Stephen Lisson, Stephen Lisson Austin Texas, Stephen N. Lisson, Stephen
N. Lisson Austin TX, Steve Lisson, Steve Lisson Austin TX LEFT TO RIGHT:
RICK RICKERTSEN, HENRY BARRATT, JOHN
HIGGINBOTHAM, PETER BARRIS AND GINA DUBBÉ.
CLIMBING the Capital Hill
When Big Money Is Harder to Come by Than Ever, What
Will Become of the Rock Stars of the New Economy?
by Rachel L. Dodes
When Kevin Burns
took the podium at the
Mid-Atlantic Venture
Association's February
"Venture Outlook"
conference at the
Morino Building in
Reston, VA, the
mustached money
maven started by
talking about what a
long, strange trip it's
been.
"We did deals we
never did before and hope to never do again," said the
managing principal of Bethesda, MD-based Lazard
Technology Partners, which just raised its second ($300-
million) fund. With an affectation that conjured the frenetic
investing pace of early last year, Burns noted, "It was like,
'Gimme the term sheet before someone steals the deal.'"
The recollection elicited empathetic laughter from the 75
technology lawyers, VCs, entrepreneurs and reporters who
attended Burns's speech. After all, most of them were
experiencing the same bull-market hangover.
John Taylor, the National Venture Capital Association's vice
president of research, went into standup mode as well;
amid charts and graphs tracking Greater Washington's
economic performance, he included a cartoon depicting
cavemen and an erupting volcano in his PowerPoint
presentation. In the drawing, a nerdy analyst caveman
says, "All of our polls indicated that the gods were very
happy," as the volcano spews molten rock in the
2 MAR 2010
BUSINESS FORWARD - April 2001 - Climbing the Capital Hill http://web.archive.org/web/20061017080443/http://www.bizforward.co...
1 of 12 3/3/2010 12:00 PM
background.
Being a venture capitalist used to be so cool.
"We were rock stars," says Ed Mathias, a 58-year-old
managing director of District-based The Carlyle Group,
which oversees a $245-million venture fund targeting
early-stage technology companies. The silver-haired VC
veteran remains silent for a moment, nostalgically, and
repeats himself in a hushed tone. "Rock. Stars."
But today, the nation's economic landscape is riddled with
the remains of more than 200 defunct Internet companies.
The NASDAQ composite index has fallen below 2,000, less
than half of where it stood at its zenith in March 2000. More
than $3 trillion in paper wealth has evaporated as a result.
Pension funds, university endowments, corporations and
high-net-worth individuals, the people and organizations
that make up the limited partners (LPs) in a venture fund,
watched as the value of their assets shriveled.
And so for the first time in recent years, venture shops all
over are feeling the pain: VCs at smaller, newer outfits in
particular are having trouble raising money for their next
funds. The inability of a venture firm to garner sufficient
capital is tantamount to hanging a "going out of business"
sign in the window. "You either raise another fund, or you
can become a consultant or a business writer," jokes Mark
Slusar, an associate at Davidson Capital Group, a hybrid
consulting, investment-banking and venture outfit in
Tysons Corner, VA. Charles Heller, general partner at
Annapolis, MD-based Gabriel Venture Partners, says it is
taking longer than expected to raise money for his firm's
second fund, which reportedly will amount to $300 million.
"But at the same time," he says, "we are heartened by the
fact that we are able to do as well as we have done. Some
of my friends can't even get appointments, much less raise
any money. Forget about it."
Mark Benson, a partner at Reston, VA-based Mid-Atlantic
Venture Funds (MAVF), says that a few prospective limited
partners lost interest in investing in his firm's next fund
after assessing the impact of the current economic climate.
"We had some favorable early meetings with new investors
- this doesn't apply to the old ones - and we seemed to be
on a pretty positive track," he recalls. "But after the blowup,
they decided they'd rather be cautious." MAVF will
probably wind up raising $125 million by the time it holds
its final closing sometime this spring; the firm was planning
on raising 20 percent more, $150 million. Partners at other
local venture concerns - notably FBR Technology Venture
BUSINESS FORWARD - April 2001 - Climbing the Capital Hill http://web.archive.org/web/20061017080443/http://www.bizforward.co...
