Source: Fortune Magazine, December 6th, 1999, edition
This message contains Parts I, II and III (of a six-part article)
Nice Work If You Can Get It
In an age of easy money, the clubby world of venture capitalists has given
way to something more aggressive and cutthroat.
By Melanie Warner
© Copyright 1999 Time Inc.
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George Zachary found this year's Sand Hill Road Challenge a bit
disappointing. The energetic 34-year-old partner at Silicon Valley venture
capital firm Mohr Davidow had come to the event looking forward to some
friendly jousting with his fellow venture capitalists. For months, rival VCs
spend thousands of dollars building the fastest, most state-of-the-art
soap-box-derby cars. On the day of the event they don silly racing suits and
roll the cars down Menlo Park's Sand Hill Road to see whose can go fastest.
Sure, the race is ridiculous--Zachary calls it the "Sand Hill Ego
Challenge"--but he'd always found it appealing, in a clubby sort of way.
This year, however, Zachary wound up besieged--he was hounded by the same
sorts of people who pester him all week for advice. They want to know this:
How can they be more like him? In his offices, during the past two weeks,
he'd met with the head of a European retailer who wants to find the next
Amazon.coms and help them set up operations in Europe, and the CEO of
old-line printer R.R. Donnelley, who is thinking of starting a VC fund.
Lately, not a day passes without a call or e-mail from someone who wants to
become a partner at an established firm such as Mohr Davidow. (Zachary's
quick advice: Go start a successful company. Then we'll talk.) And here they
all were at this event, this event that used to belong to the venture
capitalists! There were investment bankers, Wall Street analysts,
consultants, lawyers, and other assorted wannabes. They came from Merrill
Lynch and Goldman Sachs and the law firm Brobeck Phleger & Harrison, which
lent to Jamis McNiven, the eccentric founder of the race, a large camel that
complemented the firm's Arabian-theme tent. "I want to tell them all, 'Go
away,' " joked Zachary, navigating through the crowds and past McNiven on
his camel toward Mohr Davidow's "car"--a collection of motorbikes strung
beneath a red foam-rubber dragon with a protruding 20-foot tail. "I don't
need the competition." This is a story about what it's like to be a red-hot
venture capitalist at a time so extraordinary that it seems everyone and his
cousin wants to be a VC. Zachary and the four other VCs on the following
pages are part of a group doing venture investing as it's never been done
before. They're the guys everyone else wants to be, nurturing the next big
things and making piles of money doing it. The top venture firms in the
Valley are giving themselves and their investors annualized returns north of
100%. The really, really good ones--like the ones in this story--are
clocking 200% or more. Venture capitalists have never before scored these
kinds of returns, and it has made the best of them very, very rich.
Investment bankers, the deal sharks who once sat at the top of the economic
pecking order, look poor by comparison. The several million dollars that top
bankers pull down is chump change next to the $20 million a year some VCs
are making. If the rewards are richer than ever, the work is more demanding
than ever. The alpha VCs are pouring more and more money into young Internet
companies, paying higher and higher prices for the privilege of doing so,
and furiously running around to keep up with the companies they've already
funded. The last deal Zachary did--Andale, an auction services company--came
together in less than three weeks, from his first serious meeting with CEO
Munjal Shah to the signing of term sheets. That is lightning-bolt
fast--until recently, VC funding negotiations would poke along for three
months. Geoff Yang, one of the Valley's most enduringly successful VCs,
closed a deal even faster--in a mere ten days. He and two of his partners at
Redpoint Ventures, a new firm that was spun out of Brentwood Venture Capital
and Yang's old firm, IVP, held 10 p.m. meetings with the founders of
Octopus.com, a personal-portal company, and almost rescheduled a firm
off-site at the Pebble Beach golf resort. Yang and Zachary--who's also
funding Jim Clark's new startup, Shutterfly, and spends time every day with
CEO Jayne Speigelman--expect the pace to get even crazier. Yang is raising
his largest fund ever. Redpoint Partners I will get $600 million from
investors--it's astonishing that a firm's first fund could be so big, more
than halfway to the billion-dollar mark that VCs are enamored of these days.
