The New Reality Featured

9:37am EDT July 22, 2002

If you want to start a company that will attract venture capital funding, make it a dot-com.

Sage advice if you found yourself in 1999 carrying the proverbial pick and shovel into the whirlwind gold rush that was the Internet. But that was then.

At the time, you could dazzle the world with little more than unabashed gumption and a great idea to sell books or vitamins or health advice or even virtual women's communities to the world while almost thumbing your nose at conventional business.

But they seemed to forget a seemingly minor detail called revenue. And profitability.

Wall Street didn't, though, and many of those high-flying companies, whose valuations once transcended reason, have been taking it on the chin ever since. The whole Internet space, as the techies call it, has ventured at least part way back to Earth.

Now, an e-future seems to be emerging that is built not on New Economy vs. Old Economy, but rather on a reasonable partnership between the two that embraces new business paradigms while acknowledging the strength of good, old-fashioned relationships and other traditional business fundamentals. The driver behind much of this New Reality? The venture capital community itself.

"There's no use trying to be the 23rd pet food site," says David Whitmore, managing partner of Highgate Ventures (formerly i-Gate Ventures), a venture capital fund that spun out of i-Gate Capital (formerly Mastech). "The business-to-consumer market is not the place to be."

Gold rush temptations

Whitmore, who runs the $75 million venture fund from Westport, Conn., admits he was tempted -- if ever so briefly -- by the mad gold rush last year as he watched company valuations temporarily skyrocket.

"I was very envious," he says, laughing only because he didn't yield to such temptation. "It seemed that, with the right management team and story, you could go public and make a lot of money on paper."

The key phrase, of course is "on paper," because many of those high-net-worth entrepreneurs eventually watched as stock prices -- and their net worth -- dropped from, say, $40 a share to little more than $1, in some cases, virtually overnight.

Sean Sabastian, managing principal of Birchmere Investments and general partner of its Birchmere Ventures II venture capital fund, puts the valuation adjustment into perspective: "Until they're at break-even, they're not really a company. They're just spending other people's money."

Thanks, but no ...

That hasn't stopped start-ups from trying to raise huge amounts of capital, however. But when they approach Sabastian, he has a thing or two to say.

"Thanks, but no thanks," he says. "We've walked away from more opportunities on valuation. We try to maintain a rationality, and we try to stay away from the froth."

His advice to such firms in this New Reality environment: "Get real, pretty bluntly."

Sabastian is in a pretty good position to say that. His firm's first venture fund, funded by steel company magnate Richard Simmons, chose an early winner in FreeMarkets Inc., even with the company's dramatic drop in stock price after losing General Motors as a customer.

Recently, Birchmere teamed up with the principals of local venture capital veteran CEO Venture Fund to create the Birchmere Ventures II, a $75 million fund that plans to invest upwards of $5 million per investment -- and not all in Internet companies.

A marketing investment?

At the recently established Pittsburgh operation of Silicon Valley-based Redleaf Group, Doug Goodall, senior director of the Pittsburgh investment team, offers a similar observation, particularly when it comes to the business-to-consumer market.

"What we discovered was that, from a technological innovation standpoint, not much was going on" in many of last year's much-hyped B-to-C market, says Goodall, who recently joined Redleaf after spending the previous 18 months overseeing the establishment of the state-funded InnovationWorks, which funds high-tech start-ups. "It had to do with the percentage of dollars needed to invest in technology vs. TV ads and marketing.

"We started seeing companies spend 10 cents of every dollar on technology and 90 cents of every dollar on marketing. It was a pure marketing play."

Goodall adds that many of the start-ups played a rather dangerous game of "trying to steal consumers from one channel to another." But, he stresses, "the next thing they needed to do was keep them.

"We call it the 'dot-wall' category because these were the technologists who ignored business fundamentals," Goodall says. "If there's a digital highway, there's also digital roadkill."

Internet infrastructures

So what do these Internet-oriented venture capitalists really want as the New Economy high-tech market goes back to bring the Old Economy into this hybrid New Reality?

"Core technologies," Goodall explains.

While there's no denying that Redleaf targets Internet-oriented companies, it's looking for early-stage technology applications in the business-to-business space that provide infrastructure support to a business -- support that doesn't necessarily discard traditional business practices but which enhance them or make them more efficient.

For example, Goodall says, Redleaf is interested in Auction engines targeting specific industries which enhance current supply-chain channels rather than replace them. Case in point is one of its recent investments, a company called FurndX in North Carolina.

It's a commerce exchange for the furniture industry that matches the supply side of the business to the raw component side, "making the existing channel more efficient. It's the second generation of e-commerce. It has to blend new technologies with other parts of the team, and it can't be that disruptive" to business relationships and other traditional fundamentals, Goodall says. "We like it the old-fashioned way."

In other words, "Our goal is speed to revenue, with profitability right behind. It used to be just speed to market."

Redleaf, which seems to approach the investment game differently than most venture firms, is seeking some of that infrastructure technology at the earliest of embryonic stages in some cases. In fact, Redleaf has just struck a partnership with the University of Pennsylvania's Wharton School of Business to serve almost as a technology transfer center whose aim is to quickly commercialize the most promising of technologies coming out of academia.

Asked about rumors that Redleaf may be working on a similar arrangement with Carnegie Mellon University, Goodall declines to comment.

So far, Goodall says, Redleaf has available an estimated $203 million for investment globally, although the firm plans to raise another $400 million in a second round in the near future. It typically will invest between $3 million and $5 million in start-up ventures.

And by the end of the year, the firm hopes to aggressively search for attractive deals via as many as 12 offices globally. It currently has nine offices from coast to coast.

Highly differentiated

Birchmere Ventures likewise is aiming its financial muscle at B-to-B technologies which are "highly differentiated" in their respective industries, Birchmere's Sabastian says.

"We want companies where the managers exhibit deep domain knowledge."

The firm also is looking for earlier stage companies with the potential to return at least 10 times the value of its initial investment. However, depending on the situation and risk factors, Sabastian says, Birchmere will consider those with the potential to earn the firm as little as two times to as much as 20 times its initial investment.

At Highgate Ventures, David Whitmore says the venture fund has always focused on Internet infrastructure development companies and services. He is most interested in start-ups "where the Internet is viewed as another channel, another business strategy."

He mentions wireless/mobile telecommunication investments, as well as companies developing Web-driven voice recognition systems in terms of infrastructure "plays," as he calls them. Whitmore is also interested in application service providers (ASPs) that develop open-source software platforms that allow businesses to use the Internet as simply another tool to do business more efficiently both internally and externally.

Quick to cash-flow positive

Whitmore expects his investments to break even on a cash flow basis within roughly 18 months of the investment.

"They need to become cash-flow positive relatively quickly," he says.

Since March of this year, the fund has invested roughly $14 million in six start-ups, with another 18 opportunities in the pipeline for capital. Meanwhile, Whitmore and his partners in Pittsburgh, San Francisco and Portland, Ore., have reviewed at least 500 plans. The firm is moving forward with plans to raise $150 million for yet another venture fund to tap into the opportunities available.

Says Whitmore, "We really have a lot of opportunities." How to reach: Birchmere Ventures, (412) 803-8000; Redleaf Group, (412) 201-5600; Highgate Ventures, (203) 221-7747

Daniel Bates (dbates@sbnnet.com) is editor of SBN.