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Sign of a Top: A VC Fund for Jocks


By Hal Plotkin
CNBC.com Silicon Valley Correspondent

Looking back, it’s always easy to pick out the big milestones in technology investing. The first Hewlett Packard calculator to hit university bookstores, for example, or the creation of the wickedly addictive computer game Pong, or the introduction of Apple Computer’s first point and click user interface, to name but a few.

It looks like we’re at another one of those turning points.

The venture capital IPO gravy train, which has enjoyed an unprecedented bull run, is finally showing signs of running out of steam. It’s a development with some very major implications.

The surest sign of the coming sea change was the recent news that a bunch of mostly-retired athletes led by ex-49er football greats Ronnie Lott and Harris Barton had put together a $150 million dollar athletes-only venture capital fund; minimum buy-in, half a mil. They won’t do the investing themselves, but are placing their money with Silicon Valley’s usual suspects, including the Mayfield Fund, Softbank Venture Capital, Kleiner Perkins Caulfield & Beyers, and New Enterprise Associates.

A bunch of guys who used to bang their heads together for a living figure they can now make some easy bucks as venture capitalists. That’s got to tell you something.

What it tells me is that this era of investing excess in Silicon Valley is finally at an end.

Even before the Nasdaq began its long march downward last spring, seasoned Silicon Valley venture capitalists were saying–only in private, mind you–that things had already gotten out of hand.

Here’s how. Once it became routine for early-stage companies with little operating history and no profits to go public, the venture-capital business went from a system of long-term portfolio investing to a get-rich-quick casino. Instead of nurturing startups for years until they could stand on their feet, and earning healthy 20% to 30% annual returns for their funds, VCs were suddenly able to double their money in as little as a year by selling unformed “New Economy” companies to an eager public market.

Those returns attracted more money than the Valley has ever seen. New venture capital investments swelled to $7.56 billion dollars by the second quarter of 1999, up from roughly $6 billion for all of 1995, according to the National Venture Capital Association (NVCA).

And so the spiral began: Soon, there was way too much money in the venture capital pipeline and far too much competition for the best deals. And the VCs who couldn’t get in on the top deals weren’t about to send the money back to the institutions and wealthy individuals that invest in venture funds. No way.

So, some of the money wound up in deals that probably never should have been funded. “There was lots of financing of flaky ideas,” says Michael Moritz, general partner at Sequoia Capital, the 23-year old Menlo Park-based firm that helped midwife Apple Computer.

That’s how you end up with tens of millions of investor dollars squandered on the likes of Furniture.com, MotherNature.com, and Pets.com, which have simply vanished. Others, such as Priceline.com, Webvan and Healtheon/WebMD have been anything but the solid bets that the investment banks assured the public they would be.

The arrival of the millionaire jocks on the playing field tells me the whistle is about to blow. The smart money has already headed for the showers.

A more conventional barometer–IPO performance–is pointing to a much chillier climate in the Valley, too. Last year, 504 companies went public in the U.S. and through year-end they racked up a huge 191% post-listing gain. This year, only 375 companies had launched IPOs through Oct. 31. And, the average post-IPO gain has fallen to just 15%, according to IPO Monitor. Another omen: In October, fewer than one in five planned IPO’s even made it out of the starting gate.

“For a while there, there was just complete and utter pandemonium,” recalls Moritz, a 15-year veteran who got in on some of the best deals in the Internet, including the $1 million he put behind a couple of college kid named David Filo and Jerry Yang in 1995. That bought 12% of Yahoo, a stake that is now worth north of $3 billion dollars.

By the end of the decade, however, too many investors came to think that all startups were potential Yahoos. “It was very easy to get caught up in the belief that no hill was too high to conquer. It led to some very questionable business propositions and some implausible companies,” says Moritz.

“It was something of a mass delusion,” agrees George Zachary, general partner at Mohr, Davidow Ventures, also based in Menlo Park. Zachary helped take Critical Path {CPTH} Inc. and Accrue Software Inc. {ACRU} public, among others.

“We had people shamelessly stating that we were in an entirely new economy,” he says. “Everyone was amplifying each other. The only trouble with that is, we’re not in a new economy.”

Not that new companies with great new ideas won’t continue to come out of the Valley. But they will have to master the nuts and bolts of the old economy, like finding ways to sell stuff for more than it costs them to supply it.

There’s good news for investors in Silicon Valley’s looming return to normalcy. That’s because the average investor stands a much better chance when choosing among companies that come to market only after they have proven they can actually deliver revenue and earnings growth. There may be less potential for the giddy highs that last year’s hype-driven, flavor-of-the-month IPOs provided, but there’s also a lot less risk of a painful hangover.

After all, even school kids know that a tortoise with earnings can usually beat a hyped up cash-burning hare in a race of any real distance.

The other good news is that the IPO slowdown is forcing venture capital firms to rededicate themselves to the more important work of building profitable, lasting businesses rather than scrambling to keep up with a bloated portfolio of short-term, get-in-get-out investment vehicles.

Nurturing small companies into market leaders after their IPOs is, after all, how the real VC fortunes were made. Microsoft’s market cap, now about $363 billion, was a chump change $400 million when the company went public in 1986 after 11 years in business. The VCs got similar windfalls from their investments in Oracle and Cisco, and many of the other successful companies that grew their real legs only well after their IPOs.

Unfortunately, it looks like many of today’s post-IPO flops will fold up entirely without ever getting much of a chance to grow legs. Sometimes a flawed business plan is to blame. In other cases, the VCs will say they’re having trouble finding the management they need to take those companies to the next level. That may all be true. But the there is another factor for which VCs must take responsibility: Many of these flagging firms should never have been funded in the first place.

That’s why the athletes might want to reconsider dabbling in the world of venture capital just now. For the time being, they’d probably be better off sticking with stuff they know, such as pooling their hard earned dough to buy a sports franchise or something like that.

After all, sports franchises are usually worth at least something after a few losing seasons. The athletes may soon find out how much less forgiving the sport of venture capital can be.

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