Getting real

Venture capitalists are, by nature, optimists: their stock in trade is growth and development. They would claim that optimism is edged with a pragmatism born of expertise and experience that can factor in market volatility and other contingencies that may threaten the welfare of an investment. That optimism is resilient, especially for investors in the TMT sector over the past 15 months or so since the collapse of the Nasdaq, even if not all of them retained their focus on the practicalities of a particular investment during the heady days of the fever.

Of the TMT sector generally Andy Bailey, associate director at IT investment and advisory firm, Interregnum, says: “Greed overtook common sense at the height of the boom last year. Investors quite often threw away the rule book in their frenzy to invest.”

John Bernstein, a partner at Advent International, adds: “There was no fundamentals investing’ going on back then and prices were going crazily high.” The subsequent “meltdown”, he says, was inevitable. It is a view echoed by Antoine Schwarz of Goldman Sachs: “Some people were investing on the momentum basis’, following Nasdaq rather than the fundamentals of the business. When Nasdaq went down, that investment thesis went with it.”

Nor is the shakeout over: the boom brought in a whole range of new investors chasing a seemingly unending production line of ideas to fund; when the bubble burst, the new wave’ of entrepreneurs and investors alike took ill and some are surviving only on a lifesupport machine, hoping against hope “for the market to turn, or for the idea to find its time”.

In fact, so crazy were some valuations, so illthoughtout were some ideas and the decisions to back them, and so frenetic the activities of a host of opportunistic funds jumping on the bandwagon, that some investors saw much good in the collapse: there were far too many players in the sector that had to be weeded out and that has been happening over the past year.

According to Bailey: “There is a need to stay focused. There was a tremendous blurring of what is and what is not a technology investment. In Interregnum’s opinion, the socalled dot.coms were never technology investment opportunities. They were retail plays, often with very poorly thoughtout retail business models associated with them.”

Although there is some gloom in the sector, there remains that fundamental optimism. It has to be remembered, said one investor, that the downturn notwithstanding: “Venture capital in the US since the mid1990s has funded the growth of an entire new industry based on the flow of technological innovation; it is doing so in the UK and in Europe now and will continue to do so.”

Latest figures from the British Venture Capital Association allow grounds for optimism. They show that private equity funds outperformed the FTSE 100 index and the All Shares index last year and also beat these indices over three, five and 10 years. Stars of the show last year were the technology funds. Some 60 funds saw a net return of 78.3 per cent compared with a 21.5 per cent return enjoyed by 200 or so nontech funds. Earlystage tech funds were easily the best performers.

But there is no doubting the harm that exposure to certain technologyrelated investments can do. Take 3i: net asset value per share was nearly 20 per cent lower on March 31, 2001 than it was on September 30, 2000, in no small part due to the volatility in the TMT sector, which accounts for around 25 per cent of its portfolio. The shares have fallen by a third since their peak last September, but analysts have been upbeat, noting that the shakedown in the TMT sector will eventually throw up more realistic and more fairly priced investment opportunities to complement 3i’s nontech portfolio. And 3i has been aggressive in the mark down on the high tech element of its portfolio.

This drop in technologyrelated share prices has had a “significant impact” on the venture capital industry in the industrialised word according to the OECD’s latest report on the sector in its Financial Market Trends. The intergovernmental thinktank, based in Paris, noted that a general weakness in technologydominated stock markets, such as Nasdaq, have created uncertainty about the feasibility and profitability of IPOs, therefore forcing a rethink among venture capitalists as to exit strategies. The OECD report adds that in Europe, such doubts are most evident in Germany where providers of risk capital have publicly voiced concerns about the particularly weak Neuer Markt.

If the door is temporarily closed for IPO exits, then prospects for a trade sale are also unpromising. Current valuations are nowhere near levels they had reached, say, two years ago, lowering potential returns; and those larger companies that have been most active in acquiring technology companies are themselves busy with the timeconsuming and taxing job of integrating those businesses already purchased. Not to mention the slump in their own stock prices and the knock on effect this has on their fundraising position.

How to exit an investment, then, is part of a wider rethink that has occurred in the TMT sector, a rethink that is underpinned by the prevalence of a backtobasics mentality. The buzzword now is real’: business plans must be aimed at real customers; there must be real possibilities of a return, real revenues. Everyone, it seems, is getting real’ or sticking to the knitting’. Valuations, for a start, are much more realistic. Michael Elias, managing director at Kennet Capital, says: “The public markets have got real. Valuations in these markets are spiralling down and so are those in the private equity and venture capital sector.”

