SAN FRANCISCO (The Red Herring) - In November 1995, fresh from his post as head of America Online's Internet products division, Sunil Paul was starting a company.
After months of searching for financial backing, only a stroke of luck landed him the $250,000 bridge loan that funded Freeloader, a push-technology company that hoped to differentiate itself by aggregating and delivering business content over the Internet. In March 1998, less than two and a half years after founding Freeloader and just nine months after the company was shut down, Paul secured more than $5.5 million -- one of the largest seed rounds ever -- to start Bright Light Technologies. It was armed with a seasoned management team (from AOL, Xerox's Palo Alto Research Center, Netscape, and Silicon Graphics) and a business plan targeting a fashionable problem (managing unwanted email, commonly known as "spam") but little in the way of a product, even by startup standards.
Such is the state of affairs in today's startup market. Just as technology stocks have been driven to deoxygenated heights, so the cost of private equity has become wildly inflated. The problem? First, as most venture capitalists will confess, the amount of private equity seeking ideas to fund has outpaced the number of ideas that merit funding. Second, enormously deep-pocketed and mature technology companies are willing to pay top dollar to finance and acquire promising startups that threaten or could enhance their market leadership. Because startups have tremendous access to capital and because acquisition has developed into a lucrative exit strategy, the scales that once favored those supplying the capital have been tipped in favor of high-tech entrepreneurs. And their abstruse ideas, once incubated in garages, are now developed in far more comfortable environs.
The bad news--of sorts--for all startups, however, is that more companies than ever before are getting funding. And to generate a return on the enormous investments they have taken, high-tech entrepreneurs must move quickly to stay ahead of a crowded market. This compulsion has profoundly affected the state of innovation in technology. Innovation was once about creating transformational technologies that redefined markets and toppled market leaders (as Intel did with Fairchild Semiconductor, and Microsoft did with WordPerfect), but it is now more often about being first with technologies that target overlooked niche markets or markets that are poorly addressed by the dominant companies.
Take our money, please
The recent phenomenal returns of venture capital funds have attracted untrackable amounts of private equity to the technology sector. New funds are springing up at an astounding rate, and their sizes are growing as wide-eyed institutional investors seeking high returns pour money into VC coffers. In addition to huge amounts of traditional venture capital, there are also countless angel investors--wealthy individuals, often experienced entrepreneurs who have made their fortunes, who help companies get off the ground--and enormous corporate private equity funds, estimated by some to control three times as much money as VCs do.
Because all of this money must find a home, competition to fund promising startups is stiff. "Certainly the Internet has spawned wonderful entrepreneurial creativity," says "Surreal" J. Neil Weintraut of 21st Century Internet Venture Partners, "but while the sheer volume of ideas has exploded, the number of ideas that translate into viable businesses has not kept pace with the amount of capital chasing them."
In short, the market for good ideas has become a seller's market, with the bargaining power shifting from the venture capitalists to the entrepreneurs. "In 1991 VCs had all of the leverage, whereas today the entrepreneur holds most of the cards," laments Peter Barris, a general partner of New Enterprise Associates, which funded Silicon Graphics, UUNet, and Ascend Communications. "Our money is no greener than anybody else's, and there's plenty of money available."
Because there is indeed plenty of money, more companies than ever before are securing funding. Because almost all money is created equal (there is some value in having the "right" venture firm), entrepreneurs have several directions in which to turn. High-profile startups like Bright Light have the luxury of choice. "We didn't have to shop the idea for the company around to different VCs," Paul recalls. "We could afford to be picky, so we pitched the idea to only a couple of firms." Accel Partners, which invested $2.75 million, was the sole VC firm to get the nod. The remainder was raised from angel investors, including high-tech veterans Ben Rosen, Andy Bechtolsheim, Bob Peters, Ron Conway, Bud Colligan, Roger Sippl, and Esther Dyson.
Of course, despite the glut of venture capital, not every startup can be as fortunate as Bright Light. Three-time startup veteran Jerry Kaplan, CEO of the online auction company OnSale and self-professed "Miss Lonelyhearts of entrepreneurs," regularly sees business plans of companies that are having difficulty obtaining funding. "There's a whole pyramid of people trying to get VC funding. At the top are the few who have no trouble, but at the bottom there's a ton of people who can't get their feet in the door," he says. "Exactly how far down that pyramid VC money flows varies over time. These days it flows pretty far, but many startups out there still can't get funded."
This is precisely how the market should work, says Hans Severiens, the coordinator of the Band of Angels, a group of 120 high-tech executives looking to fund startups: "Good ideas will always get money, but a lot of deals just don't deserve funding." Of greater concern, he argues, is the number of investments being made at the base of Kaplan's pyramid by what Severiens considers to be unqualified VC firms. Weintraut puts it more bluntly: "Currently there's more capital out there than brains to invest it."
As a result, says Netscape cofounder Marc Andreessen, the standards for what constitute a good investment have dropped precipitously since his company--which introduced that most recent example of a transnational technology, the browser--was conceived. "There's a lot of crap out there getting funded at valuations that are out of whack," he says. "Investors aren't vying for companies, products, or even unique features. Increasingly the competition is for an arguably novel idea and somewhat qualified people."
