Tempting Bait
Venture capitalists are trying to reel in resellers with wads of cash. Bu=
t
before you get hooked, make sure there are no strings attached.
By Ed Sperling [email protected] & Laton McCartney, [email protected]=
om
Sm@rt Reseller, June 28, 1999, www.smartreseller.com
Copyright =C2=A9 1997-99 Ziff-Davis Inc. All Rights Reserved.
Every morning when Mark Tebbe wakes up, he knows one thing is certain:
someone will offer him money for a piece of his systems-integration firm.
Lots of money. And if Tebbe turns them down, those same investors will tr=
y
to reel in other solutions providers. Throughout the computer industry, a
seemingly endless supply of money is chasing a limited number of investme=
nt
prospects--developers, service providers or some combination of
both--creating competition among investors and a seller's market for thos=
e
seeking funding.
The numbers are staggering. In Q1 of 1999, for example, $4.29 billion in
venture funding was doled out to companies, a 41 percent increase over Q1
last year. Fully 84 percent of that money went to technology companies, w=
ith
the average investment coming in at $5.9 million. Some of the cash comes
from traditional venture-capital firms (VCs). But a profound shift is und=
er
way in this market, whereby a growing portion also is derived from IT
vendors. "Every major technology company now has a venture arm," says Kir=
k
Walden, national director of research, PricewaterhouseCoopers.
For struggling start-ups, venture backing can make the difference between
success and failure, launching a business and never getting it off the
ground. Given the current availability of capital and the competition amo=
ng
investors, resellers and start-ups probably have one of the greatest
opportunities in history to structure a deal in their favor even if it co=
mes
down to playing would-be investors against each other. Still, accepting
venture money has some risks. Unlike MTV, there is no such thing as "mone=
y
for nothing" in the venture world. Corporate investors, like traditional
VCs, often extract a highprice for their support, demanding everything fr=
om
a piece of the action to key information about the start-up's crown jewel=
s.
What can go wrong? An investment from one hardware giant can, for instanc=
e,
quickly end any possibility of partnering with other hardware veterans.
What's more, the funding you receive may include a stipulation forcing yo=
ur
company to develop for only one type of operating system, directory or
database--which means you'd better be betting on the correct horse.
Take The Money, Please
Taking an equity stake in small companies is nothing new in the vendor
community. In the past few years, however, the volume of corporate
investments has increased exponentially, jumping from 149 deals in 1992 t=
o
447 deals last year, according to VentureOne Corp. Clearly, many of these
corporate sugar daddies are driven by the desire to cash in on the jackpo=
ts
being generated by dot-com-related IPOs and soaring stock prices in the
technology sector. "They've seen professional venture capital get returns=
of
80, 90 or 100 percent," notes Ken Andersen, assistant managing editor of
"Venture Finance," an industry newsletter. "That's enticing." "The sheer
return on dollars is causing many companies to invest," adds Jerry Colonn=
a,
a partner with Flatiron Partners, a New York-based VC outfit. "If you're =
the
CFO of a relatively cash-rich company, you need to get cash off the balan=
ce
sheet. Investing in funds and companies is a good mechanism for that,
because the high-end, high-risk technology investments are still better t=
han
almost anything you can put your money in."
Another recent change that's brought corporate players into the venture g=
ame
is the speed with which new products hit the market. With product cycles
compressed to as little as six months, in some cases, big vendors no long=
er
can keep up with the market. So instead of spreading their R&D resources =
too
thin, they invest in start-ups. That gives them access to products faster
than ever before, a bird's-eye view of the latest technologies, and a
glimpse of where the market is heading. Those vendors also see equity
investments as a way of helping to defray the cost of research and
development by farming it out to small, not to mention much more nimble,
start-ups. Vendors want access to a new product either because it's a hot
technology or it will help them sell their existing or future products.
"These investments take on a more strategic nature," says Walden at
PricewaterhouseCoopers. "Many vendors consider the companies in which
they've invested farm teams for acquisition."
What They Want
For resellers shopping for capital, certainly one of the essential steps =
is
to understand what the vendor is looking for--and what its track record i=
s
in backing other entrepreneurs. In the case of Novell, which has set up
Novell Ventures, a $50 million venture arm, it is looking for start-ups t=
hat
add value to Novell Directory Services (NDS), a technology on which Novel=
l
has bet the farm. "What we do is take Novell's product road map and look =
at
companies that fit into those areas," says Blake Modersitzki, the fund's
director. "Then we go out and actively solicit companies in those spaces.=
"
So far, Novell has looked at about 300 business plans and has made nine
investments, mostly in companies that offer software apps and tools for N=
DS,
Modersitzki says. Of those, three were made this year. "We do a host of
due-diligence questions, both business and financial," he says. "We facto=
r
in their management teams, their technology and who their other investors
are." One atypical Novell investment is its minority stake in Red Hat
Software. Here, Novell and other vendors, including IBM and Compaq Comput=
er,
have taken positions in order to get close to Linux technology and offer =
an
open-source operating system. As an added benefit, these investors are
almost sure to profit big time from Red Hat's upcoming IPO.