2 of 12 3/3/2010 12:00 PM
Partners, Blue Water Capital, Draper Atlantic, Mercator
Broadband and Updata Capital - all relate similar stories.
It's the first-time funds that appear to be looking at the
highest hurdles when it comes to raising cash, especially
from wary institutional investors. "There will be people who
want to raise a first-time fund now and will never get it
done," says Gene Riechers, managing director at FBR
Technology Venture Partners, which is raising its third
fund. (Riechers would not give exact numbers, but sources
say the firm is trying to hit the $300-million mark by this
spring.) In fact, partners at many venture firms in Greater
Washington were unwilling to discuss where they stood in
the fundraising process and requested that their names
not be mentioned in this article, as sure a sign as any that
the venture business has changed. As recently as last fall,
VCs throughout the region were only too happy to talk with
the press about their lofty goals.
There are two primary routes for venture capitalists to raise
a fund - a task that puts them in the role of supplicant for,
rather than dispenser of, big money. It's not an activity the
VCs really enjoy, and they raise money at most every
couple of years. Ironically, given their line of work, some
VCs find raising money so distasteful that they farm the
dirty work out to investment banks to do as private
placements. The bankers take a negotiated percentage of
the fund, run through an extensive due-diligence process
and then "help introduce the fund's managing partners to
[potential] limited partners," says Rich Harris, a partner at
Reston-based SpaceVest, which is expected to have its
first closing on a $150-million fund, the firm's third, early
this year. "Essentially, you do a road show," he says,
adding that the process can take four to 12 months. Harris
says SpaceVest used investment bankers for its first two
funds, but is not using one to raise the third.
This is not an unusual pattern. Some firms, typically those
with an established track record, do not use an investment
bank to raise a new fund. "You go to contacts in your own
database" of deep-pocketed individuals and institutions,
says Harris. The amount of time spent in fundraising mode
depends on "how long you've been in the business and
your breadth and depth of limited partners." The trackrecord
factor is particularly important for institutional
investors, and the network effect should not be
underestimated among high net-worth individuals.
It is important to bear in mind a key distinction: There is a
big difference between having, say, $100 million in
commitments and actually closing a $100-million venture
BUSINESS FORWARD - April 2001 - Climbing the Capital Hill http://web.archive.org/web/20061017080443/http://www.bizforward.co...
3 of 12 3/3/2010 12:00 PM
fund. The state of "being closed" implies that the limited
partners have signed all the binding legal documents and
the fund is free to call in the capital to invest in actual
companies. Up until the closing, potential LPs can back
out or change the amount of their committed investment.
"We have closed on $110 million," says Jack Biddle,
cofounder of McLean-based Novak Biddle Venture
Partners, which just raised its third fund. "It is done. We
have already started calling down the money, and we can
admit new partners for the first 180 days."
So are small funds now at a particular disadvantage when
it comes to fundraising? "I think that smaller funds that
have a stable base of limited partners that they have made
money for in the past will be OK," says Harris. "Other
funds who do not have as strong a track record will have a
tough time raising the next fund. It is inevitable. That is the
way business works - always in cycles."
Being a venture capitalist used to be so cool.
Lazard's Burns, a former entrepreneur who's been in the
venture-investing business for the past five years, says that
as the NASDAQ soared ever higher through 1999 and into
2000, he was the envy of all his friends: "Last year,
everybody wanted to be a VC," he recalls. In the current
climate, however, the fun factor has diminished in the
venture world, as VCs are spending 80 percent of their
time - as opposed to the 40 to 50 percent they once spent -
managing their existing portfolios: "It's not just like, 'Hey,
cool, let's give away some money, yeah,'" sighs Burns.
