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shaking the moneytree 3: Q1/2000

has the bubble burst?  

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the rise of the corporations

Mr. Ayers:  In each quarter that we do the survey, new things bubble to the top, such as new trends and new issues which start to emerge.  Let's take a look at corporate funds.  A lot of entrepreneurs are coming to us, and I'm sure they approach you, as well, with questions about corporate investments, such as, “What does it means when a strategic corporate investor approaches you?”  Our survey has begun to track this sort of investment activity.

          Can you give the audience your take on this, and what appears to be, at least from our survey, increased activity?  Do you find yourselves competing or cooperating with these investors for deals?

Mr. Kerins:  First of all, you have to realize that there’s a real spectrum of ways in which these companies approach investments.  We have a couple of portfolio companies that have gone a pretty long way toward negotiating a potential equity investment with Microsoft.  Microsoft is very blunt about their desire that every product in your firm will be Microsoft, that every product you sell will be NT-based, that every server you have will be NT-based and that what they are all about, really, is trying to use their equity dollars to further infuse their market share in venture-type backed companies.  They have a lower market share there than they do in the Fortune 1000.  In our view, having negotiated with them, that is their primary objective more than having returns.  Having also dealt with the people at WorldCom Ventures, they are more on the other end of the spectrum.  They understand that it's a competitive world.  They would like to offer you services, but they are more interested in return, visibility and what's happening in the market so that they can better tailor their offerings in the future.  AOL seems to be in the middle in negotiations we have been involved with them.  They approach some deals on a return-oriented basis, others in a way that has more strategic linkages with AOL.  That often creates some limits and problems for the companies in which they want to invest, because they want to exclude a whole list of corporate “bad guy” competitors they have from doing business with the company.  That can be a problem.

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          In general, almost all of the VCs in this region take the view with one another of more cooperation than competition.  When the corporate investors have come into this region, they found that, and we have tended to deal with them in an open, cooperative way.  Where they have fallen down¾and I would say that I have spent much more time negotiating with these firms than closing¾is that they're corporations and they have corporate needs.  What an entrepreneur and the board of directors of an entrepreneurial company have to worry about is that their investment contracts come with their own sets of terms, such as rights of first refusal, options to buy more stock and corporate “bad guy” lists with whom you can't do business.  The technology markets are very unpredictable.  You just don't know whether it make sense for you not to license your software to Yahoo! at this stage in the game, which is something that finds its way, occasionally, into an AOL contract.

          We found entrepreneurs spending lots of time with these guys, closing deals with partners who are interested in return, in growing the equity value of the company and in the same things as the entrepreneur and the VCs care about.  We have found more trouble and less closing going on in the corporate funds that are more interested in the strategic needs of the corporations that are sponsoring them.

Ms. Abramson:  I totally agree with Pat.  A cautionary word to entrepreneurs is that they have to be very careful and know what they are getting.  I look at this as more money on the table, more money into the pot, but, as Pat says, corporations have different agendas.  Often it's just an investment; other times it's a strategic move.  Because Intel invests in your company early doesn't mean it's going to invest in the next round or the next.  Often they are seeding a bunch of deals and won’t necessarily do it the next time around.  Generally, a venture fund that makes a decision to invest is planning to invest the next time.

          From the point of view of an entrepreneur, you need to know what you have, what the corporation wants to do with you and what kind of relationship you’ll have going forward.  We are in deals with Motorola and another with AOL.  We continue to do them and want to do them, but, from the entrepreneur's point of view, it isn't just getting a strategic investment, and that's what they need to be wary of.

Mr. Walker:  This is clearly a good/bad kind of situation.  First of all, it's money, and that's good.  Sometimes it's crucial.  But it comes with a price, as we have already heard.  If you are really trying to build a business that wants to be ambivalent towards any particular company, when you get an investment from one company you may have just lost other investors and some other customers.  You have to weigh that.  It's a significant price.  It's money, and that's good, but sometimes it's too much money or it's money at too high a valuation.

