 or 30 articles a year, most of them holding up the Band as the epitome of the melding of technological know-how with entrepreneurial risk-taking. "Silicon Valley was the most-hyped part of the bubble, and Silicon Valley was the Band," says Antonio Salerno, CEO of Conxion (pronounced "connection"), a network infrastructure company.
The concept of angel investors banding together to pool their resources and jointly vet investment pitches spread within the valley and across the country, combining socializing and investing in varying degrees. Carol Sands, a marketing consultant who had decided that she had been spending entirely too much of her life on airplanes, created the Angels Forum in 1997 by assembling a circle of 25 knowledgeable and affluent partners from varied technical fields to meet weekly for painstaking supervision of the start-ups they backed. "I realized that what I didn't know could absolutely hurt me," she says, "so I surrounded myself with skills and knowledge different from mine."
The Band evolved. At first, says Reidel, "the deals we saw reflected the bias of the group. We saw a lot of semiconductor deals, also disc drive deals because some guys had come from Seagate," a leading disc drive manufacturer. There was a sub-specialty in medical devices, thanks to the presence of entrepreneurial inventors such as Rodney Perkins, a Stanford School of Medicine professor who invented a hearing device and had started six companies between 1975 and 1995 (and two more since then). When the group realized it was short on software and networking companies, it recruited members from those fields.
For three or four years, the system whirred like a top. In 1998, when Severiens sought institutional investors for a large venture fund to co-invest with the Band, he and a partner calculated that Band members had made roughly $40 million in investments in 80 deals since 1995, producing gains averaging about 140% a year.
"Those were heady days," Severiens says. Some investments were going to IPO within two years, producing enormous profits. Keynote Systems, which offered a traffic-monitoring service for the Internet, went public in 1999 at $10 a share and closed the first day's trading at around $40. It eventually peaked above $120. One Band member made $10 million on that stock alone.
The dot-com era had arrived, even if the craze was not in itself novel. Many members were experienced enough in high-tech investing to have seen numerous crazes come and go. Rodney Perkins had lived through a similar cycle with medical device companies, which were in fashion for a few years until, inevitably, there were too many of them. "The curves of all these companies were identical: The IPOs zoomed up, then crashed," says Perkins, tracing the baleful trajectory with the edge of his hand. "A lot of these investments were not about a product. The real product was the company--that's what was built up to sell to the public market. They tried to milk the goose too fast."
No one had seen anything like this. It was the biggest boom of their lives, featuring the most absurd market valuations, the most outlandish business claims, the most inexperienced managements. "The dot-com guys were all young," Reidel says. "None of them had ever run a business before."
For a group that had relied on each others' expertise to judge new ventures, the dot-com period was agonizing. "The tragedy of the bubble was that everyone tried to invest in something they knew, but no one knew the Internet," says Carsten, today a silver-haired 61. This would have been manageable if the dot-com promoters understood that they, too, were flying blind. But many were twentysomethings who were seduced by their lionization in the press and the marketplace. They were convinced that they were tapping into a reality the rest of the world did not comprehend. They appreciated the venture investors' money, but not their advice.
"Just because they'd take your money, that doesn't mean they'd listen to you," says Jack Gottsman, a Band member who had been CEO of two start-ups and four corporate turnarounds. "A company would start with $500,000 to $600,000 from angels, and the second round, from the VC firms, would jump up to $10 million to $12 million. They took that as a vindication of what geniuses they were."
The Band resisted most of the wackier proposals it saw in this period, thanks to engineering backgrounds that helped members preserve their skepticism of any phenomenon that could not be reasonably quantified. "The group focused on the quality of people involved, and very quickly the talent pool got diluted," Reidel says. "These were people who had never done anything before, and although our guys were willing to suspend some disbelief, they still wanted to see some sort of a business plan. The 'New Paradigm' talk cut no ice. Hardly anybody [in the Band] was willing to believe you could make money without making money."
Encouraged by the frenzy, many fledgling companies demanded absurd market values. This showed up in negotiations over their so-called "pre-money valuation," traditionally a number entrepreneurs try to inflate and venture financiers try to deflate. The reason: If you own a $1-million company and you raise $250,000 from new investors, they will own 20% of your brainchild. If your company is worth $5 million, however, that same $250,000 buys them less than 5%. At first these tugs of war were over modest differences of opinion. By the late '90s, the differences had become astronomical.
"We'd get business plans in which the company projected doing $1 million in business in year one, $2 million in year two, $4 million in year three, $20 million in year four and $50 million in year five," Severiens says. "They'd say, 'We'll be worth two times revenues, so today we're worth $10 million.' The epitome of ridiculousness was the time I got a business plan from someone whose business was writing business plans." Yossi Vardi, the Israeli entrepreneur who sold the instant-messaging program ICQ to America Online for $400 million in 1998, coined a saying that captured the lunacy: "Business plans have been invented in order to give astrology respectability."