April Young, senior vice president of Imperial Bank, which
loans money primarily to venture-backed businesses, rose
from her seat at the end of the February Mid Atlantic
Venture Association (MAVA) event to ask a question. The
Netpreneur program's Mary MacPherson offered Young a
microphone, but she didn't need one. "My voice carries
well," joked Young. "I am used to screaming at my portfolio
companies." (Later on, Young explains, "I don't really
scream at them, per se; I mother them.") Young says she
has been encouraging entrepreneurs to take lower
valuations from investors lately, because if they want to
make it in this market, they have no real choice: "The
entrepreneurs are having to give up more [of the company]
than they want to," she says. "And investors are afraid that
BUSINESS FORWARD - April 2001 - Climbing the Capital Hill http://web.archive.org/web/20061017080443/http://www.bizforward.co...
4 of 12 3/3/2010 12:00 PM
they are putting money into something that won't grow up."
Indeed, financiers have had to make some particularly
difficult decisions lately, like knowing when to pull the plug
on an unprofitable company without a viable exit strategy.
For example, at the end of December, Reston-based The
Dot Com Group shut its doors after the company's board of
directors determined that its $900,000-plus monthly burn
rate made the venture untenable. The company had $5
million on hand when it closed, which was given back to
the same investors who had just plunked down $10 million
in June. Fifty cents on the dollar is not ordinarily the return
investors seek, but it's a lot better than the alternative - a
total wipeout. Experienced VCs note that the down market
has taught some lessons to the younger players in their
profession who got a little arrogant in the high-flying days
of 1999 and early 2000. "Venture capitalists suffering from
severe hubris have gotten some religion," observes
Carlyle's Mathias, who sat on The Dot Com Group's board.
Still, it isn't all bad news. Because of the market
rationalization, company valuations have come down more
than 50 percent, so the climate for investing, in a sense, is
better now than in the very recent past. "Prices were too
high for too long," says Jim Lynch, managing partner at
Reston-based Draper Atlantic, a firm founded in 1999 that
just closed a $75-million fund. "A company cannot sustain
a valuation that high; at some point someone is left holding
the bag." Draper was seeking $300 million for this same
fund, the firm's second, as recently as August 2000.
Stephen Lisson, publisher of InsiderVC.com, which closely
monitors the venture industry, says now is the time for a
venture firm to get in on some fabulously priced deals.
"Everyone is glad the feeding frenzy is over," he says.
"How can anyone say that the [investing] climate right now
isn't happier and better and good?"
But falling valuations are, in some respects, a
double-edged sword for venture capitalists. That's because
residing in the portfolios of many local firms are companies
worth much less now than they were when they raised
their last round of funding. "I am seeing a lot of companies
where the private valuations are not getting written down
as aggressively as they were written up," says Lisson. To
keep the overall value of portfolios high, which is especially
useful when VCs are trying to raise new funds, firms will
sometimes wait for an event to occur, i.e. bankruptcy or a
down-round of financing (which takes place at a
significantly lower valuation than the previous round),
before they take write-downs. Lisson, a critic of the ways in
BUSINESS FORWARD - April 2001 - Climbing the Capital Hill http://web.archive.org/web/20061017080443/http://www.bizforward.co...
5 of 12 3/3/2010 12:00 PM
which VCs spin their returns, finds this tactic deceitful and
onerous: "The lemons ripen early," he says, "but you don't
want to take a write-down, because then you have to pay
the IRR [internal rate of return] piper."
When a venture firm "writes down" a company, it has the
effect of slashing its rolling IRR, a percentage that's
calculated differently from fund to fund and tends to
obfuscate as much as it clarifies investment results
because of the disconnect between paper returns and
actual distributions of cash or stock. Carlyle's Mathias put it
best: "At the end of the day, it is POM, or piles of money,
that matter." For example, Silicon Valley venture behemoth
Accel Partners saw its net IRR decline by about 5 percent
in the second quarter of last year. But at the same time,
the firm's fifth fund was distributing $866 million to its
limited partners, more than five times the fund's value in
1996, according to data compiled by InsiderVC.com.