According to Sam Humphreys, CEO of Syntek Capital: “Fundamental business principles do apply to TMT businesses. Generating rapidly growing revenue in excess of costs must be the goal of these businesses! Valuations based on some factor other than income statement data (i.e. number of visitors to a web site, number of “users”, number of “clicks”, “stickiness”, or any of numerous other absurd, rationalising, nonrevenue related factors) are thankfully no longer of interest to investors except to the extent they actually affect revenue, pretax profitability, etc.”

Jim Sanger, director and head of technology investments at DBeVentures, adds: “Early stage funding is going to be much harder for companies in the US and Europe to achieve, and it will be at very sober valuations. Most large VCs will focus on companies with proven product execution and sales capabilities. Most early stage investments, except in very hightech component areas, will have to seek funding amongst angel and seed investors.”

James Bennet, founder and managing director of the European Technology Forum (ETF), says: “Early stage investment is virtually impossible if a company cannot demonstrate intellectual property and a potential customer base.” There has to be a realistic assessment of expectation too. He continues: “Companies that attempt to grow at warp speed are setting themselves up for a major fall if a slowdown hits. The costs associated with fast growing companies are far higher, making them much more vulnerable than slow growth companies. Many businesses expected to keep growing and did not expect things to unravel in the way they have.”

The types of companies that get funding will be those that have managed to leap significantly higher hurdles than in the recent past. An aversion among investors to what one venture capitalist called “socalled and ecommerce solutions” have meant the business plan has to be tighter, the company showing it can provide real solutions, give a client what it needs and not what it thinks it wants.

It is the general consensus that this year, fewer earlystage concepts will be funded compared with last year and few of those startups funded in the frenzy period can be said to have produced any really innovative, processoptimising technologies.

These higher hurdles, the finer filtering that is now much more common at businessplan stage have had the effect of changing the balance of power in negotiations, according to Alasdair Warren, managing director and cofounder of nCoTec. “The balance of power has shifted back to the provider of capital from the provider of ideas; this is unquestionable”. A year or so ago, a company with an idea was in a position during the feeding frenzy to run what amounted to an auction among capital providers, who then paid lots of money for extremely highrisk projects. “Business plans were flying everywhere,” said another venture capitalist, “and more than a few of us joined the queue to bankroll some pretty kooky ideas.”

Entrepreneurs and investors alike joined the helterskelter rush for an exit as soon as possible, in some cases in less than a year. That has now changed in this “age of new conservatism”. Sanger of DBeVentures says: “Prudent investors are indeed going back to traditional investment lifecycle analyses and are realising that companies need to be nurtured and grown properly for them to develop into exitable vehicles. A renewed focus on investing in good companies and helping solid companies become better companies will be a clear hallmark of professional VC approaches, over any VC approach, over the next several years. VCs are very conscious of the need to balance their exit strategies and focus on investing in companies that could be good acquisition targets as well as candidates for the public markets.”

So it’s back to the three to five or three to seven year cycle and real profitability, real customers: no more froth’ or hype. But will the backtobasics approach stifle innovation among entrepreneurs? Some have complained that venture capitalists have become overly riskaverse; that good, workable ideas cannot get off the ground for lack of funding.

Jim Sanger says: “We feel that innovation will not necessarily be strangled, although the pace of innovation, particularly for “revolutionary” or “paradigm shifting” technologies may be slowed as investors focus on return as part of some of the traditional, fundamental elements of a particular venture and not on hype. It is arguable, in fact, that real innovation may speed up, because so much VC funding over the last four years has gone into ventures with tenuous business models and unproven market acceptance. A focus on hardware strengths may indeed lead to more balanced investments in immediately useable technologies.”

It can be argued, too, that later stage investors will be more likely to be drawn to a business plan that has scaled much more rigorous barriers to entry, that has been set and has met clearly defined targets and performance milestones.

And there is much money around: billions, in fact. And prices, according to Dr Paul Castle of MTI, “have eased back to where they were in 1999”. He also points to the fact that three groups Advent, Amadeus and MTI have each raised ninefigure funds over the past year. Another plus is that the collapse may also have had a beneficial effect on the supply of good personnel. In the past, some funds have experienced difficulties in finding the right people to take a new company forward: people with excellent industry experience capable of boardlevel decisionmaking. The string of redundancies that have followed the bankruptcies or downsizing of many a company has added to the pool of experienced technology personnel.

Finance is finding its way through to the opportunities that exist in Internet technologies and infrastructure, data solutions, financial applications, security solutions and collaborative commerce, among others.

Lorcan Burke, vicepresident, UK and Ireland at the ETF Group, has voiced the optimism now guiding the tech business: “The TMT sector will grow faster than other segments. Now is the time to invest, but it has to be in the right circumstances as there are still a lot of weak business plans out there. There will be longer due diligence, a much more selective filtering, and there must be real customers.”