VCs Haven't Lost Their Sense of Adventure - Industry Trend or Event

Venture capital spending may be slowing, but there's still a lot of money out there. Some of it will create new dot-coms.

It's official. The venture capitalist has become the scapegoat of the Internet Economy. Much like the blame placed on investment bankers in the 1980s, when junk-bond scandals and unfriendly takeover bids seemed to capture all that was wrong with the times, venture capitalists are now getting the rap for the excesses of the Internet era and the subsequent market correction.

"I was talking with an entrepreneur just the other day who said to me, 'Accel, Kleiner, Benchmark and Sequoia are responsible for this downturn because you all overfunded the Internet,'" says Accel managing partner Jim Breyer, who just a few was ranked among the 40 wealthiest businessmen under 40. "This is wildly overstated."

There is, of course, some truth to the charge. Venture capitalists have overfunded the market to a point where there-are too many companies with little prospect for the tong run. But lost in the finger-pointing are the lasting changes brought about by VCs over the last few years. They have led the creation of a host of huge Net companies that have changed the corporate landscape. And though there will be a thinning of the ranks over the next few years, venture capitalism has evolved from a cottage industry to an established financial sector that has institutionalized risk-taking and entrepreneurship.

Now that the boom times are over, VCs have become more cautious about where they place their bets. Yet even in this horrible P0 market, firms are still raising billion-dollar funds- with very little effort - on the appeal of investing in startups. Last month, for instance, a little-known Minnesota firm, St., Paul Venture Capital, raised a fund of $1.3 billion, an amount that would have been almost inconceivable two years ago but is now barely news. A few days later another second-tier firm, VantagePoint Venture Partners of San Bruno, Calif., closed a $1.6 billion fund.

What's striking is that investors are ponying up money now amid widespread reports that returns are dropping. The second-quarter returns to venture funds were 3.9 percent, a plummet from the 59.4 percent in 1999's fourth quarter, according to recent figures from Venture Economics, a research unit of Thomson Financial Securities Data. Investors apparently don't believe the hot dot-com days are completely over.

Indeed, Venture Economics projects VC spending to be at least $20 billion in the third quarter, up from $14 billion in the same quarter a year ago, but down from $25 billion in the second quarter of this year. Kirk Walden, who runs PricewaterhouseCoopers quarterly survey of venture capital, estimates that 1,200 companies received venture money in the third quarter.

For many VCs, competition to finance new dot-coms remains intense. Michael Rolnick, a partner at ComVentures in Palo Alto, Calif., says he recently finished working for eight weeks at securing a deal with a startup. He gathered what he describes as an "all-star syndicate of investors" and shook the CEO's hand to seal the deal. "They called back over one weekend and told, me they got another investor at twice the valuation," he says.

The herd mentality of the business fuels part of the competition. First came the boom in business-to-consumer e-commerce dot-coms. Then business-to-business dot-coms were the rage. Now it's optical networking.

Talking about his firm's investment in ONI Systems, an optical networking equipment maker that had a hugely successful IPO in June, George Zachary, a partner at Mohr, Davidow Ventures in Menlo Park, Calif., explains: "When we invested in ONI Systems, people asked us, 'Why are you funding technologists? You should be doing b-to-c.' But when ONI went public, everyone all of the sudden everyone said optical is going to be huge. Now optical is being overfunded."

Some VCs like Andy Rappaport, a partner at August Capital in Menlo Park, still dabble in even riskier areas like music. While many analysts were declaring the consumer Internet sector dead, Rappaport invested $6 million in March and took a seat on the board of Uplister, a music playlist sharing company that launched at the end of September.

Music is not a hot investment area: A lot of venture capital firms are steering clear of music for fear of stepping into a potential legal quagmire, and there's little sign of success in the public markets. But Rappaport was attracted to the music company because it's in an industry in the midst of change. The pet-supply market isn't going to change radically by 2010. The music business most definitely will.

"We're investing in nothing that is about the Internet, but we're investing in industries that will be changed because of the Internet," says Rappaport, taking the long view.

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