Cisco Systems takes a similar approach in investing in high-tech start-up=
s.
The company's funds target three areas: minority stakes, marketing and
technology partnerships, and outright acquisitions, says Michael Darby,
Cisco's senior manager for business development. Cisco's philosophy is th=
at
the companies getting financing either have to provide enabling
technologies, offer learning opportunities or help generate demand for th=
e
vendor's various products. At the other end of the spectrum, Intel's
approach to the market is more scattershot. The company expects to make
literally hundreds of investments this year. "Our investments have a prim=
ary
motivation and a secondary consideration," says Paul Otellini, executive =
VP
and general manager of Intel's architecture business group. "The primary
consideration is whether, at the end of the day, we can sell more faster
processors. That's things like more compelling content or applications. T=
he
corresponding secondary consideration is that it must be a decent busines=
s
investment. Based on these factors, we've done awfully well on our
portfolio." Earlier this year, Intel established the $250 million Intel64
fund, which includes other corporate sponsors such as Hewlett-Packard, De=
ll
and Compaq. Investments here will be targeted primarily at developers
writing applications and tools for Intel's next-generation 64-bit
architecture.
Another corporate fund, Lucent Venture Partners Inc., which is wholly own=
ed
by Lucent Technologies, opened its doors in 1998. "We look for both
strategic investments and return on early-stage investments in high-tech
companies that focus in high-growth communications areas such as
communications software, wireless or data networking," says John Hanley, =
the
fund's managing director. Most of the companies in the Lucent Venture
portfolio complement the parent company's product-development efforts or
fill a gap in Bell Labs' R&D, Hanley says. And for the most part, these
companies are run by seasoned entrepreneurs.
"For us, a quality management team is the most important consideration in
evaluating companies," Hanley notes. "We're looking for executive talent,
people who have started a company or brought a product to market before."
For resellers, the good news in all of this is that competition among
corporate investors has become so heated that almost once a month a new f=
und
comes out. As a result, there's money out for almost every sort of soluti=
ons
provider, no matter what technology path it chooses.
The Benefits
The value of a corporate investment often goes well beyond fattening an
entrepreneur's bank account. A big-name vendor like ibm also can bring
instant credibility to a start-up with no market or credit history. In tu=
rn,
that can help boost market acceptance and raise the public offering stock
price. ObjectSpace is a case in point. The company began as a service
provider in 1992 and now calls itself an advanced technology company that
provides Internet and intranet solutions.
ObjectSpace started with very humble intentions, based on a $20,000
investment by company president and CEO David Norris and his partner, and
for the first four years it grew rapidly without any outside cash. But in
1995, the company hit a wall, and ObjectSpace brought in $5 million in
venture-capital money from David Cook, of Blockbuster Video fame. The goa=
l
was to develop products that could be coupled with ObjectSpace's services.
"What we wanted to do was sell solutions that would combine technology wi=
th
our consultants," Norris says. Multiple offerings and $17 million
later--including a strategic investment by Novell--Norris says his compan=
y
is about to extend its product line, which allows executives on the go to
rebook flights over a wireless device.
All this is a precursor to going public. Norris would not say when that w=
ill
happen, but he does characterize the company as "pre-IPO" and ready to
generate a stock offering.
A relationship with a corporate backer also enables the start-up to tap i=
ts
sponsor's resources. "The entrepreneur may have access to additional
technology," says Dave Witherow, president and CEO of VentureOne Corp., a
research firm that tracks the venture world. "In addition, the corporate
investor can provide captive customers and some form of channel or licens=
ing
agreement, intellectual capital and expertise."
For instance, companies in the Lucent Venture Partners portfolio can draw
upon market and technology research from both Lucent Technologies and Bel=
l
Labs, which spends $4 billion a year on R&D. Such research can be a criti=
cal
success factor in today's fast-moving technology market. "In my previous
company, we evaluated ourselves and 'morphed' the company if necessary ev=
ery
six months," says Tim Guleri, president and CEO of Octane Software, a Net
app provider that Lucent backs. "Now, in order to stay ahead of the pack,=
we
have to measure ourselves on a weekly basis."
In these instances, Lucent's venture arm certainly helps Octane stay on
target. "You need people looking out for you," says Guleri. "It's importa=
nt
to be leveraging off somebody. There's a huge value-add." Lucent has a
non-voting director on Octane's board, to whom Guleri goes for advice and
mentoring. And when Octane recently drew up a market plan, Lucent helped =
the
start-up make some critical adjustments. "Their product strategy team in =
New
Jersey gave us some market direction advice based on an analysis they'd
done, which pointed us to a much larger market, complete telephony
integration, than we initially targeted," notes Guleri.
