Choking on Cash

Loaded with loot, Net startups must quickly master high-finance.

Venture capitalists
EBUSINESS  "Choking on Cash"
Enough is, how much?
Build-and-hope strategy
Paranoia factor
Know when to say when

These are the days of wine and roses. Investor appetite for Internet initial public offerings was insatiable in 1999: Through September, 147 companies had raised $11.6 billion, a tenfold jump from the $1.4 billion raised by just 30 companies in all of 1998. And the longest-running bull market is still on a tear.
With their eyes on the IPO jackpot, Net startups are demanding private equity at a fever pitch. Everyone wants in: Entrepreneurs need the cash, venture capitalists want to reap the returns, and corporations just want a piece of the action. Even the gold rush metaphors for the manic New Economy are sounding tired.
Ecommerce companies, especially business-to-consumer plays, are caught in the proverbial land grab. As these pioneering expressions suggest, entrepreneurs must rush to establish a place they hope will lead to their dominance on the Web. The key to success is brand building (a blitz of advertising and marketing) — developing company recognition on par with America Online or McDonald's. To do that, startups need cold, hard cash and lots of it.

The number of companies in a VC firm's portfolio of funds has jumped along with the absolute dollar amount in funds. In 1995, venture capitalists held an average of 6.7 companies per fund. In 1998, that number increased 30 percent to 8.7 companies per fund.
The wild success of Internet IPOs has stuffed venture capitalists' coffers with cash; startups, in turn, are receiving ever larger rounds of capital. Of course, many startups can't get funded or turn down VC offers because they do not agree to the proposed terms. But in the first half of 1999, VCs invested $12.7 billion in high-tech startups, almost as much as the $13.5 billion total for all of 1998, according to Technologic Partners, a research and publishing firm. Venture capitalists are lavishing startups with huge funding rounds in part because companies need bigger war chests to compete these days.
But the situation still raises questions: What are the effects of large chunks of money on a young company's growth and how well is it spent?
Take a look at some recent fat financing: Online car retailer CarsDirect.com gobbled up $280 million, the largest single round of venture capital in history, from Michael Dell's MSD Capital and Hambrecht & Quist to name two. Digital grocer Webvan received $275 million from Benchmark Partners and Sequoia Capital when the service reached only one city. Webvan's pre-IPO funding totaled a staggering $441 million, beating its $375 million IPO in November. Other Internet startups such as Boo.com, ThirdAge Media, and HomeGrocer.com each have raised $100 million or more. Compare that to old names such as Amazon.com and Netscape Communications, which received $8 million and $5 million respectively in total venture capital — chump change in today's market.
The fattening venture rounds are a reflection of the current Internet bonanza, which has forced changes in VC behavior. Competition is fierce to snag the home-run startups, leaving venture capitalists no time to sit on their hands. Deals must be executed faster. But, in most cases, the number of partners has not grown in proportion to the amount of money and deals flowing in, leaving firms stretched to their limits.

Swelling funds from recent market jackpots force venture capitalists to pump more money into each deal. A $5 million deal that might have been split three ways a few years ago now goes to a single firm. "Venture capital was about building companies. Now the philosophy is about building market capitalizations," says Roger McNamee, lead partner of Integral Capital Partners, which invests in expansion- and growth-stage companies. "Venture capitalists used to be like orangutans that have babies every eight years and invest a lot in each baby. They'd get the largest piece [of a company] early, sustain it as long as possible and keep the valuation low."
Dollar Daze
(venture funding) CarsDirect.com — $280 million Webvan — $275 million Boo.com, ThirdAge Media, Homegrocer.com — $100 million-plus
With the market awash in capital, it is an entrepreneur's market. "The tenet in the Internet [space] is 'I can raise money, therefore I am,'" says Edward Rollins, co-founder and CEO of Cimtek Commerce in Johnson City, Tenn., which operates Medicalbuyer.com, an online marketplace for the medical supply industry. "It's a bit crazy, but it's partly to maintain credibility." Rollins says Medicalbuyer.com, which closed its first venture round of $11 million, does not need money at the moment but is looking anyway.

