What's Panning Out, After The Gold Rush?

May 4, 2002
Reprinted with permission of The Connecticut Tech Tribune, April 29, 2002

Bio's alive, telecom's niches are dicey

One of the earliest stops for a tech entrepreneur in search of funding is Connecticut Innovations, Inc., the Rocky Hill-based quasi-public fund that has given many of the state's startups an initial boost.

But today, with the exception of biotech, a tough venture capital market is keeping tomorrow's entrepreneurs toiling at their day jobs, says CI Executive Director Victor R. Budnick: "In life sciences we've seen an increase, in other areas, we've seen a decline. At this part of the venture cycle, people who are currently employed are holding onto their existing positions. They may be planning, but they're not stepping out. So the rate of venture formation has paused."

He projects a horizon of 18 to 24 months before public markets become hospitable for new ventures in most fields, with one healthy exception. "New companies are being formed with the purpose of discovering new [pharmaceutical] compounds and exploring new discovery techniques."

Venture capital opportunists haven't stopped shopping, says tech counselor D. Terence Jones, of New Haven law firm Wiggin & Dana, but some of the smartest money isn't tempted.

"You see this on-the-sidelines money-often called vulture funds-looking in places like telecomm at some remarkably low valuations, and passing. They know somebody is going to make money in the turnaround, but it's hard to tell which will be a survivor-of the way-too-many companies that got funded with way-too-much money."

Hartford-based Conning Capital Partners, which focuses on the financial services industry, also invests in promising tech developments. Partner Greg Batton said that while in 1999 about 60 percent of his time was spent looking at candidates, and 40 per cent overseeing existing portfolio companies, today it's the inverse.


But despite the excitement of that era, Batton says his fund rejected almost all the offerings it examined. "Either we couldn't see how they were going to work, or the valuations were so incredible we didn't see how you were going to make money- unless you found a greater fool."

A good VC has to be able to resist the pressure to invest with the herd, but VC success requires a lot of work selecting people, Batton says.

"You don't often start with the team that takes a business public, so it's a lot of work 'improving the breed' if you will. Working with the board and other key players [to] recognizing the inflection points of the business, looking at the people you've got, and determining how to buttress any weaknesses. Many CEO's want the board to opine on a particular person, so it's part of the job for VC's, as members of the board."

Right now, for people who hatch new companies, "It's back to the business we all grew up with - everything's hard work. It shouldn't have been that easy," Jones says, adding, "It's no longer enough to do one thing well, just have an idea. You have to do a thousand things well, over time."

If VC investors were acting like horse bettors three years ago, they're more like horse breeders now, says Richard Borden, an attorney at Brown Raysman Millstein Felder & Steiner. In the frenzy at the close of the 20th Century, it was common for venture funds to back a broad ticket in hopes that at least one long-shot that would carry the day. Now, in the regional funds Borden follows, a smaller group of companies is selected, with longer-range commitment to multiple rounds of financing.

Connecticut venture capital specialist Frank Marco sees a scene where evaluation of a prospective company's "niche" has never been more important. "I think in general the whole investment community has really tightened down the screws, making sure that the companies they are investing in are the ones that will be able to come out of the gate when the market rebounds, because they're in niches in various industries that have the greatest promise. It's more of an unknown than it may have been at any time prior to this."

Some of Marco's clients at the New Haven offices of technology law firm Mintz, Levin, Cohn, Ferris, Glovsky and Popeo are venturing into niches of wireless telecom, fiber optic network technology and streaming video hardware.


In telecommunications and software, over the last couple of years, "we've lived in an environment where people felt there was such internet demand, such computer demand that the sky was the limit."

Now, he says, focus is critical, and investment is directed to small segments where a specific, demonstrated need is perceived.

And even those companies that get funding these days won't be threatening the world's champagne reserves.

"Back in the dot.com era, a seed stage company could get funding at the $12 million valuation. Well, forget about it now," says Marco. "Many companies now feel that if they can do a flat financing, they're doing fine. In normal times, what you're hoping for is a constant scaling up of valuation from when the company's started and when it achieves liquidity-almost a hockey stick increase. Nowadays, companies that started when valuations were very lofty often need to hold the valuation the same or even do a round at a down valuation, a so-called 'down round.' "

A newborn tech company fortunate enough to get financing is likely to be tightly supervised, says Marco, and many backers today will demand tougher terms, such as a "superliquidity clause." That would provide payback of venture investment at a two- or three-fold rate of return. The clause would assure a profit to the earliest investors even if the company is sold without a huge increase in value.

"If it's sold at a modest price, then these provisions become very important," Marco said. "If a company's sold at a billion dollars, and the investors take back three times their investment, that's not going to kill anybody. But if the company's sold at a modest price, [a superliquidation clause] can take a huge piece out of the proceeds. And that's coming out of the hide of the common stock holders."


"I think that people who are starting companies now, first of all, are not in it just for the gold rush. I think it's gotten back to some of the more pure motives for building a business, which is pursuing an entrepreneurial dream." The founders' focus, today, has to go beyond a short-term rush to liquidity.

"The other healthy thing," he added, "is that you don't have this artificial time to market pressure that you had before. The feeling that 'if we don't get out there, the market's going to pass us by.' That was causing a lot of compression, a lot of paranoia almost, as to what was going on."

In one of the fields that was considered wildly promising in 1999, business to business e-commerce, there are still a large number of companies, and technologies, struggling for prominence. Their backers, says Jones, can be devoted to a fault. "There's the down-round phenomenon. They go out of business, they merge, or they take a tremendous down round hit to their original equity. [Is this] good money after bad? Yeah . . . . Sometimes. That's why I say it's still winnowing. I believe it's going to come back. I'd be pretty darned surprised if it came back this year."


He compares the plethora of designs for business to business Internet companies to the personal computer industry back in the mid 1980's. A field of scores of competing and incompatible PC designs has now become a virtual commodity, narrowed down to two or three operating systems.

While the long-range prospects for Internet B2B are solid, predicting who will ultimately deliver it is devilishly daunting, Jones says. "It's a real market, it's a real place. It's going to grow. It's not likely to see the kind of investment it had before - and it shouldn't. [The focus is on] trying to find out who's going to be a winner in what's left. And business to business is where the long-term effort is going to be. It may not be the best technology that wins-it may be who has the best business plan, who is the best led, and who has the best luck."