Fertile Ground

Venture capitalists see bloom not doom

Odds are that the Nasdaq will stay at less than 2,500, and maybe even go to less than 2,000, according to the Puke Point Poll.

Admittedly an unscientific survey and probably weighted at the negative end of the investment sentiment scale, the Puke Point Poll nevertheless has accurately forecast the downward trend in the market since it was created last fall when the Nasdaq was at 4,234, according to Eric Janszen, creator of the poll.

The unappealing name refers to what an investor does when he or she panics in a down market and sells everything, says Janszen, an unlikely source of such levity. He is a venture capitalist who has helped several successful companies, but who shunned the dot-com world because he believed it was headed for trouble.

To spoof the whole craze, Janszen in 1998 started iTulip.com, a fake company that sells fake stock certificates in the company and T-shirts decorated on the front with tulips and on the back with the statement, "I lost $100,000 on Internet stocks and all I got was this lousy T-shirt." The Puke Point Poll is on the site. The "Tulip" part of the companys name refers to the great tulip mania in Holland in the 17th century, when the flowers sold for hundreds of dollars before the market crashed.

Sales of the shirts and stock certificates have fluctuated with the stock market, says Janszen, who donates proceeds to Woman-to-Woman, a Boston organization that tries to help women move on from dead-end jobs. Janszen doesnt need the money: He and his partner, Jeff Osborn, run Osborn Capital, a venture capital firm that does early-stage — about $100,000 — financing for technology companies. Janszen says Osborn Capital has made $10 for every $1 it has invested.

Among Osborn Capitals investments have been Aptis Communications, a carrier switch manufacturer, which was acquired by Nortel Networks; ArrowPoint Communications, a switch company, and Compatible Systems, an access router manufacturer, which were both bought by Cisco Systems; and Valence Research, a supplier of load balancing products for Windows NT networks, which was acquired by Microsoft.

Good Times for Venture Capitalists?

Though the stock market is depressed, this is the best of times for venture capitalists, Janszen maintains. Not only are valuations low because the stock market is low, but many talented people are looking for work — and its easier to motivate employees who are happy to have a job to build a new company.

Companies that can supply software to configure services for data carriers, such as Gold Wire Technology; that have software to manage data storage systems, such as Astrum Software; or whose servers and software provide security, authentication and roaming for wireless devices, such as Bluesocket, have good business opportunities, Janszen says. Osborn Capital invests in all three.

The firm has kept itself liquid during the dot-com craze, but some of the angel investors are sitting on the sidelines because their wealth has contracted with the stock market, Janszen says. In addition to those angel investors, Osborn Capital works with larger venture firms in later stages of financing.

John Taylor, vice president of research at the National Venture Capital Association, and Tracy Lefteroff, a managing partner at PricewaterhouseCoopers, both say that there is a great deal of money available for investing, but that there will be a slowdown as venture firms keep a watchful eye on their portfolios and the stock market.

"It is clear that 2000 will be a record year, with over $100 billion invested vs. $70 billion in 1999," Taylor says. "The fourth quarter was definitely the slowest of the year, and there is reason to expect that will continue into 2001. Valuations have come down quite a bit, and there is still a way for them to come down further — especially in the business-to-consumer area, after seeing the effects of the holiday season."

The megafunds — those with more than $1 billion to invest — are taking their time to invest, and instead of cashing out within a year through a stock offering, the funds expect to stay with their companies for two to three years, Taylor says. "That is more in line with the way things were done before 1998. It is a more typical cycle," he adds.

PricewaterhouseCoopers estimates that $70 billion was invested by venture firms in 2000, almost double 1999s $35.5 billion. Depending on how the stock market performs, less will be invested in 2001, Lefteroff says. But the number of companies receiving funds will probably not drop, which is another indication of falling valuations and how much venture firms have come to rely on public markets for an exit strategy.

Hard Bargains

"The capital market for private companies going public is not there," says Ryan Busch, a vice president at Mellon Ventures. His firm is looking at a number of companies that had expected to complete initial public offerings by now, but have had to go back to private financing because of the virtual shutdown of the IPO market.

"It is not only that valuations are lower, but the structure of the deals are better," Busch says. Provisions are now being included that grant the last investor the right to collect his complete investment in case the company is sold, he says. So, a company that raised $100 million, for instance, including $20 million in its last round of financing, would guarantee those last investors that they would receive at least $20 million, even if the company is sold for $50 million.

Mellon invests in early-stage companies, later-stage deals and even buyouts. The firm is still optimistic about business-to-business (B2B) companies and infrastructure investments, Busch says.

Firms planning to sell portfolio companies either to another corporation or to the public in an IPO are now hoping to break even, or at best double the return on their investment, says John Raeder, managing partner at Raeder Venture Fund, based in Denver. In the previous four years, venture capitalists were reaping tenfold profits on investments, he says.

Raeder says his firm is expanding and expects to double in size this year compared with last year, even though some investments, especially in competitive local exchange carriers, have not gone well.

The fund is investing in companies with B2B strategies, software developers that can demonstrate a value proposition for major corporations and online training firms, Raeder says. But he has "backed away" from telecommunications carriers because of the "meltdown" affecting both large and small carriers. The very large carriers will "come in and buy up the assets [of Digital Subscriber Line carriers] for pennies on the dollar," he predicts.

The slowdown in the economy and the inability of new carriers to continue buying equipment has hurt hardware, software and service companies that sell into that market. Copper Mountain Networks, Keynote Systems Portal Software, Turnstone Systems and Tut Systems have all reported slower growth because carriers dont have money to buy their products. Investors have battered all their stocks, and even the shares of market leaders such as Cisco, Juniper Networks and Nortel.

"I dont have to see any more data points," says Andy Schopeck, a securities analyst at Nutmeg Securities in Westport, Conn. He predicted that Cisco would have a tough time meeting growth rates in the quarter just ended, and in the quarter ending in April. A day after Schopeck made that projection, Cisco President John Chambers confirmed at an investment conference that the economy was challenging Ciscos growth, but he said he expects to meet growth rates.

Investors who expect the Federal Reserve Boards 0.5 percent interest rate reduction to lift share prices should look at a report from Instinet Research. It tracks the performance of industry segments immediately after rate cuts back to 1980. There is good news — shares in almost all categories go up — and bad news — some sectors rise further than others.

In the first three months after rate cuts, communications equipment, computer services and hardware, and broadcast and media stocks have had positive returns, but they have not done as well as the Standard & Poors 500 Index. After six months, however, broadcast and media stocks beat the S&P by 8.48 percent, while computer services and communications equipment shares outpaced the index by 5.86 percent and 4.06 percent, respectively. Computer hardware stocks trailed the S&P by 4.93 percent.

Whatever happens with the stock market, investors who like to bet that technology will be key to the economy see opportunities. "More people are innovating than ever before," says Bart Stuck, partner at Signal Lake Venture Fund, a venture capitalist firm that does early stage investing in photonic, semiconductor and wireless firms. What will he do if demand for those products dries up? "Invest in software companies," he replies.