After years of talk about the rules of the new economy, it's beginning to look like the chickens are coming home to roost. And of everyone who's been talking, no one has put their money where the mouth is more than the venture capitalists.
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In 1999, VCs invested $35.6 billion in Internet startups in more than 4,000 individual rounds of funding. This is even more remarkable considering that few of the companies they funded have even a passing familiarity with the term "positive cash flow" or expect to anytime in the foreseeable future. In fact on April 11 Forrester Research issued a report predicting that within the next year most dot com retailers would be out of business.
Is this any way to run a capitalist economy?. In some ways this new-economy looks a lot like the old state-funded Soviet system where money-losing enterprises were placed on perpetual life support in order to provide entire system with the veneer of success and accomplishment.
And when it comes to new-economy accounting methods, well, there's nothing new here either. The savings and loan industry of the 1980s used the same flexible definitions of profit, loss, and assets to create the biggest financial crater in U.S. business history. Charlie Keating would love the Internet startup game. Many of the same smoke and mirrors accounting methods that got Keating in hot water with federal banking regulators 15 years ago are celebrated as "thinking outside the box" in the new economy.
But wait, the story has yet to unfold entirely. Unlike the savings and loan industry and former Soviet Union there are no federal umbilical cords pumping freshly minted money into these startups.They are burning through real money, much of it venture capital.
The Pizzo Files Read or listen to these other recent interviews by Steve Pizzo: Cluetrain Manifesto: How traditional marketers would have handled the Titanic disaster: "705 delighted passengers arrive in New York." (29 March, 2000) Jon Katz: "Publishing houses don't even link their Web sites to anything else on the Web. They think their secrets are going to spill out." (6 April, 2000) |
VCs take enormous front-end risks, putting money into startups long before these companies go public. Their payoff comes when one of their little wards makes its debut on Wall Street as a public company. Over the past three years this game has been unusually lucrative as The Street seemed to have an insatiable appetite for these cute little money-losing Internet companies. But in April all that changed. Suddenly it seemed no one wanted them anymore. There was even (gasp!) wild talk on Wall Street about applying traditional measures of success and failure to Internet businesses.
So, how do venture capitalists feel about that? In early April, we talked with two venture capitalists from Wakefield Partners, Steve Nelson, and Michael Elliot. They didn't pull any punches. Their verdict: The party is over. It's time for Internet companies to grow up.
Michael Elliot on the game mentality:
I think this market has clearly pulled a lot of us into a little bit more of a game mentality than is healthy for anybody. A lot of money has been made by a lot of different types of investors as the revenue multiples have gone up and that has become the measure versus some sort of estimation of future earnings.
But I do think that days like today are going to refocus the venture guys, in particular on the fundamental issue of building long-term value in these businesses. And that all sounds pretty, but what that means is ignoring the gaming aspect of what's been going on in terms of the market, and really getting down to some of the basics which do come out of MBA classes.
Michael Elliot on ramp-up time:
There has been a paradigm of more and more capital as the reward for faster and faster growth ... I remember in the late 80s, it took a little while to build a company to a billion-dollar market gap.
There's the go fast model: Collect as much ammunition as you can in terms of capital and just go and grow because it's all about getting market share. And there's still a piece of that that is absolutely valid, but if you go back in '85 and '86 when the deals those days were all about specialty retailing and you started adding up retail square-footage for all these new specialty retailers that were launched with tons of capital and grew and grew and grew. A lot of those companies obviously didn't make it. Several did, which are nice, fundamentally sound companies. Today I think we're going through the same thing in the Internet world, especially on the consumer side.
Michael Elliot on the long term:
The thing that has been so fun and interesting about the venture business that you do to some degree get to ignore the ups and downs of the flavor of the month, and you're all about recruiting people, building great teams, and building companies, and we have really focused -- because of the way that this has turned into a little bit more of a financial game on these markets, and what I hope that days like today do besides take a ton of value out of our portfolio is sort of bring folks back to the reality of what we are all about. It's a long-term game. It's not an invest and 24 months later you're public and out.
I think a lot of folks today are in a way hoping that the metrics have changed or would like to see them change, but I think at the end of the day there's got to be not only ROI [return on investment] but ROA [return on assets].
