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shaking the moneytree Q3/2000

what goes up . . .

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on the herd mentality

Mr. Ayres:  Some people would argue that many investors tend to follow the herd when it comes to making investments.  It’s that Gretzky quote everybody hears, “Investing where the puck is versus investing where the puck is going to be.”  However, I'm going to pose another argument, that herd mentality investing is not always bad.  I'll call it “positive herd mentality investing.”  It creates competition, breeds talent and creates buzz for companies and for regions, so it does have a lot of positive effescts.  I want to take this argument and compare it to a particular industry sector that's starting to show up in our survey, one which a lot of people think has a lot of promise, particularly for Maryland.  When looking at the third quarter, we saw that health care services began to emerge among the most significant investment areas in this region according to the MoneyTree.  We have the National Institutes of Health (NIH) here, as well as Johns Hopkins University, the federal government, lots of labs and even the human genome project in our backyard.  I think NEA has done quite a bit in this field, but do regional investors have the credentials and experience necessary to create “positive herd mentality investing,” particularly in areas such as bioinfomatics and others where the life sciences and IT are beginning to converge?

Ms. King:  We went through a period when a lot of competitors were getting rid of their medical practices; medical partners were retiring, so they ceased investing in the medical field.  At NEA, we made a conscientious decision not to do that.  We have had a strong franchise there for many years and have very experienced partners in that category.  From a portfolio play, we didn't want to get out of the market because you have to stay in a market to have the credentials.  Just jumping into the medical market fresh would be very difficult.  We've stayed in it, and we have seen a lot of promise.  We had nine IPOs this year, and the first four were medical.  The majority of our investments on the East Coast in the last several months have been the medical field.  I think that our firm, as a whole, believes it's a ripe opportunity, especially since a lot of VC firms have gotten out of the market.  We even added a partner in our West Coast office in the medical sector, so we are firm believers.  Again, it's still focusing on the credible deals and on the real companies.

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Mr. Harris:  Space Vest hasn't done much investing in this area, but I guess the larger question is, is there enough knowledge base in this region on the part of the investors to really make a go of it?  I think the answer probably is yes.  NEA has been highly involved, and, to the extent that these companies are really IT-focused companies, there are plenty of interested VC firms.  We just saw Infomax as a local IPO.  Infomax is really an IT company that happens to be very focused on genomics.  You may see the firms that dropped their health care practices revamp and start them up again, if it becomes very, very hot, which it looks like it could.  That's the herd mentality you are talking about.  I don't see SpaceVest starting a big genomics practice, but I'm sure there will be some other firms that start to pour more dollars into that area and allocate more resources to investing in it.

Mr. Biddle:  The joke in the venture business is that when VCs turn 55, they wake up one morning and start to get very concerned about advancing the state of the art in health care.  All of us are under 55, so it's not so important to us.

Ms. King:  I have a lot of partners who are over that.

Mr. Ayres:  Somebody should do a study on it.

          Let me ask you this general question.  Novak Biddle has a big, new fund; you are going to do deals.  You are going to do big deals that have the right factors.  What's keeping you up at night?  What sectors are you afraid you might miss?

Mr. Biddle:  We feel pretty good about where we are.  What really kept us up at night over the last year-and-a-half was that we would under-perform our competition, which was, we thought, doing wacky deals but getting lucky.  I guess that we were afraid they would make more money than us and that the limited partners would say they were better, that we were being wimps.  We really wanted a shakeout so that the business could return to what it used to be, and we have tried to position ourselves to be one of the survivors by being disciplined.  Historically, 10X return funds were unheard of.  One or two a year would get lucky, but a lot of funds have had 10X returns the last few years.  In the current environment, a 2X return on a fund is going to put you way up there, so the key is that our companies get their Series B rounds and stay alive.  A friend of mine who built a Fortune 500 company says that one of the keys to success is “stay alive,” because, if you stay alive long enough, sooner or later you get lucky.  That means getting through the next couple of years with a good brand and with dry powder, not losing our bait on our weak deals and having some wins on our good deals.  That’s exactly what we have been doing.

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on the VC’s money hunt

Mr. Ayres:  Everybody in this room probably gets VentureWire.  It seems as though the number of press releases for new funds being formed has decreased dramatically over recent months.  We are aware of difficulties that investors are having, both nationally and locally, in raising new funds, losing commitments, etc.  Is it difficult for institutional funds to raise money right now?  What's the landscape like, and what are the challenges that funds are facing?

Mr. Harris:  We are actually in the market now, so this is a good question for me.  I think that a lot of the limited partners allocated a substantial amount of money earlier this year when a number of funds were in the market, so funds that have been ramping up their fund raising in Q3 and Q4 are finding it more difficult.  It's taking longer.  In some cases you are trying to ask limited partners to go above their allocation for you, and they are also being more disciplined, just as we are.

          The venture capital business is an interesting business, and it can be a tough one.  It's very easy to quantify performance, so every time you finish a fund, if your returns are not there, you are going to have difficulty raising money.  You are constantly being monitored, and limited partners are very, very disciplined in terms of long-term return on investment.  They also want to see diversification within a certain asset class, so they are looking for funds that not only produce good returns, they also have to have a clear differentiator from the other funds.  If you have the returns, the track record, a clear focus and a clear differentiator, I think you will have an easier time raising money.  For those that don't have one or two of those aspects, I think it is quite difficult.