Even without a product, then, Bright Light's search for funding was brief and fruitful. Like many startups in today's climate, Bright Light commanded relatively cheap money and special attention from their VCs. "Our expectations for a $1 million angel round flowered into an oversubscribed $5.5 million venture round," recalls Paul. "Demand was so high, in fact, that our valuation doubled over the course of the process."
The strategic risks inherent in funding ideas and people rather than technologies, however, are compounded by the competitive risks of an increasingly crowded startup field. "The days of going undercover for a year, hammering out a product, testing it with a few customers, then announcing your company are over," declares Weintraut. "Today, seed-stage companies can be assured that at least three other startups are trying to solve the same problem, so the primary objective has become to attract as much attention as quickly as possible and later figure out how to make money." CrossWorlds Software -- a marketing machine designed to become the leading vendor of enterprise application integration software before its product is even available -- exemplifies this strategy. (For a closer look at the company, see "Into the Enterprise.")
CrossWorlds, which has raised $40.6 million since its start in 1996, also shows that building a company quickly is far more capital intensive than growing it slowly. And today startups rely more frequently on venture capital as the only means for development. According to VentureOne, the average size of a VC investment has risen 86 percent, from $3.5 million in 1992 to $6.5 million in 1997; the average total amount of venture capital raised by a company has increased 126 percent, from $9.5 million in 1992 to $21.5 million in 1997. And private equity investors, eager to fund the next Netscape or Yahoo -- and either forgetful of or undaunted by the well-publicized failures of companies like General Magic, 3DO, and MicroUnity -- continue to funnel money down the levels of Kaplan's pyramid.
Having emerged victorious from their own startup wars, companies like Cisco, Intel, and Microsoft recognize the threat posed by nimble young companies getting technologies to market at unimaginable speeds. And they're willing to pay extremely high premiums to protect their franchises. "There's no question that prices are higher for these companies, but we are sometimes best served acquiring technologies no matter what the price," says Greg Maffei, chief financial officer of Microsoft, which famously doled out $425 million for WebTV and $400 million for Hotmail. "Unfortunately, we can't know if we've overpaid until later." Fortunately for market leaders like Microsoft, however, the fantastic growth they've enjoyed for the past ten years translates into vast amounts of capital to spend.
Because the high-tech aristocracy is so ready to pay up, the days when acquisition was considered failure by venture investors and entrepreneurs are no more. And because acquisition is a more immediate and less complicated payoff than an initial public offering, venture investors and the startups they fund are less inclined to redefine markets. Instead, innovation is focused on the quick returns of intrinsically conservative, but profitable, vertical markets like enterprise resource planning and electronic commerce software, application-specific integrated circuit designs, and competitive local-exchange services -- niche industries that aim to improve existing businesses but are unlikely to result in long-term, autonomous companies. The result is an environment in which startups no longer seek to be the next Cisco, Intel, or Microsoft so much as to be purchased.
Taking the notion to its extreme, Andreessen can imagine a future where technological innovation occurs almost exclusively outside established companies but is nevertheless acquired by them because, as he asserts, "big companies are systematically ineffective at incubating new ideas, and small companies lack the sales and marketing forces to bring new ideas to market." Sweeping as it may seem, his generalization is strongly supported by recent history. Companies that traditionally have been pillars of internal R&D have turned to both venture investing and outright acquisition. "Our investment strategy of the last few years is an explicit acknowledgment that Microsoft has no great lock on innovative ideas," says Maffei. Even Lucent Technologies, with 30,000 scientists working at its Bell Labs, has established a $100 million venture fund for emerging technologies and has acquired more than ten companies in the last two years.
Does all this mean we will never again see truly transformational technology startups? It would be foolish even to guess. Paul, for one, hopes this is not the case. His lofty ambitions include building a billion-dollar business around his antispam platform, but he recognizes that his company has only just embarked on its journey. "We've got the right talent, the right investors, and the right partners," he says. "Now we've got to get our product out there as soon as possible."
Andreessen points out that nobody could have predicted the transformational products of the past. "Timing is such an important factor that it's almost impossible to start a company with the intention of creating a new market," he argues. "At their geneses, nobody could have guessed that Cisco, Intel, or Microsoft would be the next great thing." But as Netscape has discovered, toppling market leaders is even harder these days because of the oligopolies that exist in now-mature technology sectors. (For a closer look at Netscape's difficulties, see "Balancing Act.")
Count on nothing
Whether Bright Light succeeds as an independent company is as uncertain as how the private equity market will evolve. The concerns that venture investors are voicing echo the worries that have plagued the public equity market for years: many fear that the current investing mania will inevitably lead to shrinking returns. The industry consensus is that venture returns may have already peaked.
But as the adage goes, "Markets climb a wall of worry." As long as there is concern, the market will likely keep going up, venture capital in its many forms will continue to flow, and startups like Bright Light will have the luxury of working outside the garage.