Here's how it works: IRR is a number that describes how
much money will flow, on an annualized basis, to investors
from a given investment. If a venture fund invests $1 million
in company X, and one year later the VC gets back $5
million when company X gets acquired by company Y,
then the IRR for that investment is 400 percent (minus a
few percentage points for the discount rate which takes
inflation into account). Calculating the IRR for an entire
venture fund is much more complex, as VCs need to
account for inflows and outflows of multiple sums over an
array of time frames. To do this, a complicated equation,
which can yield multiple solutions based on how each
variable is assigned, is used. And not surprisingly, venture
firms typically pick the methodology that will allow them to
report the best possible IRR to their LPs. Long story short,
IRR can be manipulated; it is not absolute. One local VC
who requested anonymity went so far as to call the metric
"voodoo."
But the fact that IRR is not standardized from firm to firm is
not the main reason it is so widely criticized. Rather, IRR
raises eyebrows because it is not necessarily based on
actual, realized returns. "A lot of funds put IRR to the
public in terms of unrealized [returns]," says Allen Wolff,
and associate at Space Vest. "This [percentage] shows
what their positions are worth right now in nonliquid
companies - you don't have access to that money."
So if a VC invested that same $1 million in the
aforementioned company X, and X were acquired a year
later by company Y for stock rather than cash, the venture
firm's stake in company Y would likely be locked up for a
BUSINESS FORWARD - April 2001 - Climbing the Capital Hill http://web.archive.org/web/20061017080443/http://www.bizforward.co...
6 of 12 3/3/2010 12:00 PM
period of time before it could return anything to its limited
partners. Assuming that at the time of the acquisition the
stock in company Y were worth the same $5 million, the VC
could still post the near-400 percent IRR, even though he
or she couldn't actually realize the gain.
Henry Barratt, managing director of Blue Water Capital, a
McLean, VA-based outfit that's seeking to raise $150
million for its third fund, recalls a situation in which a local
venture fund - he wouldn't name names - valued a
technology company at $100 million. After the market
turned, a partner at the firm offered Blue Water an
opportunity to invest in the company at a $10-million
valuation, one-tenth of the previous figure. "It's still not
worth $10 million," says Barratt, a relatively conservative
investor who has been in the venture business since 1995.
"But you know what they're doing?" he asks. "Carrying it
on their books at $100 million."
However, venture firms can only maintain overvalued
companies on their books for so long. At some point,
insiders say, you either have to toss more cash at the
money-losing enterprise, a tactic that InsiderVC.com's
Lisson calls "negative follow-on financing," or take the loss.
Barratt expects to see many write-downs in venture
portfolios in the coming months. "In the first and second
quarters, you're going to see a significant decline in IRRs,"
he says. Once the dust settles, the venture capital market
might heat up again. Or it might not. It depends on who
you ask.
The reason for much of the uncertainty: Institutional
investors are experiencing allocation issues that are yet to
be fully resolved. Most of the big institutions that are the
bread and butter LPs for the best venture funds allocate
their overall portfolios on a percentage basis. The piece
that typically gets allocated to higher-risk investments like
venture capital is small, maybe 5 percent, and rarely more
than 10 percent. The rest gets invested in stocks, bonds
and other financial instruments. But if the sum total of an
institution's assets changes dramatically - with a sudden
Wall Street technology sector meltdown, let's say - then
the venture portion of the portfolio can quickly represent a
much greater portion of the overall than the institution is
comfortable with, and thus needs to be adjusted
downward. "What they intended to be 5 percent of their
assets, for example, is now 10 percent," says FBR's
Riechers. "You get in a position where you have to allocate
money out of private equity [including venture investing]
and back into the public markets."
BUSINESS FORWARD - April 2001 - Climbing the Capital Hill http://web.archive.org/web/20061017080443/http://www.bizforward.co...