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Hello, this is Stephen Pizzo for the O'Reilly Network. As we record today's show (April 4, 2000) the tech-heavy Nasdaq is nose-diving. Sure, the Microsoft verdict spooked the market a bit, but there has to be more to the sell-off than that. After all, Microsoft's misfortune has to be good news for many of the tech companies that investors are just willy-nilly dumping this morning. No, there's something more afoot here.
Two weeks ago, Barron's ran a cover titled "Burning Fast." The story, written by veteran business reporter Jack Willauby, took a hard look at the glitzy Internet company sector, and discovered that underneath all the glitz was an ugly picture. Jack listed company after company burning through its investors' capital as fast as an SUV burns gasoline and wondered out loud whether they would be making it to the next gas station before they ran out.
Jack's piece in Barron's unmasked the Internet businesses' dirtiest little secret: You can buy the appearance of success without actually succeeding. The trick is to keep investors pumping money into your company. But there's no guarantee that new money is going to be found. The question now is: Will venture capitalists also start to pull back?
Before the April Nasdaq -- dare I say it? -- crash, forecasts for the next year were that even more VC money would flow into Net start-ups. In 1999 a staggering $36 billion was pumped into Net companies in 4,000 rounds of funding. In February of this year, analysts were predicting that it could grow to $50 billion this year -- well maybe, and maybe not.
Just how long are VCs and their investors going to be willing to shovel money in to fire the boilers of Net companies that know how to spend it, but don't seem to know how to make any of it? We're on the phone today with two partners in a venture capitalist firm, Wakefield Group. The Wakefield Group is a bit unique in the world of tech VCs since they've resisted the temptation of moving its operations to Silicon Valley. They've remained based in Charlotte, North Carolina, where it began in 1988.
Steve Nelson and Michael Elliott. Welcome, gentlemen.
Pizzo: And we're talking today -- it's April 4, a day which I guess will go down in history with October 17, 1987, a very bad day on the Nasdaq. So, how do venture capitalists feel on a day like this?
Elliot: Well, I remember back what I was doing in October of 1987, and I'm sure I was running around trying to get one of the start-up companies funded, and I'm only taking comfort in the fact that we lived through '87 to sort of get through today. This is not a good day.
Pizzo: I don't know whether any of you caught the article a couple weeks ago in Barron's titled "Burning Fast" by Jack Willauby, but in that article, Jack broached the issue that I guess nobody in this Internet business wants to talk about, and that is that venture capitalists and investors are shoveling enormous amounts of money into Internet startups. None of them seem to be making money right now, or very few of them, if any, and the question becomes, "How long is long enough?" At what point does a venture capitalist company look at a company that it is funding and say, "Look, guys, I don't want to hear about new paradigm this, new paradigm that, blah, blah. When are you guys going to start making money?"
Nelson: First thing I think we're looking for is: Is there really even a market there? Is there a revenue opportunity? Period. Not just in the traditional world but in -- everybody's now funding this new economy world. The second is: Is there some unique vision that would allow you to differentiate yourself versus others that are chasing that market that you've convinced us exists? And then third: Is there a team that actually can pull it off, either because they have a unique set of skills, domain expertise, or most important to us to have actually done it before?
I think the making money is important -- obviously on an ultimate basis, but can you capture a big amount of that opportunity from a revenue perspective actually means there is a market there and you have an opportunity to be first or second in that space.
Pizzo: Well, that all sounds fine, and that could have come out of a regular MBA course, but we know that this environment is different, and you take a site like DrKoop.com. Who had better branding than this guy with a beard, everybody knew him, and he starts his own site. The thing opens at $14 and a year later it's down to -- what is it? -- $2.97 the last time I checked. It may be lower today, and he's talking about running out of cash. So the measures that you folks use to determine the worth of one of these companies: Are they outdated?
Elliot: Well, I think this market has clearly pulled a lot of us into a little bit more of a game mentality than is healthy for anybody. A lot of money has been made by a lot of different types of investors as the revenue multiples have gone up and that has become the measure versus some sort of estimation of future earnings. It's not, it's really not unlike the disk-drive companies which everybody has pointed to, the graphics companies, and the buyouts in the late 80s that we all lived through. But I do think that days like today are going to refocus the venture guys, in particular on the fundamental issue of building long-term value in these businesses. And that all sounds pretty, but what that means is ignoring the gaming aspect of what's been going on in terms of the market, and really getting down to some of the basics which do come out of MBA classes.