Just about every VC firm is raising its biggest fund ever. All told, VCs
will spend about $23 billion to fund technology startups this year, $12
billion more than last year and $21 billion more than in 1991. If they keep
spending at this pace, VCs will invest something like $35 billion next year.
So if by chance you were thinking Silicon Valley couldn't possibly produce
any more young, fast-spending, preprofit Internet companies trading at
fairy-tale multiples, you're wrong. Armed with this much cash, the venture
capitalists are setting out on their biggest shopping spree. You ain't seen
nothing yet. John Mumford is over at Buzzsaw's new San Francisco offices,
shooting the breeze with CEO Carl Bass. Two weeks earlier, Mumford's
Crosspoint Venture Partners firm funded Buzzsaw, a startup that intends to
provide Web-based services and e-commerce for the construction and building
industry. Now, readying for the first board meeting, he and Bass are
verbally high-fiving each other about how well last week's launch went. "You
should see all the builders we've got already posting their jobs on the
site," says Mumford, wearing a wide grin. "For us to have this kind of
demand this early is huge." In his 27 years as a venture capitalist, this is
one of the biggest deals he's ever done. Crosspoint, which Mumford founded
fresh out of business school in 1972, invested $15 million for an equity
stake that gave the company a $65 million valuation. Mumford, 56, used to
think that was a lot of money. He's been through some grisly years, when he
wouldn't have dared invest $15 million into such an embryonic company, much
less at such a valuation. And while Buzzsaw has the backing of Autodesk, the
$765-million-a-year company that dominates the market for engineering design
software, and is staffed with dozens of former Autodesk employees, it's
still a company with no finished product and no revenues. For the deal to be
a big success for Crosspoint, it will need to return 100 times the
investment--that's what a big hit looks like these days. Which means that if
Buzzsaw goes public, Mumford will be disappointed with a market cap of less
than $8 billion.
Mumford wonders for a minute whether that seems a lot to expect from one
investment. Then he remembers Foundry Networks, a Crosspoint company that
went public just as he was putting together the Buzzsaw deal. Foundry hit
the market with an $8.7 billion valuation and is now worth $10.6 billion.
Crosspoint, an early investor, has netted $1.5 billion. That's on paper, of
course (like employees, VCs typically can't distribute shares until six
months pass), but after that sort of payoff, it's hard to think of $15
million as too much money. Mumford's still rather astonished, not just by
the speed at which Crosspoint's $9 million ballooned by a 167 multiple but
also by the fact that it happened on a deal such as this. Foundry makes
complicated high-speed switches and routers for Internet networks, not the
stuff most people are supposed to understand, much less get all twisted up
about. "Deals like this are supposed to be worth $800 million, not $8
billion," he marvels. Mumford's bets are typical of the way a lot of VCs are
investing. He makes bold choices and has no intention of stopping. Already
this year he's invested in 29 startups, just about blowing through $300
million he and his four partners raised in April. He's out raising another
$600 million and would like to use it to find more companies like
Buzzsaw--big, ambitious projects where he "owns" the deal. Crosspoint took
the whole first round of financing without sharing the equity with any other
VCs. Mumford's even thinking about using the new fund's money to do deals in
which he carries the whole company, from first-round investment to an IPO or
acquisition. If a company needed $60 million to get to an IPO, Crosspoint
would provide it all. The idea would have been regarded as pure lunacy as
recently as a year ago, but it's floating around at other firms too. Jay
Hoag of Technology Crossover Ventures and Jon Callaghan at CMGI are both
thinking about it. Mumford's not sure whether he'll end up actually doing
it, but the idea has its appeal. Imagine: Had Crosspoint been the only
investor in Foundry, the firm could have made $3 billion, not just $1.5
billion. The strategy allows for huge upside but obviously comes with bigger
risks. Or does it? Since its modern beginnings in the early '80s, venture
capital has been universally understood as "risk capital." The buttoned-up
pension fund managers and college-endowment investment officers who have
historically provided VCs their capital made a point of never investing more
than 5% of their assets in venture funds. These limited partners would
typically invest 2% or 3% of their assets. Allocating any more than that
would be too risky. The last thing you wanted was to own a big chunk of
stock in harebrained failures like pen computing or multimedia CD-ROM
companies. But at some point in the past two years, that 5% rule changed.
