Frontier Home Business Week Home Contact Us Business Week Archives


Venture Capitalists Are More Than Happy to See You
That's because they have lots of cash and you have few alternatives

There's an international financial crisis out there, but you would never know it talking to Jerry Hall. The entrepreneur is in the process of starting an Internet consulting company in Santa Clara, Calif. Nonetheless, he is almost certain he will get $250,000 in seed money from a venture-capital firm shortly, which would value his company at $2.5 million to $3 million. "That's before having a team in place and an operating plan," marvels Hall, who says he will come back for $5 million more in three months. "There are currently not a lot of companies that can advise on Internet strategy and build it," he says. "I estimate it's a $300 million market now. It'll be several billion in a few years."

Hall's exuberance may not just be a case of entrepreneurial optimism. Amid big losses at banks and uncertainty in global markets, one financial market niche is having a field day -- venture capital firms, where many young companies get their first slug of real money in exchange for part of the business.

But the venture-capital boom isn't unalloyed good news for entrepreneurs.

On the bright side, VCs are flush with cash and are buying into tiny, new companies with compelling ideas -- especially those like Hall's in high-technology and Internet-related fields -- at record rates.

The dark side is that the financial market turmoil gives venture capitalists a stronger hand in the negotiations with entrepreneurs. The plunge in the Dow Jones industrial average from its peak close on July 17, 1998 -- it's still down some 800 points -- has dissolved interest in the stock offerings of risky, unknown companies and deflated the stratospheric valuations of those that are already public. That makes it harder for entrepreneurs to argue that their brainchildren are the next wunder-stocks and thus deserve more money and better terms from venture capitalists. Nor can they bank on going public soon or getting bought out by a bigger company.

"It does give you pause if you were thinking about starting another round," says Susan DeFife, who in May, 1998, got the last of $1.5 million of venture-capital funding for her company,, an Internet site for working women. Her deal closed fast -- in only six months. But with confidence in a then-stratospheric Dow already showing signs of wear, DeFife became increasingly concerned. "We felt we had to close the deal as soon as possible," she says.

"WE ARE ECSTATIC." The shaky public markets are also a problem for venture capitalists, who count on IPOs and acquisitions to turn their high-risk private investments into liquid assets later on. But the lower valuations are mainly a buying opportunity for them. "The private equity funds have been waiting for this to happen. We are ecstatic," says Patrick Boroian, general partner of Sprout Group, Donaldson, Lufkin & Jenrette's $1 billion venture-capital fund. "It's supply and demand, and we're one of the only games in town." Indeed, Sprout has invested $185 million to date this year, vs. $130 million it invested in all of 1997, and the terms are getting better and better from his point of view.

As recently as April, a one-year-old client with minimal revenue, Rhythms NetConnections Inc. in Englewood, Colo., raised $150 million in high-yield debt that gave away warrants for only 8% of the company's equity. The debt was sold to finance a high-speed data service to homes for telecommuters.

Those terms would be impossible to get now as the bearish market psychology percolates down. "The early-stage companies are a lot more realistic than they were a year ago," says Peter Wendell, general partner at Sierra Ventures, a $500 million venture-capital fund located on Sand Hill Road in Menlo Park, Calif., the VC world's equivalent of Wall Street. For example, Sierra is about to invest about $10 million for a 30% stake in a venture that makes enterprise software for large companies. That's twice the equity that the owners expected to give up just six months ago.

GET REAL. Not all would-be entrepreneurs have caught on to the new reality. "Greed is outweighing fear still," contends Kevin Compton, general partner at Kleiner Perkins Caufield & Byers in Menlo Park. "They come to us with such unbridled optimism about a startup."

Michael Moritz, a partner at Sequoia Capital, a Menlo Park fund with about $1 billion under management, hopes that the economic uncertainty will start to deter such irrational exuberance before would-be entrepreneurs strike out on their own. "It makes people think twice about leaving a company," says Moritz. "The marginal ideas don't get financed. It's a good taste of the dark side of the moon."

Venture capitalists share some of the blame for the inflated expectations. Domestic VC funds invested $6.8 billion in 1,432 companies in the first half of the year, up from $5.2 billion and 1,256 companies in the first half of 1997, says a PricewaterhouseCoopers' survey of venture capital. In fact, investments for the first half of this year were more than the total of $6.2 billion for all of 1995. What's more, the institutional investors who have pledged money to venture funds are eager to see it put to use, especially with the fall in the value of more conventional investments, says Kirk Walden, the Austin (Tex.) director of the PWC survey. "Venture capital has had an average rate of return of 30% to 40%," he says. "If you have the money, you want to spend every damn dime of it."

That sounds like great news for cash-hungry entrepreneurs. But in the free-for-all of raising capital, it's just like any other bazaar -- the stronger player is always the one who can go elsewhere.

By Julia Lichtblau in New York

TABLE: Nothing Ventured, Nothing Gained


TABLE: Nothing Ventured, Nothing Gained

Finding Angels Online through the SBA's ACE-Net

What Makes Venture-Backed Companies Different

Search this Database for Sources of Capital

CMG Lets Ordinary Investors Play the Venture Capital Game


Business Week Logo

Copyright 1998 Bloomberg L.P.
Terms of Use