Commentary: Guess What--Venture Capitalists Aren't Geniuses

Wasn't it only a matter of months ago that venture capitalists were the smartest people on Wall Street? Investors were beating down their doors to throw billions of dollars at every high-tech prodigy they could bring public.

But as the Nasdaq has continued to stumble, and even the prospects of erstwhile high-tech superstars such as Inc. (AMZN) are being widely questioned, VCs are no longer undoubted financial gurus. Today, they are increasingly finding themselves forced back into the market to prop up flagging startups.

On Apr. 25, Benchmark Capital Partners LP, one of Silicon Valley's hottest venture-capital firms, bought 1.3 million shares in a private placement for its once celebrated E-LOAN, an online provider of consumer loans whose stock has fallen to less than 5 from a high of 74 3/8 last July. Around the same time, Benchmark was also buying shares of luxury-goods Web site (ASFD), which has seen its shares tumble to less than 10% of its November high of $35. Nor is Benchmark alone in lending a financial helping hand. On June 20, Internet holding company CMGI (CMGI) teamed up with Compaq Computer Corp. (CPQ) to provide $75 million to Engage Inc. (ENGA), the Web ad-delivery outfit whose stock has slid from a high of 94 1/2 in March to 13 3/8.

RESOURCE SHIFT. Propping up failing stocks isn't exactly normal VC behavior. Typically, they don't look back after the entrepreneurial offspring leave the fold. But some VCs are eager to prop up the valuations of their lagging investments. So instead of putting money into new consumer startups, they're supporting old ones. ''It's a defensive strategy,'' says C. Kevin Landry, CEO of venture firm TA Associates in Boston. ''They're conserving capital to protect existing investments.''

But don't shed too many tears: By and large, venture capitalists are responsible for their current predicament. The industry threw too much money at too many companies that were following the same business model. Last year, some $5.5 billion was invested in consumer e-commerce companies, up from $607 million in 1998, according to Venture Economics, a researcher that tracks venture funding. Nobody, but nobody, really believed the world needed that many new Net stores.

Then, in many cases, VCs took these clones to market way too soon. Instead of the four to five years it used to take before a company could get public investors to pony up, companies are now being pushed out after less than two years on average, estimates PricewaterhouseCoopers. Inc. beat even that: The teen-information and e-commerce site filed for its IPO a mere 10 months after its online debut. The problem with that kind of strategy is that neither the company nor its management has enough experience to prove consistent performance.

INDISCRIMINATE INVESTING. Every VC was, instead, eager to have the next America Online Inc. (AOL) or Inc. So they tossed huge amounts of money at redundant companies in an attempt to outspend and underprice rivals. As a result, heavily funded startups became locked into price-cutting strategies that turned into death struggles. Last Christmas, eToys (ETYS) duked it out with venture-funded companies,, ToyTime, and Now, ToyTime and are out of business, and KBkids pulled its initial public offering. And when the consumer market seemed to be played out, VCs engaged in some of the same type of indiscriminate investing in business-to-business Web sites, infrastructure, wireless, and optical networking. The same trends could eventually play out in those sectors.

VCs could have handled this differently. Instead of pushing everything out the door, everyone would have been better served if the VCs had used their considerable business acumen to decide which companies were worth investing in for the long haul. And they could have done so with later rounds of private financing, not IPOs. Now, investors are disillusioned with the very model that promising e-tailers depend on for growth. And without further capital, many green e-tailers are getting a savage business lesson that may well spell their demise.

By Heather Green and Norm Alster
Green, in New York, and Alster, in Boston, track venture capital. Timothy J. Mullaney contributed reporting.

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Commentary: Guess What--Venture Capitalists Aren't Geniuses

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