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Pizzo: Would you say that the venture capitalist companies may be part of the problem? And let me give just a little bit of background on that. Steve and I were both at a start-up company, so Steve I think you could probably speak to this as well. As the venture capital money comes in to these companies, a company that puts $25 million into a company that has 10 employees doesn't want to wake up a year later and turn around and see a company that has 11 employees. There's a certain impetus there to grow, whether that growth makes sense or not. We experienced exponential growth over a 36-month period from 14 employees to 400 at the company that Steve and I had worked at: Is this smart? Is this growth just for the appearance of success, and are you just simply purchasing the appearance of success?
Elliot: Well, I think that's a great question, and I do think fundamentally in the board rooms that's going to be the question that is asked. There has been a paradigm of more and more capital is the reward for faster and faster growth, and I think that a lot of people have been on that train. I remember in the late 80s, it took a little while to build a company to a billion-dollar market gap.
Pizzo: And in those days, the traditional method of operation was to capture a small portion of the market, consolidate that territory, make sure it was solid and well in your hands, bring in your new lines of logistics so it's well supplied, and then capture the next piece of territory. It seems that the business model on the Internet is more of a General George Patton type business model which is just simply keep the tanks rolling and just keep moving through the territory, don't worry about consolidating what's behind you.
Elliot: I would agree with you, and I think that a lot of that is and should change and will change over time. I mean there's the go-fast model: Collect as much ammunition as you can in terms of capital and just go and grow because it's all about getting market share. And there's still a piece of that that is absolutely valid, but if you go back in '85 and '86 when the deals those days were all about specialty retailing and you started adding up retail square footage for all these new specialty retailers that were launched with tons of capital and grew and grew and grew. A lot of those companies obviously didn't make it. Several did, which are nice, fundamentally sound companies. Today I think we're going through the same thing in the Internet world, especially on the consumer side.
Pizzo: Do you get a sense as I do that this may be the point where reality is starting to set in, both with investors and with people who buy their stocks -- the VCs and the investors on the stock market -- basically saying, "Look," you know, "these P/E ratios are way out of whack. We may have suspended the physics of the business world in deference to the Internet's uniqueness, but we didn't repeal them, and sooner or later you guys are all going to have to start paying attention to gravity again." Is this the year that that happens?
Elliot: This is Mike, again. I hope so, because it's, you know, fundamentally the thing that has been so fun and interesting about the venture business is that you do to some degree get to ignore the ups and downs of the flavor of the month, and you're all about recruiting people, building great teams, and building companies, and we have really focused -- because of the way that this has turned into a little bit more of a financial game on these markets, and what I hope that days like today do besides take a tone of value out of our portfolio is sort of bring folks back to the reality of what we are all about. It's a long-term game. It's not an invest and 24 months later you're public and out.
Nelson: Yeah, and I'd like to add to that. I think what everybody's been trying to do was to amass a war chest. He with the most capital can be declared the winner in advance of the battle, and that was actually the race was to say that "I raised my $30 million first" or "my $100 million first" or "went public first," and with it comes the claim of victory because there will be a segment that looks at how well-funded they are. I think what's really happening now is the notion of "Is there a real business?" "What business are you really in?" and "How do you make money doing it?" And I think it's certainly, over the last several days for us, it's asking us every day, the market is: Are we really backing the right companies? Are we considering backing the right companies? Are the valuations sane? -- because there have been obviously, you've seen a third to two-thirds of the value of some of these companies, even in the business-to-business world, come off in the last several weeks. So I think it really sobered us all up, just to remind us of: What business are you in? And how do you make money doing it?
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Pizzo: We hear about venture capitalists investing in these companies and we know that you folks put some of your own people on their boards of directors and certainly if you don't do that you at least show up at those meetings and make your feelings known. I've always wanted to be a little fly on the wall when you show up at a company that just really isn't quite performing well. Can you just sort of give us a window into what that closed-door session is like.
Elliot: Sure, it really depends on the team at the table. Some of the meetings are -- can be extremely argumentative because it's very difficult to communicate, defend yourself, or to attack a management team, which is what we try notto do. Others can be a little bit more, it comes across a little bit more like a relief on the part of the entrepreneur because everybody understands that the company is not performing. By the time the venture guys are scratching their heads about it and banging on the table, believe me the entrepreneur has had many sleepless nights trying to figure out which direction and which way to go. So, what has been surprising to me is how often that discussion comes as a relief to the entrepreneur.