          We have seen a situation where a strategic investor has come in and they don't really care or are not aware of the valuation for that level of company.  That's great for right now because you are going to get good money for a relatively small piece of your company, but the next time you need money, if that partner isn't there to pay you that same high valuation, you are going to have to compete with everybody else.  In many cases, we have had deals that are very hard to work because the valuation was too high too early.  This doesn't just happen with strategic partners, it happens with angels and others.  You have to be wary of taking too much money too fast.

          A great thing about strategic partners is that, let's face it, even before the last gazunk, most companies don't go public.  Most companies don't do an IPO; they get acquired.  A lot of companies that do go public get acquired.  Strategic partners can be incredibly valuable as you move toward that kind of an exit.  Most of the companies we are talking about, here, are companies that are proving a technology or an idea that the big guys don't have the energy or the resources to try.  What makes this successful is that there are big guys out there who are willing to buy them.  Strategic partnerships, and here I'm talking more about the later stages in the development of a company, can be critical to the final exit strategy for that company.  Indeed, if nobody at an industrial level is interested in investing in you, you may get so far and then just dry up.  There is good and bad here, and you have to be very careful which of these you take, but don't be afraid to take one just because there are some down sides.

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on incubators

Mr. Ayers:  Another hot topic that's been popping up increasingly is incubators.  I have a running list in my office where I write down the different new incubators I hear about.  They are popping up so fast that I can't type them into a spreadsheet.  Additionally, many of these incubators are now coupled with substantial investment funds.  In the Los Angeles market for Q1/2000, for example, IdeaLab was the most active local investor.

          How do you view the role of local incubators here in the DC market?

Mr. Walker:  I think this is a great place for them, although I don't know how many of them there can be.  Most of the companies we have invested in have not been through the incubator process.  There are a lot of companies that are making it without having to physically be located somewhere.  That's nothing against incubators, however, because they are doing a very useful thing for some very, very early stage companies.

          I'm a little concerned about how many there are because there are only so many people who can come to a particular place.  If you have one in downtown Baltimore, you are not going to attract somebody from Northern Virginia or southern Maryland, so you are going to be able to serve just the community around you.  This is great stuff, though, and I encourage it to happen.  You don't want to get the company too dependent upon being at that incubator, however.  I’ve talked to a lot of people running incubators and they get into a situation where they don't know how to tell the people to leave.  You have a two-year term, but it's a cozy situation, so you want to keep it going.  That's a problem.  Don't become so dependent upon the support you get that you can't survive on your own in the real world.  Eventually, you are going to have to go.

Mr. Kerins:  I can't see any negatives to incubators, generally speaking.  There does appear to be a real proliferation of them.  I think that we tend to pay more attention to those that have investment funds associated with them.  It adds a certain discipline and ability to keep score about how well they are doing that is consistent with our goals, so we pay more attention to the incubators that have investment funds associated with them, as opposed to the ones that only provide real estate and corporate services for equity.  I think there will be a shakeout in the number of them in this region, and that will be fine.  They’re a great source of deals for later stage VCs.

Mr. Ayers:  I think we are already starting to see some consolidation among incubators.

Ms. Abramson:  You need to look at incubator in a looser term than that, because “incubator” has come to mean a variety of things.  It's an “accelerator” as companies like Andersen and McKinsey are using them, or a “virtual incubator,” the way Steve works with his portfolio companies.

          What is important for an entrepreneur is are they investing, and what is the caliber of the people who are helping you?  There are a lot of incubators and virtual incubators out there, as well as a series of preferred providers working together who say that they are going to incubate you.  Who are these people and what kind of experience do they really have?  Have they grown businesses?  We looked at a company in Philadelphia, recently, and met somebody from an incubator in Texas.  He said, “We are making an investment in this company and then we are going to incubate them.”  We asked, “With whom?”  And he said, “We're going to hire some people to do it.”  This company is giving a share of itself to this incubator for some people who have yet to be hired.  The entrepreneur really needs to look hard at who they are getting, what they are going to provide, how much time and what they are giving up.

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deals, deals, deals

Mr. Ayers:  I want to take a look at some of the deals that the panelists have done recently.