Venture capitalists traditionally value a company on four areas: technology, management, market positioning, and financial projections. But on the Internet, new business models have replaced technology as a valuation benchmark, even though many of these models are unproven. So how much money does a startup need? It depends on the business.
Consumer-oriented companies, like online retailers, depend on driving eyeballs to a site, which typically requires a huge marketing budget. But for a business-to-business company, establishing customer relationships is important, so it relies on direct-sales forces and email campaigns instead of a marketing blitz. Check out the numbers: In 1999 B-to-B companies spent a total of $460 million on advertising, a figure that was dwarfed by the $2.8 billion business-to-consumer companies spent, according to Forrester Research.
Different technology requirements also determine how much capital a startup gets. For example, a networking or communications startup probably has more expensive infrastructure costs than a portal site.
Different technology requirements also determine how much capital a startup gets.
"I think there are cases where large amounts of equity capital are needed and justified," says Tom Alberg of Madrona Investment Group in Seattle, which has invested in Kirkland, Wash.-based HomeGrocer.com. "The [HomeGrocer] model requires opening warehouses in each metropolitan area, so the money is needed. And hopefully, the profit potential is there."
The online grocer, which raised about $200 million from Kleiner Perkins Caufield & Byers, Amazon.com, along with Madrona and others, started operations in June 1998 in Seattle, Portland, Ore., and Southern California. Creating the company's physical network for delivery is the largest expense. The company leases all of its trucks and warehouses and relies on a 100-person, in-house, technology team for back-end systems. HomeGrocer's rollout plan is a new distribution center every month, with service in 20 cities by end of this year.
But what about Web media companies, where there is no physical infrastructure to develop? Marketing is the lifeblood for online media companies such as ThirdAge, a portal for the 45-to-60 age set. Started in 1997, the company has raised $104 million from CBS, Merrill Lynch, and Softbank, to name a few. ThirdAge hopes to be the No. 1 destination for seniors and aging baby boomers. It plans to push its Website content through other media channels — such as television and radio with its partner CBS
So far, the company's marketing budget has been a modest $360,000 a year. But its recent capital infusions are going toward a large advertising and marketing campaign. Online ad spending will account for 10 percent of total media costs with the rest going to broadcast and print outlets. ThirdAge makes money from advertising, sponsorships, research, and commerce. So sure-fire marketing is crucial to driving traffic to the site and keeping advertisers paying.
ThirdAge's online ad spending will account for 10 percent of total media costs with the rest going to broadcast and print outlets.

Throwing millions of dollars at marketing can be a risky strategy. "It's unwise to spend money before the model is proven, but to get market share you have spend," says Tim Draper, managing director at Draper, Fisher, Jurvetson. But it is a slippery slope for young companies. Venture capitalists say one symptom of too much money is sloppy thinking — "Build it and they will come" — when the idea is really "Spend it and hope they come."
Ultra-hip sports retailer Boo.com may be a victim of the "build and hope" strategy. The London-based e-tailer has built a Website in seven different languages to carry 22 brands of sports- and streetwear from designers such as Jil Sander and Patagonia at full retail cost. The company has received between $150 million to $200 million in three rounds of financing, according to a Boo.com official who declined to be identified. The infusion came from Bain Capital, the private equity investment arm of consulting firm Bain & Company, and luxury-goods company LVMH, Louis Vuitton Mo‘t Hennessy, among others.
"It's sportswear for people who don't sweat," says Paul Kanareck, company spokesperson. Sweating is probably what Boo.com's investors have been doing. The launch was plagued by delays month after month. But that did not stop the company from swelling: Headcount doubled from 200 last July to more than 400 by October.
Founder Ernst Malmsten says the biggest expenditure is on the technology for the back-end systems. Boo.com ships everything (at no cost) from two distribution centers — one in Louisville, Ky., the other in Cologne, Germany. The second major cost will be a marketing push, mostly offline — television, fashion magazines, and gorilla (on the street) marketing. Revenue will come entirely from the catalog, with no advertising stream, and Malmsten expects gross margins of 50 to 60 percent.