Soon, as many as one-third of the Band's presentations were coming from dot-coms, and several dot-commers who had cashed out early were among the Band's members. They seem to have been privately considered parvenus by the older members, who complained that they often failed to carry the load of finding new deals and subjected them to close analysis.
"A lot of people joined angel organizations then because it was a cool thing to talk about," says Gottsman. "These were the people you could never get to help you with the due diligence."
The basic economics of venture investing got turned upside-down. The angel segment always had been three to four times as big as the VC firms in terms of money invested, with 10 times as many deals. During the bubble, that ratio flipped, says Jeffrey Sohl, director of the Center for Venture Research at the University of New Hampshire. Venture firms were making investments at earlier stages and bidding up the valuations, squeezing angels out of their traditional niche.
Given the easy-money atmosphere, it was perhaps inevitable that the Band of Angels would finally get sucked into a dot-com deal all its own. This one was Sendmail, a company that developed industrial-strength e-mail systems for corporations and Web service providers.
Sendmail had an impeccable pedigree, numbering among its board members and major backers Andy Bechtolsheim, a co-founder of Sun Microsystems. It was eagerly sought after by the venture capital firms Kleiner Perkins Caufield & Byers and Accel Partners, big leaguers of the big leagues. After months of seething while the big VC firms snatched away deals, the Band turned the tables by outbidding the firms and taking the financing round for itself. With $5 million invested, Sendmail would become the Band's largest and most controversial deal.
"Our group couldn't wait to put money into it in 1998," Severiens says. One Band member, a former computer company president who invested $75,000 of his own money, said at the time that he would have plunged even deeper if there were an opening. During negotiations, Sendmail's pre-money valuation shot up, from $4 million to an eventual $20 million.
Some members regarded the deal with bemusement. "I'm one of the few who didn't invest," Carsten says. "I'm not gloating, because I almost did. But when I heard how much the Band was investing I said, 'That doesn't sound right.' " To Carsten, Sendmail shared the shortcomings of too many other dot-coms: It was in a business with a low barrier to entry, meaning there was little to protect it from competitors with equivalent technology, and it was absurdly expensive. "Everyone should have taken a hard look at it."
Sure enough, Sendmail's promise soon ebbed as corporate spending on network services and other information technology, or IT, dried up after 2000. "The company ramped up very nicely, then hit the IT spending wall," Severiens says. Expectations that Sendmail was destined for an early IPO vanished. (The company is still privately held, having been kept afloat by four subsequent rounds of venture financing, the latest of which valued the company this year at $14 million--30% less than its initial round.)
Although people say that the dot-com bubble "burst," insiders saw the phenomenon as more gradual--a balloon wheezing flat rather than popping. Only in mid- to late-2001 was it possible to look back and realize how thoroughly investment money had dried up. In 1999 the Band put a collective $22 million into new companies; in 2002 the figure was $3 million.
"Now, as an entrepreneur, it's very tough," Perkins says. "VCs are shellshocked. They're valuing things very low. I've told people that if they have an idea that isn't perishable, they should keep it under wraps for a few years. You could have a cure for cancer and you'd get single-digit valuation right now."
I a basement office suite that he rents in Los Altos, a tidy enclave of successful executives just south of Palo Alto, Carsten still makes deals. At the moment, a semiconductor company he is nurturing has piqued enough interest that three investment firms are bidding to participate in the next round, a rare expression of enthusiasm.
Like many who managed to come through with their resources and their wits more or less intact, Carsten can take a judicious view of the turmoil. "Both [Severiens] and I were beneficiaries of the bubble," he says. The frenzy over technology allowed them to raise sizable funds from institutional investors, money they are still deploying privately. The preposterous pricing of the boom years is gone, and fledgling companies with terrific potential are once again scrambling for backers at reasonable valuations. Many of the people who rose to fame in the boom have returned to the obscurity from whence they came.
"Even as bad as the investment climate is, the Band is still healthy," Carsten says. "The old faces I saw at meetings four or five years ago are still around and some of the bubble players are gone. Bubble millionaires who were worth $100 million could put up investment money. Now they're worth $5 million, and two-thirds of that is in their house." Like many Band members, he harbors a conviction that the dreary economic environment today is part of a natural cycle and that somewhere the drivers of the next boom are being conjured forth in labs and garages around Silicon Valley. All that is required is some of the smoke to clear from the great boom and bust.
"Medical technology could catch the public's eye," he speculates. "Cameras will be electronic. I have a company making chips for digital cameras because the public is demanding these. Other consumer markets are getting hot, and that's the kind of thing that excites the public in IPOs. There will be other leaders."