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The gods of capitalism
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August 29, 2000: 6:05 a.m. ET
Redpoint Ventures explains why making five times your money isn't enough
By Staff Writer David Kleinbard
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NEW YORK (CNNfn) - For the Gods of capitalism, Mount Olympus is a series of two-story wood shingled office buildings located on an arid patch of land called Sand Hill Road just a few miles from Stanford University and the ultra-wealthy enclaves of Woodside and Atherton, California.
From the outside, the Sand Hill Road complex resembles a 1970s office park. It looks like a place where people go to get their teeth cleaned, rather than to request millions of dollars in funding for new ventures that may one day become the mainstays on the Nasdaq.
Everyone who is anyone in the world of West Coast venture capital is located within a few buildings on Sand Hill Road. The venerable Kleiner Perkins Caufield & Byers is there, as are Mohr, Davidow Ventures, Sequoia Capital, Benchmark Capital, Brentwood, New Enterprise Associates, and U.S. Venture Partners.
The inhabitants of Sand Hill Road, when combined with a few firms in nearby Palo Alto, have more than $22 billion under management. While $22 billion is a drop in the bucket compared to what mutual fund companies like Fidelity and Vanguard manage, it's a Fort Knox for nascent private companies looking for the $10 million that will get them off the ground.
The Gods of capitalism are few in number. The top 10 West Coast venture capital firms combined have a total of about 100 partners. You are more likely to make it as a professional basketball player in the NBA than to be a top-tier venture capitalist, which helps explain why a talented VC can become richer than his counterpart in professional sports.
The VCs can give life to a startup that consists of little more than a business plan and a management team. If they fund a company, it could eventually sport a multi-billion dollar market cap; if they don't, the company's ideas and technology may die on the vine.
A newcomer to the field
Redpoint Ventures, based at 3000 Sand Hill Road, is a relative newcomer to Mount Olympus. The firm was founded in the fall of 1999 by three partners each from Institutional Venture Partners and Brentwood Venture Capital, two of the top 10 Silicon Valley venture outfits. Both Brentwood and IVP were evenly divided between early stage Internet and healthcare investing. To achieve greater scale and depth, the two firms merged their Internet investing operations to form Redpoint and their healthcare operations to form Versant Ventures.
Unlike the dark mahogany paneling favored by some of the older, more traditional VC firms, Redpoint's offices are an open, airy architecture of light woods, metal and glass. They are decorated with antique lithographs of San Francisco and meticulously crafted model trains. A model steam engine near the front entrance is one of two that were built - the other is in the Smithsonian. Redpoint's partners believe that the Internet is to the 21st century what steam engines and railroads were to the 19th and 20th. The models are their way of paying tribute to the past drivers of the Industrial Revolution.
Another item on display in the entranceway is a four-foot painting of a $1,000 bill with charred edges. The artwork, called "Burn Rate" reminds both the venture capitalists and entrepreneurs that startups burn cash fast.
Focus: Internet infrastructure, commerce
Redpoint focuses on Internet infrastructure, business-to-consumer and business-to-business Web companies, and Internet content plays. Most people have never heard of the companies in their current portfolio because they are still small and privately held. They include BizBuyer.com, Calix Networks, eNet, ePeople, HelloBrain.com, Internet Machines, Music Match, Rapid5 Networks, and Responsys.com.
However, many of the previous investments made by Redpoint partners have since become household names in the tech field, including 3Com, Ask Jeeves, Excite, Foundry Networks, Juniper Networks and TiVo. Several ventures that originated with Redpoint partners have since been acquired by industry giants such as Cisco Systems, Nortel Networks, and Microsoft.
Unlike mutual funds and asset management accounts where investors can redeem their holdings at any time, venture capital investors need to be long-term players. Like most VC firms, Redpoint invests through 10-year partnerships where the firm is the general partner and outside investors are limited partners. Redpoint invests money in startups for the first three years of a partnership's life and spends the remaining seven years managing and liquidating them. Because investments in small, private companies are illiquid, this is not a business for investors looking for quick turnaround.
Putting $2 billion to work
Because Redpoint partners are well known to institutional investors through their previous work at Brentwood and IVP, Redpoint has been able to raise almost $2 billion in less than a year. In the past, that was more than most venture capitalists could manage effectively. Because VC investing is very hands on and labor intensive, firms in the industry generally don't want to manage more than 50 investments at any given time. However, limiting $2 billion in capital to, let's say, 40 investments, means having an average of $50 million in each company - a large sum by VC standards.
"The amount of money it takes to get a company to the IPO stage is larger than it used to be," said Redpoint partner Tom Dyal, who came from IVP and has nine years of experience in data communications and networking. "It used to be a $2-$3 million initial investment and $8-10 million over the life of the company. Now it's more like $15 to $25 million over the life of the company."
Today's Internet startups are raising large sums and spending money like water to grow aggressively. Any newcomer to the field has to be able to match the spending power and hyper-growth rates of its competitors.
