Vulture Capitalists --- Lots of new companies. Lots of bad ideas. Looks like
a new growth industry might be bankruptcy lawyers.
By Craig Bicknell, Business 2.0, October 1999 issue
© Copyright 1999 Imagine Media Inc.
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Like lots of folks in the San Francisco Bay Area, Michael St. James expects
his business to boom in the next few months. But don't confuse him with your
typical Web CEO-St. James is a bankruptcy lawyer.
With Silicon Valley feasting on the fat of one steaming-hot IPO after
another, it's easy to forget that for some folks scraping to get an online
company up and going, it's been lean times. In the early '90s, St. James was
living large off a steady diet of businesses gone bust. But then an
improving economy came along and spoiled everything, driving Bay Area
bankruptcy filings to their lowest levels ever and leaving alarmingly slim
pickings for the insolvency industry. "Twenty-four months ago, things were
pretty dead," he says. "It had just become very difficult for people to
fail.... A great deal of money was flowing into Internet companies with much
less critical analysis than you see today."
Now the idea of easy money online has been displaced by the cold reality of
trickling incoming revenue streams and mounting unpaid bills. Bankruptcy
firms are about to enter into a feeding frenzy. "The consensus is we're
about to hit a boom in the insolvency industry," says St. James, an attorney
with Rosenblum, Parish & Isaacs in San Francisco. "All of the firms that
handle this type of work are expanding and hiring. The laws of gravity are
taking hold." Bankruptcy lawyers began to smell blood last December, when,
for the first time in years, the number of Silicon Valley Chapter 11 filings
jumped into double digits. The trend continued through the first quarter of
1999, with 14 filings in January, 9 in February, and 10 in March. Then
Silicon Valley Bank, one of the Valley's premier tech financiers, reported
that the number of troubled loans in its portfolio had soared to a six-year
high in the first quarter of 1999. Bankruptcy lawyers, who hadn't seen a bad
omen in a good long while, were ecstatic.
"When you have financial firms reporting problems with their loan reserves,
that can be an early indicator that the number of bankruptcies will rise,"
says Nels Nelsen, a partner at Gray Cary Ware & Freidenrich in Palo Alto,
Calif. He admits, however, that "bankruptcy professionals are eternally
optimistic that there's going to be an economic downturn."
The pending bust is the inevitable result of an overheated Valley economy,
lawyers say. The market has been so forgiving for so long that investors
will now indiscriminately dump money into flimsy businesses that will almost
certainly go belly-up, says Robert Opera, a partner at Lobel Opera &
Friedman, an Orange County, Calif., firm that works with companies in
financial distress and their future buyers. Many are failing even now, he
says. But then something curious happened. The number of Chapter 11 filings
plummeted in the second quarter. There were just four filings in April, five
in May, three in June, and three in July. The numbers are misleading, Opera
insists. Numerous high-tech businesses are failing, he says, but many are
choosing to avoid the stigma of Chapter 11 by settling with creditors out of
court-a process that still requires bankruptcy lawyers. Rosenblum's St.
James agrees. "In Silicon Valley, your principal assets go home every
evening, and if they're afraid that things are going badly-which Chapter 11
certainly says-they might well jump ship before you can turn things around."
While there's broad consensus in the insolvency industry that more
businesses are tanking, it's an open question whether the increase is a
canary in the coal mine of the larger Net Economy or simply the by-product
of an incredible jump in the number of new startups.
Boom or bust?
Those who predict doom, say long-term Valley watchers, may simply have their
blinders on. "There's an automatic cynicism built into a boom," says
Frederick M. Hoar, chairman of Miller/Shandwick Technologies and a veteran
of numerous boom and bust cycles. "Winning is a condition that exists just
before losing." The Valley has been winning for an awfully long time. But
those who, like Hoar, have done business in the Valley for 30 years have
seen their fair share of losses-the dramatic semiconductor recessions of
'74, '78, and '84; and the nasty slump of '92 when 318 businesses filed for
Chapter 11 in the San Jose, Calif., office alone (compared to 77 in 1998).
