The Comeback's Missing Piece

Yobie Benjamin has serious tech cred, and it's not just because of his long hair and wonk-square glasses. Two parts Kevin Mitnick and one part Steve Wozniak, the exuberant 43-year-old Philippines immigrant has the requisite hacker--and a certain guru--status since demonstrating five years ago how to breach a financial company's computer system on ABC's "20/20."

But Benjamin also is enjoying a new career as a successful venture capitalist. He went huge during the late-'90s stock-market boom, donning a suit at Ernst & Young and managing more than 200 technology consultants. He taught the Big Three automakers how to buy their supplies online through a joint Web site, and he built up Ernst & Young's portfolio of venture capital investments. By the time Benjamin and two partners launched their own $100-million San Francisco venture fund last year, few people were more qualified to spot winning technology companies in Silicon Valley.

So with all the buzz about cyber-security, nanotechnology and the other Next Big Things of Silicon Valley, where is Benjamin putting his money?

Into dishwashing liquid.

Benjamin's 20-10 Growth Capital Partners' first investment is in Method Home, which is trying to transform the $20-billion household cleaning industry with stylish containers, environmentally friendly products and upscale prices. His fund also is considering stakes in companies that run electronic ad marquees in shopping malls, sell children's clothing and operate barbershops.

Benjamin has some regrets about turning his back on technology. But with venture firms laying off staff and the survivors reducing their tech investments, trying to pick which young companies might provoke the next boom "is an extremely crowded field," he explains. "When you do what everyone else is doing, you lose."

Then he excuses himself to listen to a pitch for a chain of spas.

As much as any empty building or line at the unemployment office, Benjamin's loss of nerve speaks volumes about the state of the Silicon Valley economy. Venture capitalists like him bankrolled the adventures of the past decade, making billions of dollars for themselves and others. The companies they funded created tens of thousands of jobs, and the 1,000 square miles of former farmland between San Jose and San Francisco pushed the global economy so fast that experts spoke of a permanent change in the way the economy works, even the end of capitalism's classic cycles.

The world now knows those experts were wrong. And no one has taken those lessons more to heart than the fast-talking, fast-acting preachers of progress in the valley. A little less hubris and a little more humility were certainly overdue, so it's not a bad thing that fewer truly stupid ideas are getting venture money now. But many entrepreneurs complain that the pendulum has swung too far in the other direction--venture firms like Benjamin's still control billions of dollars, but they're so nervous that they're not investing much of it.

Until they gird their loins and open their wallets again to technology, Silicon Valley will continue to struggle and the U.S. economy will be without one of its most powerful engines. How long that will take is anyone's guess. But just as some old-growth forests need a fire to regenerate, the scorching pain of the recent downturn is a necessary first step to recovery. Many of the precursors for opportunity in the valley already are falling into place.

The most fundamental changes are taking place behind the scenes, in the dynamics of the money that fuels ideas both great and not-so-great. It all started with the fall of the stock market. Without an appetite among public investors, the smorgasbord of initial offerings ended. That meant venture firms couldn't cash out, and it seemed suddenly unwise to keep pouring money into companies that were years from profitability. As the venture firms' progeny disappeared, the 200% returns that many firms had been giving their limited-partner investors went the way of the Netscape browser. The average dollar put into a U.S. venture fund in September 2001 was worth less than 80 cents a year later, according to the National Venture Capital Assn., the first time in at least 20 years that venture investors, as a class, lost money.

The resulting caution has changed almost everything the venture capitalists do. They are investing more in later-stage companies that are closer to profitability, and they are more likely to back companies with proven products. "You can no longer invest in companies that will take $50 million or $100 million to get to break-even," says Ken Lawler of Battery Ventures, which recently let two of its partners go.

The shift is most pronounced in the depressed world of biotechnology, which is still one of the areas most cited as a good bet. At an annual conference in San Francisco in January for investors learning about public and private biotech firms, CEOs looking for money said the early-stage fund-raising was the hardest. Both specialized venture funds and big drug companies had for years backed ambitious firms that make tools to analyze genes or proteins. This year, there was little interest in anything too far removed from a pharmacy shelf. "Now we're more about new products," says Thomas Taapken, who invests venture money for Aventis Pharma SA of France.

A few venture firms are exploring other and less risky forms of finance, trying leveraged buyouts or even buying shares of publicly traded companies. To some valley technologists, that smacks of desperation and the abandonment of the important mission of venture capital.

"What they're doing is playing to the stock market. They're not behaving like VCs," complains longtime entrepreneur Dave Winer, keeper of one of the longest-running Web commentaries on Silicon Valley technology, Scripting News. "The heyday here was around 1979, with the founding of the chip companies and Apple. It got progressively further divorced from reality as the hype became more and more of a lie."

Now the retrenchment is leaving even the best ideas without backers, Winer says. "This is not a place for innovation. I've given up."

The economic situation has driven many others away. Silicon Valley lost 127,000 jobs, or 9% of its total employment, in the 15 months through June 2002, sending the unemployment rate up to 8%. Local venture investment fell 42% last year. Office vacancies are close to 20%, and even the mightiest tech firms are cutting employees as spending slows and their stock prices fall. No one sees a new bubble soon.

