Shotgun Wedding, VC-Style - Industry Trend or Event

How can a venture capital firm back out of a soured investment and save face? Many are simply folding together their weaker companies.

EVEN THE PLAINSPOKEN WORLD OF venture capital isn't exempt from spin. After years of unprecedented success, venture capitalists are thinking of ways to shutter some of their weaker companies without drawing attention to themselves.

Many are considering folding their smaller, sometimes troubled holdings into larger portfolio companies. Accel Partners and Idealab have already started, and firms as powerful as Benchmark Capital have mulled the strategy (Venture capitalists at Accel land Idealab weren't available to comment.) As VCs face troubled investments, the trend is only going to catch on, although most don't want to admit it.

"It would be embarrassing for a major VC firm to have a company go under," says Kevin Surace, president and CEO of Perfect.com, a business-to-business exchange in Palo Alto, Calif. "When they merge portfolio companies together what they are really doing is trying to save face."

There was a time, as recently as a few years ago, when venture capitalists expected some of their investments to fail. It was an unspoken understanding - unspoken so as to not draw attention to failures -- that roughly seven out of every 10 startups would die. The companies wouldn't simply fade away. They would go through bankruptcy court and have their assets sold off, piece by piece.

Then the Internet came. The Web changed a lot of things, but in the venture capital world it changed expectations. In the environment of the past three years, if a VC couldn't take a company public and see a gain on the initial investment, something was dreadfully wrong with the company.

The VCs invested accordingly. But since this spring's great stock shakeup, the expectations have changed again. Many VCs are left with companies that could never dream of hitting the public markets, much less of becoming the next Amazon.com or Yahoo.

Consolidation is already hitting the Internet industry. VC tracker Venture-One reports that mergers leaped 21 percent in the first quarter of 2000 from the previous quarter, and 28 percent above the previous four-quarter average. The merging of sister companies within a VC portfolio should pick up in the coming year, says Fenwick & West attorney Richard Dickson.

"If venture capitalists see that a portfolio company is struggling under its current business model, they don't want that investment to go by the wayside," Dickson says. "VCs will use their clout to encourage the bigger company to buy the assets of a smaller company."

Venture firms that are most likely to combine their Internet holdings are those with the greatest redundancy in their portfolios - especially when their holdings are heavier in areas undergoing a shakeout, such as online retailing and content. Telecom companies, the current market darling, will likely see less consolidation.

Dickson doesn't see weak companies being pushed on bigger companies just so the VCs can save face. "Usually a company has some value to it. And when its assets go to creditors, I'm not sure whom that helps," he says.

But when the assets go to another portfolio company, it doesn't necessarily help the founders of the company being sold. Because of the dip in Web company valuations, many VCs aren't getting any return on their investment by merging companies - especially if they made late-stage investments. That also means the employees of the smaller company see their stock options go up in smoke.

"The founders will almost always get stripped," Surace says. "If they get anything, they'll get stock in the acquiring company, but they might not get anything because the mergers will be ones of convenience, not necessity,"

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