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Venturing onto the Internet
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August 27, 1999: 6:50 a.m. ET
Funding from the top venture capital firms often results in dot-com success
By Staff Writer John Frederick Moore
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NEW YORK (CNNfn) - The Internet revolution may not be televised, but it is heavily subsidized.
Try to forget, just for a few minutes, all the talk about paradigm shifts and new technologies tearing down borders and consider the harsh reality: Creating a flourishing Internet business requires cold, hard cash. Indeed, one would be hard pressed to find a successful Internet firm -- by Wall Street standards, at least -- that hasn't received funding from at least one big-name venture capitalist.
And as cyberspace continues to expand as rapidly as outer space, the amount of money flowing through Internet startups continues to soar.
Internet-related companies garnered $3.8 billion in venture-capital funding in the second quarter, up from $947 million in the year-earlier period and half of the $7.67 billion recorded for the entire funding industry -- Internet and non-Internet firms alike.
Internet companies on average raised $9.2 million in funding, compared with $7.84 million in the first quarter.
More and more, venture capitalists are showing the money to Internet companies. Just as critical, however, are the intangibles venture-capital firms bring to the table.
Street cred
Aside from massive amounts of cash, big-name venture capital firms -- such as CMGI (CMGI), Paul Allen's Vulcan Ventures and Kleiner Perkins Caufield & Byers -- add an instant layer of credibility to Internet startups that may later want to make themselves attractive to the average Wall Street investor as a publicly traded company.
A professional investor throwing money at a small company is practically an instant stamp of approval for that firm's chances of success. That kind of endorsement is especially important when it comes to Internet firms, since everyone and their semi-literate half brothers seem to have some kind of online business they're ready to take public these days.
"There were about 125 IPOs through July this year, and there was a lot of chaff in that group," said Paul Cook, portfolio manager of the NetNet Fund. "Venture capital backing identifies the companies with worthy investors who have already taken a piece in it."
"It's not an absolute lock that you need venture funding to find success on Wall Street, but the road is paved a lot more smoothly," said Jesse Reyes, managing director of Venture Economics, a unit of Thomson Financial Securities Data that tracks the venture capital industry.
The most prestigious name in the bunch is Kleiner Perkins, which has established a reputation as the Michael Jordan of venture capital firms. Among the Internet firms that were able to collect much-needed spending money from the firm in their infancy were America Online Inc. (AOL) and Amazon.com Inc. (AMZN).
More than the money, investors favor Internet firms with venture backing because of the extras venture capital firms bring to the table. Having a firm such as Kleiner Perkins in your corner adds value beyond an investment in an Internet firm ready to go public.
"It's not just the money; it's the brand name and connections venture capital firms have with other companies in the industry," said Kirk Walden, PricewaterhouseCoopers national director of venture capital research.
"If you're looking to get $10 million in a first round of funding, and you need a chief financial officer, these guys can help find someone for you."
In cases like this, a venture capital firm will often make two bids on an Internet startup.
"They may come to a company with an offer for a $15 million investment with the current management team, and they may offer $20 million if the company takes on the CFO the venture firm wants," Cook said.
The venture capital firms that provide these sort of services are also known as incubators -- companies that nurture fresh, young startups until they're ready to walk on their own two feet.
"Incubator firms can add a lot of value because they can open up other sources of revenue and create strategic alliances" through their other investments, Cook said. "That's why CMGI has been so successful."
"These are not passive investors," Reyes said. "These companies are actively involved in [Internet startups'] management portfolio."
Internet time
Companies typically scrounge around for venture-capital funding in two phases: startup and expansion. Way back when -- in the 1980s, that is - capital for expansion was as important as securing funding for helping businesses get off the ground.
But times, as the saying goes, have changed.
"The early stage of financing and getting off to a good start" has become paramount, Reyes said. "Ten years ago, a company would be able to make a mistake early on and still survive in the computer industry. That's not the case now. The window of opportunity closes much more quickly in Internet time. Coming out of the gate quickly seems to be the order of the day."
It's not just a matter of how well a company executes its business strategy, but how quickly. Speed is especially important when it comes time to reach for the Holy Grail: the IPO.
Being the first company to penetrate a given industry segment is critical to success as a new publicly traded company.
"As recently as three years ago, the natural progression from seed to exit [either IPO or acquisition] was three to five years," Walden said. "That window is now 18 to 36 months. Companies can get to market faster and they have the money to do it."
From a money manager's perspective, however, funding during a company's expansion phase is often a better guide to what will make a potentially good investment when an Internet firm begins trading publicly.
According to Cook, many of the less-desirable startups will have disappeared from radar by the time a venture capital firm decides to fund a company's business expansion.
"As an investor, I'm concerned with the later phase," Cook said. "There's a higher level of commitment from the venture capital firm by then."
But not all Internet firms that seek funding view it as a springboard to success as a publicly traded company.
Of the approximately 5,000 companies that have received venture capital financing over the past five years, only about 400 of them -- or 8 percent -- have gone public, according to Reyes.
Often, financial backing is the key to a strong exit strategy -- that is, being acquired by a larger, more established firm. That suits the financial backers just fine, too.
Case in point: Cisco Systems Inc. (CSCO) on Thursday acquired closely held Cerent Corp. for $6.9 billion in stock -- this for a firm has recorded only $10 million in sales in the 2-1/2 years it has been in business.
Kleiner Perkins, by the way, had invested $8 million for a 30.8-percent stake in Cerent, a stake that is now worth approximately $2.1 billion.
"There are a lot of companies, especially business-to-business Internet backbone companies, that never go public," said Walden. "These companies will often be bought by Cisco and Microsoft (MSFT) -- at a very handsome return, at that."
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