Venture firms used to share risk and reduce their exposure to individual investments by syndicating parts of each deal to other VC firms. However, syndication is much less common now, which has increased the average investment a VC fund needs to make in a startup and also increased the industry's overall risk level.
A homerun business
Venture capitalists aren't satisfied with market rates of return. To justify the hard work and above-average level of risk associated with VC investing, they need to post returns that leave the benchmark S&P 500 index in the dust. That requirement leads Dyal to an explanation of VC rate-of-return math.
"If we have a $1.25 billion fund, it has to return at least $5 billion to the investors at the end of the 10-year period to be considered successful. So, if we invest in 50 companies, each one has to have an average carrying value of $100 million. If we put $15 million into a company, it has to rise in value to about $100 million just to carry its weight within the portfolio."
"We turn down a lot of good investments where we could make three-to-five times our money with relative certainty. Instead, we need to have higher-risk investments with higher potential outcomes to move the needle within a $1.25 billion fund," said Redpoint partner Jeff Brody, who came to Redpoint from Brentwood, where he started in 1994.
While it would be tempting for one of the partners to invest his own personal money in one of those three-to-five times your money deals, ethical restrictions prevent them from investing in a company that the fund has turned down.
"This has increasingly become a 'homerun' business," Dyal said. While there is no precise definition of when an investment becomes a 'homerun,' Dyal says that a $20 million investment would have to grow to between $500 million and $1 billion to deserve that label. The Redpoint partners aim to have two-to-three homeruns out of each 40 companies they fund.
Perhaps the ultimate homerun in the history of Silicon Valley venture capital was Sequoia's $1 million investment in Yahoo! in 1995 in return for a 25 percent stake in the Web portal company. After Yahoo! went public, the value of that $1 million investment grew to nearly $8 billion by early 1999. Investments like that make entire careers.
Irrationality fed irrationality
Dyal and Brody are funding Internet startups at a time when many business-to-consumer Web stocks have fallen 90 percent from their highs. Consumer-oriented Web stocks initially tripled and quadrupled in the months following their IPOs, only to come crashing down when the supply of new capital for those young companies dried up. Many Web companies should never have risen to such high valuations to begin with, Brody said.
"Irrationality fed irrationality," he said. "Many of these businesses were founded on the basis that they would need to raise $150 million to $200 million to become profitable; when sources of additional funding dried up, there was a risk they would never reach profitability."
After a period of being willing to fund any Harvard or Stanford MBA with a bright idea and a good management team, the venture capital industry has "gotten back to basics," Brody said.
"That means technology as a differentiator and companies led by people who were born out of the industry that their startup is going into," he said. Thus, Redpoint is not likely to fund a Harvard MBA McKinsey & Co. consultant who wants to start a company that sells plumbing parts over the Internet. However, the firm might fund the same concept led by an executive with 20 years of experience in the plumbing parts industry and a new technology for selling those parts.
20,000 business plans a year
Redpoint's tough standards for what constitutes a good investment don't stop a lot of people from asking for a few million dollars of their money. Redpoint will receive about 20,000 business plans in the mail this year, of which about 16,000 are unsolicited. The other 4,000 come from personal referrals made by the friends and associates of Redpoint's partners. Of those 20,000 business plans, only about 40 will get funded - or one fifth of one percent.
In other words, a typical entrepreneur's odds of getting funded by Redpoint are about equal to those of him finding a $100 bill lying on the streets of Midtown Manhattan.
Redpoint's partners will meet with about 2,000 companies of the 20,000 that contact them each year. The firm will decide to do follow-up investigations on about 500 of those 2,000 that are lucky enough to get one hour in Redpoint's conference room.
"If you look back at the companies we decide to fund, we generally felt really excited about them right after that first meeting," Dyal said. "While we might find a reason not to invest after doing more research, it's rare for us to fund a company we were ambivalent about after that initial contact."
Get a recommendation, make a simple pitch
Dyal strongly advises potential entrepreneurs to get a recommendation from a person known to a venture firm's partners, rather than sending in an unsolicited business plan. Redpoint likes to get referrals from executives at Silicon Valley's major tech firms - both because those executives act as filters and because a referral can lead to a deal where Redpoint is not in competition with other VCs to fund the startup.
"A good business shouldn't take more than an hour to explain," Dyal advises. "Also, you have to convince us why now is the right time for this investment and why this management team is well-suited for the job."
"If a venture could have been done three years ago and wasn't, that tells you something about the concept," Dyal continued. "If people approach us with a technology that's five years away, that's too early. On the other hand, if it's going to hit the market in the next quarter, that's too late. You need to hit that 18-24 month timeframe."
Despite the high cost of living in the San Francisco-San Jose area (the median home price in Atherton is $1 million), the dismally low odds of being funded by a top-tier venture fund, the intense competition from other Internet companies, and the high failure rates of dot.coms, people keep moving to the Valley in the hopes of forming the next Amazon or Yahoo!
"There is a gold rush going on out there like the one in 1849 and everyone is afraid of not being part of it," Dyal said. "No one wants to say that they took an extended vacation then." 
-- Click here to send e-mail to David Kleinbard
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