Yet beneath the valley's surface, the outlook isn't as bleak as many venture capitalists imagine. The carnage of mass layoffs has eased, and things are no longer in freefall. The quick-buck artists have left town, while many dedicated engineers and programmers have stayed--some of them with money to invest from the go-go days, others laid off and with extra time to tinker. And a growing number of venture capitalists, entrepreneurs and experts say that now is a far better time than three years ago to be in the business of innovation, be it in home networking or home-cleaning products. "American genius," Benjamin says, "did not stop with the microchip."

Even many of those who remain dedicated to software and other technology markets find much to like in the current landscape, now that the write-offs are over. "We are ecstatic about the environment today versus 1999 and 2000," says Bill Tai, a partner with Charles River Ventures in Menlo Park. Peter Thiel, who co-founded PayPal Inc. and last year sold the online payment company to EBay for $1.5 billion, agrees: "It's a great time to be an investor, and an even better time to start a company."

With fewer companies getting funded, there's less competition for good employees and cheap office space. Expectations are more reasonable. Gone are the days when an entrepreneur would ask a venture firm for $2 million and be given $20 million, along with orders to take over the market by nightfall. Back then, so much money was being put behind such thin ideas that "it was awfully hard to execute a business strategy that made any long-term sense," Tai says. Realism has its benefits, and they are beginning to make themselves known.

Some venture capitalists are moderating their risk by changing their view of the rest of the world. The valley's leading thinkers are more open to the idea that great innovation can come from Boston, San Diego or China. They no longer view big as bad. They encourage small firms to link up with large ones, selling them gear or working with them to sell it to others. No Fortune 500 chief technology officer is going to bet his company on a start-up's solution, says Jim Breyer, a managing partner in the venture firm Accel Partners. "For a period of time, there was a feeling there was no need for a big technology company, let alone an old-economy company." Now he says start-ups understand that "big companies bring something of value."

Commanding new respect are the biggest outside players of all, the federal government and Microsoft. The terrorism threat has funneled money into security technology, and the feds are now seen less as tiresome meddlers and more as potential customers. The CIA has even set up its own venture shop, In-Q-Tel, and is backing its own technology firms.

Microsoft's antitrust settlement, seen in Silicon Valley as a victory for the software giant, has prompted many venture investors to swear off backing anything in Microsoft's path. That even holds true at Kleiner Perkins Caufield & Byers, the best-known venture firm, which in the past funded Microsoft competitors such as Sun Microsystems Inc. and Netscape. Kleiner Perkins general partner Ray Lane recently spent two hours chatting with Microsoft Chief Executive Steve Ballmer over dinner, trying to feel out safe areas for investing. "We have developed a good relationship," Lane says. "It makes sense to have friends that have scale . . . . You have to recognize that any software entrepreneur will want to write to that platform."

Probably the healthiest aspect of the new caution is the trend toward phased investing at Kleiner Perkins, Accel Partners and other venture firms. They provide a little money at first and reserve more to see if the company can get to a certain revenue number or customer base.

That old-fashioned, unglamorous way of doing things is working for dozens of companies, including Wily Technology, founded five years ago in the garage of former Apple Computer engineer Lewis Cirne. After deciding to grow organically, Cirne took money from his parents and their friends and knocked out a prototype of a system to evaluate how Web applications were performing on a given computer.

The prototype was good enough to get Cirne modest outside funding from the individuals known in the valley as angel investors, who provide the seed money to get a project off the ground. Then Cirne went after a few big customers, including IBM Corp. and BEA Systems Inc. The product was good enough that both agreed to modify their own server software, enabling Cirne's to hook into it, an endorsement that made raising venture money far easier. Greylock Management put in a million dollars and told him to come back in a year. Two subsequent venture rounds brought the total invested in Wily to $26 million. It now has more than 100 customers and is monitoring Web performance for giants such as J.P. Morgan Chase.

Wily's revenue of $12 million last year should double this year, bringing the company to break-even, says Chief Executive Officer and President Dick Williams. And all of it was possible because Cirne, now the firm's chief technical officer, "is not in it to get rich. He had something he really wanted to build," Williams says. "My own philosophy, even during the worst of the bubble, is you build a solid business that will survive good times or bad, and not count on luck or an IPO."

Ray Lane says the business plans he sees now are more practical and built to last. "Entrepreneurs have to prove there's a large enough market, and that they can build a business that will generate substantial cash flow. If you're saying you've got to go public before you run out of cash, you're already doomed."

But assume for a moment that Dave Winer's fears are correct, and that Silicon Valley's much-maligned herd mentality has simply turned in a new and more conservative direction. That will leave the field open for dramatic new entrants. If history is any guide, someone will take advantage.

Perhaps the biggest opportunities will come in the areas that are deeply out of fashion, where most big-money venture capitalists aren't paying attention. At Sequoia Capital, which backed Cisco, Yahoo and Google, partner Mark Kvamme says he's seeing good ideas in some surprising areas. And some of the best ones are as unfashionable as you can get. Kvamme recently told a group of aspiring entrepreneurs: "All of the Internet ones we've seen recently, we really like."

Even Yobie Benjamin is keeping tabs on his old friends and listening to their ideas. "Technology still comes to me," he explains. Sooner or later, the concepts and the timing will be right for investors.

Asked whether he thinks the next big thing in technology will come in Silicon Valley or elsewhere, Benjamin reflects on the area's concentration of technological genius and says, "I don't think it'll happen in Little Rock."

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