Feb. 11 was a good day to be a venture capitalist at Sierra Ventures. Its investment in Healtheon, which uses the Internet to transfer health-care information, had just struck gold. Healtheon was one of three Web companies that went public that day, amid an Internet-trading frenzy that drove the tech-dominated Nasdaq Composite Index to a record one-day gain.

"Our $4 million piece is now valued at $50 million," boasted Peter Wendell, a general partner at the $500 million Menlo Park (Calif.) firm. "That'll keep the wolf from the door." The shares, offered initially at $8, closed at $31.375, nearly four times the offering price.

The good fortune of investors such as Sierra Venture is also good news for entrepreneurs. That's because venture capitalists play an increasingly important role in setting the agenda and tone for small-business financial markets -- and VCs depend on a hot stock market to provide them with a profitable exit strategy for their investments. The upshot: Entrepreneurs, especially those with Web strategies, are likely to get a much warmer reception for the foreseeable future when they seek venture-capital funding.

New data show the VC market has been on a tear. The 1998 PricewaterhouseCoopers' MoneyTree survey, released Tuesday, Feb. 16, shows that U.S. VCs last year poured more money than ever into small companies -- $14.27 billion, up 24% from 1997. And the survey found that more companies are getting funded -- 2,856 in 1998, vs. 2,669 in 1997. Why the big jump? Because big institutional investors such as pension funds are funneling money through VCs, lured by the 30% to 40% return that their traditional, tamer investments can't match.

WHAT'S IN? Internet companies alone claimed $3.5 billion of the cash, up 66% from 1997 and more than triple the 1996 amount. Tech companies overall gleaned three-fourths of last year's venture money. Even the battered semiconductor businesses drew $227 million, vs. $176 million in 1997. What's out? Computers and peripheral makers reaped $437 million, down from $521 million in 1997.

The volatility of Internet stocks and the poor earnings of many Web companies aren't likely to deter VC funds from flowing that way in the future, either. That's because VCs view the Net as simply a normal way of doing business these days, says Brook Byers, a partner at Kleiner Perkins Caufield & Byers in Menlo Park, Calif., which gets a business plan a day for a Net company. The Internet isn't an exotic device, but a basic business operating tool, like electricity or a PC. "To say that there are all these Internet companies out there is missing the point. That's like saying there are all these companies that use computers. People are coming out of traditional industries and saying they want to dotcom them," Byers says.

The firm, which has backed such Net legends as Netscape, Amazon, and Excite, and also has a stake in Healtheon, says it's seeking companies that are tackling big markets. Health care, he points out, is a $1 trillion industry, of which 20% goes to administrative costs, making it ripe for Internet-style efficiency improvements.

The downside is that with the novelty long gone and more experience to draw upon, funders will subject the next generation of Internet startups to tougher scrutiny -- and only the first ones to adapt a certain industry to the medium will catch the VCs' eyes. "I don't think anyone would want to start an online bookstore or go online selling music CDs," Byers notes.

"The ones we like are the ones that are very focused," says Sierra Venture's Wendell, such as OnLink, a recently funded company that helps industrial companies sell complex goods -- customized, prefabricated building elements, for example -- to other companies via the Web.

"NON-OPTIONAL STUFF." Christine Comaford, managing director of Artemis Ventures, a Sausalito (Calif.) software startup consultant that's raising a $15 million to $20 million venture fund, says the VC interest is turning away from some popular, softer concepts: "Online communities? With all due respect, I don't get it. We want non-optional stuff," she says. Internet companies that serve small business are "starting to become a sweet spot." Also appealing are those that help companies manage their relations with Web customers -- for example, using artificial intelligence to produce detailed responses to E-mail queries.

Shouldn't this influx of money make life easier for entrepreneurs who crave VC financing? Here, the picture is mixed. Kirk Walden, director of the PWC survey, says the weak IPO market late last year meant financiers were demanding that entrepreneurs give up more equity -- at a time when other sources of funding were drying up. That crunch proved temporary. Now, says Walden, "the VCs are competing with themselves.... My take is that the entrepreneurs are probably doing a bit better."

Still, IPOs like Healtheon's put pressure on VC-funded entrepreneurs to produce the same prodigious returns -- and fast -- so that their backers can cash out. "It's gone from 5 years to 18 to 24 months," says Harry Kellogg, executive vice-president for strategic initiatives at Silicon Valley Bank, which finances high-tech startups across the U.S.

With such a short time span, VCs are playing a more active role than ever in a company's development -- especially in creating a team that can move the company to an IPO. "You have to have a quality management team," Kellogg says. In the minds of many VCs, that doesn't include you. Kellogg says the entrepreneur with the original idea is likely to see his or her operational role reduced.

Another phenomenon is that VC funds are getting so big -- some are around $500 million, compared with, say, $250 million a few years ago -- that they need to invest larger amounts. This tends to cut out the smallest startups -- those that need as little as $500,000. Last year, average funding increased 16%, to $5 million per company, the PWC figures show.

Surely with everybody going virtual, shouldn't it be possible to get VC money from just about anywhere in the U.S.? Not exactly. The survey says it helps enormously to be in Silicon Valley: The area drew 32% of all last year's VC money, compared with 14% for New England, the next most fruitful region. Why? There's still no substitute for a firm handshake, says Comaford of Artemis Ventures: "There are more networking events here than anywhere.... I have a party three times a year at my house called Schmoozefest." She says three people got funded at one of her events.

It appears venture capitalists are all too human. If an entrepreneur has an intriguing idea and is within reach, VCs are more likely to go check him or her out, says Byers at Kleiner Perkins: "It's very helpful if they're a half-hour drive away." Even in the age of virtual commerce, financiers still want to know they're investing in something solid.

By Julia Lichtblau in New York
julia_lichtblau@businessweek.com

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