Real estate and the stock market once dominated the talk at certain dinner parties. Now it's venture capital.

Back in the days before the grungy industrial neighborhood south of Market Street became the
trendy South of Market (or SOMA), before the onetime sweatshops north of Wall Street became
Silicon Alley, you could depend on conversation at a certain kind of San Francisco or New York
dinner gathering turning, sooner or later, to real estate and the stock market. Now that the merger
of "dot" and "com" has created so many young millionaires, there's a new topic: venture capital.

Everyone today has money to invest in startups, or so it seems.

Which is a problem for those who were VCs before VC was cool. Deals are expensive, there's too
much competition for the good ones, and not enough time to get comfortable with a proposal
before having to invest in it or pass and move on to the next. Once an obscure backwater of
corporate finance, venture capital has become mainstream. There's even a daily news service
devoted to it, VentureWire, with 60,000 subscribers (I publish it). So, herewith, a few timely facts
and observations to improve your party talk.

Venture capitalists do have some cause for happiness: Their business is more lucrative than ever.
Last year almost four times as many venture-financed technology companies went public (237 of
them) as the year before, raising nearly six times more money ($19 billion). Through such IPOs, a
few venture funds--Crosspoint Venture Partners, Mohr Davidow Ventures, and Matrix
Partners--made five times their money or more, and 20 firms made threefold profits or better. And
that's taking into account only the gains after the investments' IPOs. The total gains are dramatically
higher.

At the same time, however, it's unlikely that such returns can continue, because so many
well-financed investors have decided they are just as smart as today's VCs and are determined to
become as wealthy. The resulting increase in available capital produces multiple corporate births,
several almost identical startups for every idea that can support only one or two. Each of the
newborn companies, consequently, has to spend more for marketing to rise above the noise level,
and more to hire managers and a work force in these times of low unemployment. The result,
inevitably, is a rising percentage of business failures, which, in turn, reduces VC profits.

At present, equity investments from venture partnerships are running at an annualized rate of more
than $100 billion, or roughly $2 billion a week. As recently as 1993 total venture financing for an
entire year was only $2 billion. Today's hectic pace probably won't abate, given the amount of
capital available not only from traditional venture funds but also from corporations showing renewed
interest in the area as part of business development efforts. While a few venture
partnerships--idealab, for example--have recently raised investment funds of $1 billion, an even
greater number of new megafunds have been raised by corporations or their venture affiliates,
including Andersen Consulting, Compaq Computer, Electronic Data Systems, International Data
Group, PSI Net, and Softbank.

The result is deal-a-minute scrambling not seen before in venture capital. Worried that the next
Yahoo might pass them by, some private investors seem to be placing bets and then doing due
diligence, as if they were momentum players riding the bull market. Good PowerPoint presentations
now are enough to bring million-dollar financing commitments that once would have come only after
several days of studying a business plan. It's not that the VCs lack clout. In startups, money rules,
and in exchange for capital, venture investors still typically demand and get control of a new
enterprise, usually owning from 51% to as much as three-quarters of the equity.

Venture investors thus have the power to change the company's strategy, capital structure, senior
executives--even its name and its products or services--and then if something goes awry,
management can always be blamed. In today's hottest deals, however, VCs admit to "hoping for
allocations" of stock in companies that barely exist, and in negotiations with brand-name
entrepreneurs they are talking founders all the way down to ... their asking prices. Conservative
venture capitalists who insist on following the old rules and trying to build companies that are
profitable before going public are feeling left behind in the rush to IPOs.

To distinguish themselves in such an environment, VCs have taken up marketing, most notably in
the form of incubators--an apparent attempt to get extra credit for doing what they should be doing
in the first place. Venture capitalists are supposed to be intimately involved with the companies they
finance; that's why they're paid annual management fees of about 2% and get to keep 25% or more
of all capital gains. But with ever greater amounts of capital to invest, VC funds are finding
themselves forced out of caring for startups. It's simple economics. Serving on the board and
advising a company in which one has a $100,000 stake requires just as much time as fulfilling those
duties on behalf of a $10 million investment. So as its capital swells, a fund will typically invest more
money in each of its deals in an effort to achieve the greatest return on the time of its partners. As a
result, one either gives the youngest companies more money than they need or avoids such
newborns altogether. And that's what has given rise to the so-called incubators, most of which are
acting as farm clubs to the major leagues of venture capital, finding and nurturing promising
companies and then passing them along to the larger funds for later financings.

To compete, VCs are also expanding geographically. Not long ago it was common for venture
capitalists based in Menlo Park, Calif., where many are located, to boast of never making
investments outside the local area code, 650. Lately, however, a few of those same firms have
begun moving into Europe and Asia. Benchmark Capital, for example, has just started a $500
million fund based in London.

And then there's the publicity. Venture capitalists who not long ago would never speak to the press
are now permitting themselves to be pictured in magazines like this one. Who knows, a deal-hungry
VC might even turn up next to you at dinner.
 

Source: Richard A. Shaffer, Fortune,  April17, 2000
Richard A. Shaffer is founder of Technologic Partners, an information company focused on emerging
technology. Except as noted, Shaffer has no financial interest in the companies mentioned.