          In Q1/2000, Steve, you invested in  With the increased scrutiny surrounding pure content plays, tell us what differentiated and what the future holds for the company?

Mr. Walker:  What distinguishes from most other companies, and this is true of a lot of our investments, is that Ellen Haas is going to make that happen.  She is incredible.  She was the Undersecretary of Agriculture for Food & Nutrition Programs.  She can pick up the phone and call any food or agriculture-related company in the country and get the call answered by the CEO.  She can get in and have meetings, and she has done an incredible job of getting the attention of major companies.  We gave her an early round of funding, and we are putting together a second round that will have two significant strategic partners.  Unlike the comments I made a few minutes ago, these are strategic partners that are going to do incredible things for her.  You are going to see “” on food packaging.  A few weeks ago, in your Sunday paper, you got that regular bunch of advertisements, and was there because of deals that Ellen has put together.

          The deal reminds me of Zona Financiera.  I put Ellen in the same class as Zona’s founders Gregg Kehoe and his brother.  When they first came to see us, we gave them $100,000 on Christmas Eve, 1998.  They closed a round in March for $30 million at $65 million pre-money.  It’s a spectacular success.  I remember that I introduced Zona to Pat back in March of 1999.  He came back to me a couple of days later, after struggling, and said, “It's too small.”  Then they closed a round in July of last year and were going for a larger round.  When I saw Pat this fall, he said, “It's too big.”

Mr. Kerins:  There was a day in there when I wouldn't have done that.

Mr. Walker:  It's like when you grow zucchini.  There is about a 15-minute period at 2:00 in the morning in July when the zucchini is the right size.  First it's real tiny, then it's a baseball bat.  You have to get it at just the right moment.

Mr. Ayers:  With that, Pat, what made the deal so attractive to Grotech?  You recently led a multi-million dollar investment in the company.

Mr. Kerins:  Steve makes a good point.  We have invested in a lot of deals that have worked out, and a lot that haven't, but we've never invested in one that turned out exactly like everyone thought it would.  What venture capitalists really look for are groups of people who you end up believing will lead you through the inevitable twists and turns of whatever the business faces, like Patrick and Alain Hanash, the brothers who founded Multicity.  Multicity is an Internet infrastructure company that allows for a number of very interesting applications, such as realtime downloadable chat; instantaneous chat in translation to some 20 languages; the ability to embed chat functionality in email; and some other technologies that are part of the platform.  They are an interesting pair of brothers, one technical, one sort of sales/marketing/financially-oriented, and we just ended up believing in them.  We think it's a big idea.  We think that they have a lot of what it is going to take to attract the right team around them.  This was $50 million in a zero revenue company with about a dozen people, so it was intended to be a real “go for the fences” idea.  Thus far, we have been pleased with what they have accomplished, which is mostly in the team bidding and technology building phases.

Mr. Ayers:  Patty, you recently invested in a company call Cylex, a medical diagnostics company. I had the pleasure of meeting the CEO of that company, and I can see why you invested.  She is a real leader.  Most of the region's venture funds have not been active in formative stage life sciences companies.

          What made the Cylex opportunity so special for your fund?

Ms. Abramson:  I think that every six months or so we should write down what we say we are going to invest in, then look at what we do invest in.

          We always said that we'd invest in later stage companies.  We have a very diverse portfolio because our focus is investing in women-led companies.  That forces us to look outside the narrower focus of some other VCs.  This is a very different kind of investment for us because it is very early.  We were tremendously impressed with Judy Brit, the CEO.  It is an early stage company with a diagnostic tool that uses chemical luminescence for assessment of the immune system.  It was originally developed as an HIV diagnostic but it has turned out to be a platform technology which is applicable in a wide range of situations where you have donors, implants, etc.  We see it as getting early revenues from the research community, although it is obviously one that will be slower to realize those revenues.  On the other hand, it was a very, very low valuation, and we went in with some other players.  It is a company that uses its money very well and very slowly, so we decided we wanted it in our portfolio.  Most of us tend to invest in the entrepreneur.  We invest in the technology, but we also invest in the management team.  It is an aberration in our portfolio, but one that we are excited about.


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