Investors Wary of Many Security Business Plans

Investors lost untold billions of dollars in the last five years chasing the “next big thing” -- from telecom to dot-com to energy trading.

No wonder the current talk of a boom in homeland security- related businesses is meeting with a measure of skepticism among many professional money managers.

“It’s remarkable the number of companies that have managed to work ‘homeland security’ into their business plans,” said Brent Whisenant, a principal at the Carlyle Group’s venture capital fund in San Francisco. “A lot of people are stretching.”

Whisenant was one of several dozen investors who attended a “Security Growth Conference” last week in Santa Monica, where 30 entrepreneurs from smaller, mostly private, security-oriented companies paid to make presentations to industry peers and potential financiers. The conference was sponsored by USBX Advisory Services, a local investment banking firm specializing in the security field.

To be sure, in the post-9/11 world of investing, security appears to offer significant growth opportunities.

While corporate capital spending overall remains restrained, the government is spending freely, a trend expected to continue with the new Department of Homeland Security up and running and war looming between the U.S. and Iraq.

“The security industry was doing well before 9/11, and now it gets a big boost,” said USBX Chief Executive John Mack. He noted that the 2003 federal budget calls for $38 billion in homeland security spending -- nearly twice the 2002 level -- much of which will go to procurement of systems and devices.

What’s more, a February poll of corporate chief information officers by CIO Magazine found that 53.8% expect to increase their budgets for security software in the near future. That was the highest reading of planned spending increases out of eight tech sectors in the survey, topping computer hardware, data-storage systems and infrastructure software.

Still, sophisticated investors caution that security has traditionally been a highly cyclical business, that the government could be slow to award major contracts, and that there is already plenty of competition.

“Historically, the government, the Department of Defense and NASA have been very good early sponsors of technology, and companies see a lot of benefit,” said Sanjay Subhedar, general partner at Palo Alto-based Storm Ventures. “But that business is cyclical and not something you can rely on.”

That isn’t discouraging companies such as Rancho Santa Margarita-based Security First Corp., one of the presenters at last week’s conference.

Its predecessor, Ethentica Inc., ran out of cash in May 2001 and filed for bankruptcy reorganization after spending five years and $70 million of venture capital to develop its fingerprinting technology for e-commerce.

When the company’s board brought back former Chief Operating Officer Mark O’Hare as part of the reorganization, he retooled the company as Security First, changing its emphasis from password replacement to what he saw as a bigger market opportunity: safeguarding networks, data and physical structures.

Security First’s fingerprint sensors use polymer material, which O’Hare considers more durable than silicon. The company also uses “dimensional obfuscation” -- or parsing and re-encryption of data -- to further protect any network information accessed through fingerprint scanning.

“I knew the technology and I knew that security just had to be the future. There was so much [computer] hacking going on in this country,” O’Hare said. “And then came 9/11.”

The attacks “woke up” U.S. business and government to the need for tighter virtual and physical security, O’Hare said, noting that he quickly found a backer in Topspin Partners, a Roslyn Heights, N.Y.-based private equity firm run by security industry veteran Leo Guthart.

O’Hare, a Navy captain who served in the Persian Gulf War and ran the service’s aircraft carrier design, construction and maintenance program before he retired in 1998, believes that his company’s technology will find a market with military and intelligence agencies as well as private industry. “Often your technology is too early or too late, but we’re coming to market in the perfect space at the perfect time,” he said.

Other Southland firms making pitches at the conference included E-Seek Inc., a San Diego company that makes barcode readers for driver’s licenses; Torrance-based PCSC, whose products are used for video surveillance, elevator control and other security needs; and Glendale-based IntelaCard, which makes ID cards, access-control systems and other products.

Carlyle’s Whisenant, listening intently to the presentations last week, said his firm is trying to identify companies whose technologies “are truly dual-track,” meaning they have government as well as commercial applications. Carlyle also looks for managers who seem capable of navigating the complexities of the government procurement process, he said.

All in all, potential investors seem to be casting a much more critical eye on security entrepreneurs’ business plans compared with what many dot-com entrepreneurs faced.

“There’s a lot of hype to sift through,” said Klaus Koch, principal at Kline Hawkes & Co., a Los Angeles-based venture capital firm. “It’s one thing to say you have a homeland security product and another to have a couple customers validating that statement.”

Even Guthart, Security First’s main backer and an industry bull, advises caution, noting that his firm’s diversified portfolio has 80% of its money invested in non-security-related business sectors.

“Sophisticated investors are wary of when government spending will actually materialize and who the beneficiaries will be,” Guthart said. “It’s good to have the wind blowing behind your sails, but it’s also blowing behind 20 other companies, so you’re not going to win the race unless you have the right management team and the right technology.”