Pizzo: So, let's assume that this is a rocky year for the Internet companies. We've seen a very, very hot job market out there. We've become very accustomed to it now. Even former reporters, I can name some very personally, were paid way over what we were used to being paid at newspapers, working for Net companies, and I know from working at two Internet startups myself that we were paying 20-year-old kids salaries that most of us didn't see until we were 50. If things start to sort out and we start to get into more of a normal job market, how do you think this is going to hit that economy.
Elliot: I am definitely pained at watching some of the value erosion in a company. I am more concerned, quite frankly, for the long-term and structurally what this means in terms of continuing to attract and take care of really talented employees, because when you're changing the world, which is what all these guys are all about, it takes some great people. So of all the things that I worry about, certainly the valuations today, but you know, the valuations two months ago were kind of funny money anyway. I'm more concerned about fundamentally how do you keep bringing people, great people, to the table. So I don't know how long this kind of thing has to last before it's really a change in the total mindset for everyone. I think it's clearly going to change some investor mindset, but in terms of the perception for an engineer, where does he want to go? Is it a large company or a new, exciting young company? I think they'll still be considerable attraction for those folks there.
Pizzo: We have a company down here, in Silicon Valley, that's giving each new software engineer that joins them a signing bonus of a new Z3 sports car. I mean, does this establish expectations that cannot possibly be maintained in the future?
Elliot: They cannot be maintained. Period.
Nelson:At the end of the day, is the attraction to the place and to the environment and the culture and the team that you're part of and the market that you're going to go attack versus any kind of outlandish signing bonus or Z3 that's going to end up not attracting people but ultimately retaining them.
Pizzo: And at what point do we start applying traditional 200-year-old accounting standards also, to this new industry. Fifteen years ago I was a reporter covering the S&L industry when it was trying to convince Congress that the S&L business was so unique, growing very, very fast, and old-fashioned regulations and accounting methods really didn't apply to it any more, that these were old-fashioned and they should be ignored. And we all know how that ended, it did not end well. We're seeing quite a bit of that, I think, in this Internet economy as well, where we're basically being told, "Look, this is a nascent, new, very delicate industry. We shouldn't be taxed. We shouldn't allow patents and copyrights on anything." We're going through a lot of the same sort of logic that led the S&L industry down the road of ruin, and I wonder what you think about that?
Elliot: I keep this story in my mind: Way back in '82 when I was in MBA school we had a professor who loved what the Japanese were doing, and if you can recall in those days the Japanese were buying real estate. There was a tremendous amount of concern about what they were doing in America, and American economics were so short-term focused we'd look at things like IRR in some kind of a measurable timeframe and return on assets and things like that. The Japanese had this philosophy that was much broader, it was the right way to think about the new world and those kinds of things, but you couldn't make the math work in terms of the prices that they were paying for some of the real estate, in particular, because I've studied one of those. Sure enough, it didn't work at the end of the day. But there were many folks in America that thought that we needed to change the metrics, and I think a lot of folks today are in a way hoping that the metrics have changed or would like to see them change, but I think at the end of the day there's got to be not only ROI but ROA.
I've been in the business since 1983 and it feels like yesterday, but the markets have gone up and down, in sectors and in total, and you can still -- if you stick to some fundamental things -- you can still build businesses and value. Some days are really, really dark. And some years are really dark, but at the end of the day it is a long-term game. And if you are building value, it's a great business to be in, so I'm, I don't think it'd be the end of venture investing, but I think it could be the beginning of the end for venture investing as we've known it for the last two or three years.
Pizzo: Okay, last question here. I'm going to ask you both to look deeply into your crystal balls and tell me: What do you see for the year 2000?
Nelson: I think you see in the new economy world business-to-consumer, very difficult to get funded if at all. A lot of those winners have been made, a lot of those business models haven't panned out, even for the leaders like Amazon. I think you'll even hear people say that business-to-business investments have already been made, that they're on to the next one, and I think it's all now about the next generation Internet infrastructure gets most exciting, in particular the wireless opportunities. Mike?
Elliot: I think higher value is going to be placed on managers who have actually had to deal with products and customers and shipments and logics and all that kind of stuff. You're going to see a blending of the e-world with the real world, through the rest of 2000, 2001.
Stephen Pizzo is an award-winning non-fiction author, and newsman for the O'Reilly Network.
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