The average pension fund or college endowment now gives VCs 6% to 8% of its
assets. Some dare go as high as 20%. Risk capital, it seems, isn't so risky
anymore. Encouraged by the returns of earlier funds, limited partners often
implore VCs to take as much of their money as possible.
One reason limited partners once found venture capital so scary was that the
business was a minefield of failures. Accepted VC math was that out of ten
investments, four would end up losing money or breaking even. But ask VCs
about their recent failures and you realize that isn't true anymore. Yang,
41, recently told me he couldn't think of any failures. Then he remembered a
company called Whistle Communications. While he was still a partner at IVP,
Yang put $6 million into the company. Its product, an Internet server for
small businesses, worked like a charm, but the company couldn't figure out
how to sell it to the fragmented small-business market. So in June, Yang and
the other directors sold Whistle to IBM for more than $100 million, a
transaction that made IVP four times its money. With failures like these,
who needs successes? Yang uses such stories to recruit executives from
telecom giants like Lucent and Nortel to come work for one of his
communications companies. Invariably, they ask about the risk of working at
a startup. Yang tells them, "What risk? If the company doesn't work out,
we'll sell it for $150 million. If the company kind of works out, we'll sell
it for $500 million, and if it really works out, it'll be worth between $2
billion and $10 billion. Tell me how that's risk." It's not just Yang who's
finding venture capital less risky. He has one of the best track records in
the business, but other VCs have similar troubles naming their last true
disaster. Of the 76 investments TCV has made in the past four years, Jay
Hoag has watched exactly two lose money for the firm--Pointcast and
NetSystems. There's also at least one company that would have been a failure
had Hoag not sold it to a larger company. Jon Callaghan of CMGI's @Ventures
also has had just one bomb, a company called Freemark Communications in
@Ventures' first fund. Several of his companies have been saved from failure
by getting additional funding and starting over with a different strategy.
Now they're on track and look as if they might pay off. If you take away
the risk, or at least reduce the perception of it, everything about the
venture capital business takes on a different look. Consider what's
happened, for instance, to the custom of deal sharing. It used to be that if
you wanted to fund a company, you'd round up some of your VC pals to look at
it, and then, as a way of managing the risk, three or four of you would
invest. You'd chat about the deal at length and agree on a price everyone
would pay, a practice that led to the VC community's seeming all too cozy.
Some in the Valley liked to call it a cartel. Entrepreneurs love to tell
stories about showing up for meetings with VCs, handing them a business
plan, and then being informed that, oh, by the way, we've already read a
copy of your plan. Today, thanks to the flood of new money and the fact that
everyone wants to "own" deals, VCs aren't caring and sharing so much. Back
in 1995, Yang asked Kleiner Perkins partner Vinod Khosla to take a look at
six Stanford grads who had put together a search engine company called
Architext--which became Excite. Today, Yang admits, he'd fund the whole deal
himself. When VCs share deals now, it's not about risk, but time. When
you're already on 12 boards, you might not want to take on the workload of a
new company by yourself. If the VC business was once a courtly tennis
match, it's now more like a hockey game, and people are losing a few teeth.
Zachary still talks about the time he almost got cut out of what became his
most lucrative deal--Critical Path, which manages e-mail for corporations.
He and a VC at another firm, which he doesn't care to name, had agreed to
co-invest in Critical Path. The night before they were scheduled to draw up
term sheets and make the deal official, the other firm had a change of
heart. The partner called Zachary and told him that his firm wanted more
equity and was going to take the whole deal itself, cutting Mohr Davidow out
of the action. Incensed, Zachary bounded into his black Viper and roared
down Sand Hill Road to the offices of a third firm, Benchmark Capital. He
convinced partner Kevin Harvey to do the deal with him, and over the next
two days the pair fought their way back in. When it was over, Zachary and
Harvey strutted out of Critical Path Chairman David Hayden's office with
their joint term sheet in hand. The offending partner from Benedict Arnold
Ventures was sitting in the lobby. "I thought, 'I've done all this work--I'm
not going to lose this deal. If you guys want to play, I can play,' " says
Zachary, smiling about the crowning moment.
(parts IV, V and VI of this article sent separately, in a single message)