7 of 12 3/3/2010 12:00 PM
The flip side of this trend, which bodes well for the VCs, at
least in the near term, is that the largest institutions,
especially universities, are not the most agile financial
creatures in the world. Big institutions are typically unable
to turn on a dime in response to day-to-day, or even
month-to-month or quarter-to-quarter, shifts in the
economy. Bill Snow, treasurer of Baltimore-based Johns
Hopkins University, whose endowment exceeds $1.7
billion, says that over the course of the next year the
university will actually increase its venture allocation from 8
to 10 percent. "We made that decision in '96," says Snow,
who notes that these choices are not swayed by the
vagaries of the public markets.
Ironically, the fundraising situation could improve in the
second half of 2001 after the VCs take significant writedowns,
says Blue Water's Barratt. In other words, the
portion of assets that institutional investors have devoted to
venture capital may actually be much lower now than it
appears to be when seen through the current IRR lens.
"Two [endowment] funds we are talking to say that they are
over allocated to venture right now," he says. "But both of
them say that they expect all that will change once they
see all the write-downs." That is, when the individual
venture capital firms fess up that the value of an
institution's investment is actually $25 million, not $50
million, it will free up some piece of the difference to be
recommitted to venture, while keeping their target
allocation percentage in line.
The other real culprit driving the slowdown in venture
investing is the initial public offering market, or the lack
thereof. Although VCs invested more than $500 million in
early-stage companies in Greater Washington in the fourth
quarter of last year, that marked a 40 percent decline from
the third quarter, according to PriceWaterhouseCoopers'
MoneyTree survey.
"The news is mixed," said Art Marks, general partner at
NEA, at the MAVA event in February. Marks expects to see
continued growth in the region in the long term, but not at
the frantic pace of 1999. "The numbers reveal that the
MAVA venture community has become more disciplined in
new investments while working harder with its portfolio
BUSINESS FORWARD - April 2001 - Climbing the Capital Hill http://web.archive.org/web/20061017080443/http://www.bizforward.co...
8 of 12 3/3/2010 12:00 PM
companies."
Only 63 U.S. companies went public in the fourth quarter
of 2000, compared with 172 in the same period a year
earlier, according to Newark, NJ-based Thompson
Financial. Overall, 449 companies went public in 2000, an
18 percent decline compared with 547 in 1999. The
concern is that unless the IPO window reopens, and
reopens wide, many of the companies in the venture firms'
existing portfolios are going to find themselves in serious
trouble. "I expect many of these startups to be merged with
other firms [if the IPO remains unavailable as an exit
strategy]," says Sam Hayes, a professor of finance at
Harvard Business School. "Many will receive securities with
no definite market value, and this may help the venture
firms postpone the pain a little longer."
Even companies that did make it out of the IPO gates last
year experienced the pain of diminished returns. Instead of
seeing a 200 percent average first-day gain, which is what
occurred in 1999, the value of new issues, to investors'
chagrin, sunk an average 15 percent on day one. It's telling
that one of the top three performing IPOs of last year was a
deliciously Old Economy outfit, Krispy Kreme donuts,
whose stock soared more than 200 percent following its
April offering.
Since then, the role of VCs, or at least their imagined role,
has changed substantially, and perhaps irrevocably. As
Michael Lewis (author of Liar's Poker and The New New
Thing) pointed out in a recent column for Bloomberg News,
after the meltdown, VCs showed themselves to be "not the
ally of the entrepreneur, but neutral parties without heart or
soul, like Switzerland." Venture capitalists as a group have
become choosier than in the recent past. Entrepreneurs
have caught on by stretching to make their cash reserves
last, trying to avoid the fate of the damned: We've already
seen more than 25,000 Internet company layoffs across the
country, including more than 2,000 in Greater Washington.
For the right VCs, however, all the gloom and doom may
actually turn out to be a blessing. "The best always get
better in a downturn," says InsiderVC.com's Lisson. "While
other VCs are reading self-help books, spending time
throwing good money after bad and looking for Dr.
Kevorkian's phone number, you can be sure the best are
getting better."