Finally, start-ups often share data and resources with other companies be=
ing
backed by their corporate sponsors. For example, as one of the portfolio
companies in the $100 million Java Fund, Calico Technology, a provider of
e-business software and professional services, maintains ongoing dialogue
with the fund investors, Sun Microsystems and Compaq, as well as the othe=
r
Java Fund ventures. "We have access to [vendor] technology that helps us
enable all our businesses, " says Calico's chief technology officer and
co-founder, Dave Cardinal. "That's a huge leg up for us." Cardinal says m=
any
of the Java Fund company chief technology officers meet regularly and sha=
re
information and advice over an e-mail list. "Somebody sends out a message
saying, 'What are you doing about this sort of tool?' and the others
respond," says Cardinal. "You've got sort of a community and support syst=
em
around the fund, which can be very helpful."
The Minuses
Many entrepreneurs are leery of accepting venture funds, and often with g=
ood
reason. The specter of an entrepreneur being ousted by corporate Bean
counters who've taken control of his business is very real, as is the thr=
eat
of a start-up being consumed by a corporate giant. Accepting vendor suppo=
rt
also restricts your options. "Corporate backing is a mixed blessing," say=
s
Witherow. "For entrepreneurs, it limits [their options in being acquired].
If Microsoft invests in you, that legitimizes your company. The downside =
is
that Sun, say, is not going to acquire a company that has a Microsoft
representative on the board." Start-ups also can lock themselves into a
particular technology or product suite when inking a VC deal. "Intel's
strategy is to promote the hell out of its chips," says a technology comp=
any
head, who asked not to be quoted by name. "They sit you down and say,
'What's your plan to use or promote MMX?'" Entrepreneurs who fail to beat
the drum on behalf of the vendor loudly or consistently enough often don'=
t
get another dime.
Finally, there are two basic kinds of corporate venture funding. One is
money that comes from a separate venture arm. The other is money that's
doled out by the vendor's corporate development unit, usually for a speci=
fic
purpose.
Entrepreneurs who take corporate development backing run the risk of bein=
g
burned on several counts, says VentureOne's Witherow. "Development money =
is
usually offered as a one-time investment whereas VC-type investments are
ongoing," he says, noting that if the start-up needs a second round of ca=
sh,
it's not likely to get it from corporate development funds. With that
approach, you also run the risk of a strategic initiative shift by the
company, in which case its interest in the start-up may vanish overnight.
The other threat is that if the corporate development chief quits or gets
canned, the start-up may lose its champion within the corporate sponsor,
Witherow explains.
Strategies For Success
As a rule, corporate investors are somewhat less demanding then their
traditional VC counterparts. They often give higher valuations than VCs
because of the strategic premium involved. That means you can get more mo=
ney
from a vendor than a VC for the same amount of equity. At the same time,
corporate venture arms aren't being pressured by institutional investors,
which fund VCs, for maximum returns. That gives the entrepreneur more tim=
e
to develop without financial types breathing down his neck.
Still, resellers seeking backing have to safeguard their interests. One w=
ay
to accomplish this is by waiting as long as possible to take money. The
longer you wait, the more leverage you have in negotiating with investors.
Second, do your homework. Talk to entrepreneurs about their experience wi=
th
the investors you're talking to. "It's also a good strategy to combine
corporate and VC investors," Witherow suggests, noting that the two
different camps often keep each other honest to the benefit of the start-=
up.
More and more emerging companies today are taking this approach. Octane, =
for
instance, has backing from Lucent as well as money from VC firms, includi=
ng
Greylock and Sigma Partners--a move that Lucent Venture applauds. "We wan=
t
to partner with VCs rather than compete with them," says Hanley. Given th=
e
enormous demand for high-tech start-ups, resellers are also in the positi=
on
of being picky--and in some cases actually playing various suitors off
against one another and taking the best from each. Tebbe's Lante Corp. is=
in
the catbird seat with its focus on e-commerce solutions, a field so hot
among investors right now that Michael Dell and former Microsoft Presiden=
t
Mike Maples last year personally brought shares of Lante.
For Tebbe, that was just a sign of things to come. He is now besieged wit=
h
would-be investors, but he's been extremely careful to enter only into
relationships that are the most advantageous for Lante. For example, Tebb=
e's
company currently is developing software for IBM, which coined the
e-business moniker and whose future is inextricably tied to the success o=
f
e-everything. "We've been retained by IBM to build IBM products," says
Tebbe. "They look to us because we have less politics and more field
knowledge." In a VC relationship, what's important are the ways in which =
the
corporate investor and the entrepreneur complement one another. In the en=
d,
money may be the least important part of the equation. Keep that in mind
when a VC tries to reel you in.
Follow The Money
In first quarter of 1999, venture-capital investments in the U.S. reached
$4.29 billion, a 41 percent increase over the same period last year. Wher=
e's
the money going? Here's a breakdown:
Technology-based companies attracted $3.6 billion, or 84% of that funding.
$1.45 billion went to software and information companies.
$1.84 Billion went to internet companies, cutting across all industry
classifications.
Business services drew $344 million.
Communications companies got $1.15 million.
1.74 billion went to Silicon Valley area companies.
$250 million went to the New York metro area, with Los Angeles and the
Pacific Northwest each attracting about the same amount.
$552 million went to New England start-ups.
Tushar J. Mehta
email: [email protected]
voicemail: (206) 405-2335