They can't help but brace for the next one. Still, those bust times predate
the advent of the Internet, and that makes it awfully tough to predict the
future from the past. "It's difficult for anyone to conceive exactly what it
will mean to have every computer in the world connected to the Internet,"
Hoar says. "It's a scaling, exploding market opportunity. It's very
difficult for anybody to write off the possibility that we're on the cusp of
an electronic golden age. With consumer demand rising, I continue to be
optimistic about the future." Sure, it could be a golden age, say bankruptcy
lawyers, but our business will boom no matter what. "The nature of business
now in Silicon Valley really guarantees it," says St. James. "You have
businesses designed to consume cash, and the bigger ones are rewarded for
doing so. You're expected to burn cash, and you have to burn cash to make it
work."
Bay Area entrepreneurs agree that the pressure is on to spend big to build
brand and secure the coveted first-mover advantage touted by
money-hemorrhaging market darlings such as Amazon.com. "It's a land grab
right now for each segment of ecommerce," says Hans Koch, CEO of Owners.com,
a San Francisco-based online real estate listing service. "Everybody wants
to be the newest and the best, but it takes more to be a successful player
now than it did when we started in 1995. More money has to be spent to raise
the company above the noise. We're under pressure to spend money smarter,
and in some cases faster, than our competitors."
Burn-rate burn
That means Valley entrepreneurs, many of whom have little seasoning, need to
be both exceptionally skilled fundraisers and keen fiscal planners. If a
business budgets its bucks to last until December, the bucks had better not
run out in October. "It's just a question of whether you can bring in new
money fast enough," says St. James. "If your timing is a little off, you're
in trouble. It's an environment where raising money 60 days too late is as
bad as raising it 6 years too late." While market forces may play a role in
fueling a dangerous burn rate, some lawyers and entrepreneurs say Valley
venture capitalists are also stoking the flames. Their coffers swollen with
massive returns from successful IPOs, VCs are dumping buckets of money on
new startups and pressuring them to spend it as fast as they can. "They have
these huge funds, and if they have $200 million to spend, they don't want to
make 200 million-dollar investments," says an 18-year Valley veteran who's
currently the COO of a pre-IPO Net company. "They want to make 20 $10
million investments or 10 $20 million investments. They don't want to have
to do all that due diligence."
Once a VC has chosen a company to pour money into, he wants to keep pouring,
says the COO. Sure, the VC wants to build the company's brand and help it
get big quick, and he wants to scare off competitors by raising the burn
rate to uncomfortable levels, but he also wants the company to run out of
cash and return for more. That way, the VC gets a bigger piece of the
company. "A VC wants to get as much of your company as he reasonably can,"
says the COO. "One way to do that is to say, 'Go out and spend a lot of
money on marketing, then come back for more-and give me 20 percent of your
company in return.'" The COO says one VC pressured him to spend $5 million
on a project he had calculated could be done for about $100,000. While VCs
won't admit to forcing frivolous spending, some acknowledge that huge
returns have changed the way they do business. "If you have one eBay in your
portfolio, that might be worth $4 billion," says Andrew Anker, a partner at
August Capital, in Menlo Park, Calif. "Then you can afford to go out and
spend $100 million on something that may have a one in ten chance."
Folks in the insolvency business, of course, like those odds. "You've got
record sums pouring into companies at a very early stage, and a lot of them
aren't going to make it," says John Cromwell, a partner at Alliant Partners,
a Palo Alto bank that advises financially distressed companies and growing
companies that wish to be acquired. "When have you seen 10, 20, $30 million
going into companies in the first round? Before this year, never." Many of
the companies are crowding ten at a time into markets with room for two or
three, he says.
Who's burning whom
Do VCs pressure crap-shoot companies to overspend? "It's really the market
saying they have to spend faster, not the VCs," says J. Neil Weintraut, a
partner with 21st Century Internet Venture Partners. "The good news is
there's more capital out there than ever before. The bad news is that it's
just increasing the pressure and the risks for entrepreneurs. Their
competitor down the street is going to spend $15 million, so they're going
to have to spend $15 million." That's exactly what the bankruptcy lawyers
are banking on. "The lure of the big dollars and IPOs will attract many more
people than can survive, and many will be left by the side of the road,"
Opera says. "It'll be very interesting in five years to see how many of
these companies that are taking advantage of the IPO market will be around."
Craig Bicknell ([email protected]) is a staff reporter at Wired News.