Take 23-year-old New Enterprise Associates (NEA) for
example. The firm, with offices in Baltimore, Reston and
Silicon Valley, closed in November on a mammoth $2.3
BUSINESS FORWARD - April 2001 - Climbing the Capital Hill http://web.archive.org/web/20061017080443/http://www.bizforward.co...
9 of 12 3/3/2010 12:00 PM
billion fund. Peter Barris, managing partner at NEA, says
that his initial fundraising target was $1.5 billion.
"Somewhat to our surprise, we found a demand that
exceeded what we set out to raise," he says nonchalantly,
adding that the fund took on 12 new limited partners in
addition to those that had been investing with NEA for
years. Lisson is quick to note that NEA may not really have
been so surprised that it could raise more than $2 billion:
"[Barris] is spinning," he says. "$1.5 billion was never a
hard cap…. From a marketing perspective, it's a great
tactic."
With valuations falling so precipitously, though, it may take
NEA a long time to put that $2.3 billion to work. "It could
take us five years, compared with two or three," says
Marks.
That NEA was able to raise such a huge some of money
while its smaller, less established peers struggle to meet
their more modest goals underlines the reality of the
venture world circa spring 2001: The established funds are
the headliners, and the newer players are the opening
acts.
What's to become of the region's former VC rock stars?
Some will tour forever. Some will put out a few great
albums before they hang it up. And some may be ready for
their stint on VH1's Behind the Music.
FUNDRAISING AT A GLANCE
Firm Location Firm’s
announced
fundraising
goals last
summer
Fundraising
status (at
press time)
Blue Water
Capital III
McLean, VA $100-150
million
Has $30
million and
expects to
close on
$150 million
this spring.
Boulder
Ventures IV
Owings
Mills, MD
$100-300
million
Expects to
close on
slightly north
of $200
million in the
spring.
BUSINESS FORWARD - April 2001 - Climbing the Capital Hill http://web.archive.org/web/20061017080443/http://www.bizforward.co...
10 of 12 3/3/2010 12:00 PM
Carlyle
Ventures II
Washington,
DC
$750 million
- $1 billion
Target
remains $750
million. Still
fundraising.
Columbia
Capital III
Alexandria,
VA
$870 million Closed in
July on $870
million.
Draper
Atlantic II
Reston, VA $300 million Closed on
$75 million in
February.
FBR
Technology
Venture
Partners III
Reston, VA $300-400
million
Won’t
discuss
numbers.
Still
fundraising.
Gabriel
Venture
Partners II
Annapolis,
MD
$300 million Won’t
discuss
numbers.
Still
fundraising.
GroTech VI Timonium,
MD
$400 million Aimed to
close in
March 2001
on $400
million.
Mercator
Broadband*
Reston, VA $200 million Raised in
excess of
$100 million
and
completed
first closing.
Mid-Atlantic
Venture
Funds IV
Reston, VA $150 million Aims to close
this spring on
$125 million.
New
Enterprise
Associates
X
Reston, VA $1.5 million -
$2 billion
Closed on
$2.3 billion in
November.
NextCom
Ventures*
McLean, VA $50 million Won’t
disclose
numbers.
Novak
Biddle III
McLean, VA $125 million Closed on
$110 million.
BUSINESS FORWARD - April 2001 - Climbing the Capital Hill http://web.archive.org/web/20061017080443/http://www.bizforward.co...
11 of 12 3/3/2010 12:00 PM
Potomac
Bioscience
Venture
Fund*
Potomac,
MD
$50-100
million
Won’t
disclose
numbers.
SpaceVest
III
Reston, VA $150-250
million
Should close
on $150
million in the
first half of
2001.
VENTURE FIRMS ARE PROHIBITED FROM DISCUSSING FUNDRAISING WHILE IT IS
ONGOING. THE ABOVE NUMBERS ARE ESTIMATES BASED ON KNOWLEDGEABLE
SOURCE INFORMATION.
*FIRST-TIME FUND
BUSINESS FORWARD - April 2001 - Climbing the Capital Hill http://web.archive.org/web/20061017080443/http://www.bizforward.co...
12 of 12 3/3/2010 12:00 PM