Mr. Biddle:  It's just like what we have been talking about in terms of the hurdles venture funds face in looking for companies to invest in.  The elite, franchise institutions¾the NEAs, the Kleiners, the Accels, the Oaks¾they all saw this coming.  They've been in the business forever, and they have raised huge funds which have really sucked up a lot of the capital.  There is not a lot of capital left for non-franchise institutions, so the other funds¾the newer funds, the regional funds, the specialty funds¾they really have to have something special or they are not going to get funded. 

Ms. King:  People sometimes don't realize that it's not only that the limited partners have given money to other funds.  In addition, as the stock market goes down, all of these limited partners have certain allocations to private equity for their portfolio.  When we went back to a lot of our limited partners, they said, “We are over-allocated in venture, not because we've put more dollars to work, but because our public holdings have gone down.”  That's part of the problem, as well¾the balance in how much of their portfolio is held in private equity versus public in their whole asset base.

Mr. Ayres:  Is there going to be a shakeout of funds?  Are funds themselves going to be closing shop, so companies that raise small Series A rounds are going to be left out to dry?

Ms. King:  It happened in the late 1980’s.  I can't remember the total numbers, but the VC funds got reduced down to some 700 funds.

Mr. Ayres:  Did they consolidate or did they just close shop?

Mr. Biddle:  They keep collecting their management fees and just quietly slink away.

Ms. King:  They just don't raise a second fund and they harvest their portfolio.

Mr. Ayres:  Do you anticipate that happening locally?

Mr. Biddle:  I think so.

Ms. King:  In a market like this, for the established funds, it's just like it is for the companies.  The good funds will get funded, they will survive just like the good companies will survive.  It all trickles down and it gets to us as well.

Mr. Ayres:  You are all with great funds, so we know that we will see you here for a very long time.

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on recent investments

Mr. Ayres:  I'm going to ask the panel to take just a brief second to talk about a couple of recent investments they have made.  What got you excited about them?

Mr. Harris:  Jack Biddle was actually a seed investor in Woodwind Communications, and we led their Series C round. This is very appropriate company to talk about because it's been highly affected by the market.  Woodwind makes integrated access devices for voice-over-broadband.  They have a very strong management team.  The CEO, Richard Berger, used to run US sales for Newbridge Networks, and he has built a very strong team around him.

          At the time we invested, the market seemed to be poised to take off, although I guess people have been talking about voice-over-DSL, in particular, taking off for a long time, so it wasn't clear when it was going to occur.  When we invested, the company was getting some decent traction with a number of different customers, but we weren't seeing the high volume orders come in as quickly as we would have liked.  A lot of that had to do with some of the volatility in the telecom sector, and a number of suitors came on quite quickly that were interested in acquiring the company.  When the stock market really started to get volatile, some of those suitors backed away.  One remained interested, and we ended up selling the company for something close to five million shares of VINA Technologies.  The deal occurred very, very quickly.  I didn't invest thinking we would sell it in six to eight weeks, but we ended up doing that.  Jack did all the work and I got to come in at the last second and reap some of the benefits.

Mr. Ayres:  Jack, can you talk about Para-Protect?  The reason I mention Para-Protect is because, right now, I would say that the herd is running in security.  Security-based companies are raising money, or did raise money, over the last quarter nationally.  What was it about Para-Protect that attracted Novak-Biddle?

Mr. Biddle:  Para-Protect was actually a follow-on investment.  It is an area where my partner has a lot of expertise; he has been doing information security deals for 15 years.  These were ex-military people who had strong support from the National Security Agency (NSA), and that's worth a lot in a startup.  It eases your risk because they are a large customer of talent, so your Plan B is built in.  Para-Protect also fits what we have been talking about¾they are a real company with real revenues.  They signed a term sheet to raise a lot of money recently at a very high valuation which is not going to happen.  They will close a round now at a valuation that's artificially low, so this is one where we are wrestling with whether to do that deal, or just do the whole thing ourselves since it's so attractive.  They will do $3-$4 million this year, and certainly more than that next year, so it's a real company with real revenues, a business model that's not hugely capital-intensive and there are multiple ways to make money as an investor.

Mr. Ayres:  Suzanne, Opion was a new investment for you.  Could you shed some light on it?

Ms. King:  I think that's the only new investment we did this quarter.  It's one of my partner's deals.  We invested in the team, including David Holtzman, who was the CTO at Network Solutions.  It is a very, very early stage first round, including several angels.  It was one of those “good team, like his idea and we have to do it.”  That was the criteria.

Mr. Ayres:  I'm hearing: great team, as we always have heard; a revenue model that's working, not one that's merely predicted to work; people who are making money; and customers who are willing to rant and rave about the solution. That seems to be the common thread here.

Mr. Harris:  In terms of investing, nothing has really changed very much.  We still look for the same fundamental criteria that we looked for before, no question.

Mr. Ayres:  I appreciate your insights into those companies and I appreciate you sharing your thoughts on the issues.  Now I'd like to open up the floor to Q&A.


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