For green ecommerce companies, the Internet is a brutally expensive place to find customers. In the first half of 1999, ecommerce companies spent $575 million on traditional media outlets compared to $448 million spent in all of 1998. Even giants such as Amazon have to fight to stay on top. Last fall, the company told analysts it planned to spend an estimated $100 million on an aggressive marketing push, as are many others. Pure fear drives many startups to pour gobs of money into advertising and marketing. Many feel they must outspend their competitors to win.
"In the 1980s we saw fancy offices; today it's bad marketing," gripes Geoffrey Moore, a venture partner at Mohr, Davidow Ventures. Moore cites online software seller Beyond.com as a classic example of bad marketing. Naked men in advertisements might get awareness, but the $25 million-per-quarter spent on advertising does nothing to establish Beyond.com as a compelling value proposition, instead the company is using schtick. "This a case of thinking that awareness is an appropriate goal with a new technology when positioning should be the goal — and these ads do nothing to position the company as anything but flaky," says Moore.
Proof that Beyond.com is caught with its pants down: The company has reported tremendous losses, the stock in October 1999 was down 80 percent from its high in January 1999 and the company is now repositioning itself to target business customers. Stellar marketing examples include Amazon's customer recommendation service, which reinforces the brand with buyers through customer service or GoTo.com's service, where advertisers pay for each customer click-through to its site.

Too much money in a startup results in more than just bad marketing. Entrepreneurs who get their hands on too much capital too quickly can become complacent or cocky. "Way too many startups think that if they have KPCB or Sequoia they're all set," says McNamee, whose Integral Capital Partners is affiliated with Kleiner Perkins. "They stop thinking of the money as their money."
For green ecommerce companies, the Internet is a brutally expensive place to find customers.
And since capital is not hard to find, entrepreneurs could fall into an easy come, easy go mode of spending. And round after round of financing can lead to dilution of ownership — another important factor to consider as an investor or an entrepreneur. Too many employees or venture capitalists in a company (not to mention landlords, consultants, and lawyers) can water down a founder's stake. Many venture capitalists also have minimum investment requirements that they give to startups. In response, founders may inflate the valuation of the company rather than turn over a large portion of the company to one VC, who generally wants 15 to 20 percent. This can lead to an exaggerated valuation on a company. Again, putting more money than may be needed into entrepreneurs' hands.
Venture capitalists are susceptible to spending binges too — over-funding one sector and thus creating a mass of companies with no clear-cut winner. The end result is a shakeout, where many, if not all, will fail. It will be winner takes all. This year, for example, investors were falling all over themselves to fund four online pet stores — all looking very much alike. (See "K9 Commerce," Aug. '99, p29.) The biggest round — $97 million — went to Petstore.com recently. "The pet category is an embarrassment to humanity," scoffs Moore. "Keep a look out for crash and burns. They will come in the B-to-C market in the next six to 12 months. There is just too much trash in this sector."

So far the trash bin of flameouts looks relatively empty. Since the beginning of 1997, only 15 venture-backed Internet companies have gone out of business, according to research firm VentureOne. But while it takes complete disasters to wake up investors to their over-spending and put failures on VentureOne and others' radar, many more dot coms stumble irrevocably without much notice into the Land of the Living Dead, and are eventually bought for a bargain basement price without actually filing Chapter 11. "The verdict is still out, but you've got to ask questions about some of these companies," says Stuart Davidson, managing director of Labrador Ventures. "A lot of companies are spending money with little to show."

Source: By Carol Pickering, business2.com