Marathon Man: A conversation with Alan Patricof

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Published October 31, 2008 at 5:46 PM

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Alan Patricof has ridden high tech's booms and busts from the advent of the computer age to the rise of the Internet. Which is why his perspective about the latest industry spasm is worth considering.

Indeed, although Silicon Valley's venture capital titans have hogged the limelight over the past decade, few have Patricof's depth of experience in watching -- and weathering -- the cycles of investment in technology that periodically ripple across the U.S. economy, flattening some businesses as they create others.

In 1969, he launched Patricof & Co., a firm that would help give birth to Valley mainstays such as Apple Computer Inc. of Cupertino, Calif., and Cadence Design Systems Inc. of San Jose, Calif., as well as East Coast startups America Online Inc. (now owned by New York's Time Warner Inc.) and Office Depot Inc. of Delray Beach, Fla. As his firm evolved into private equity giant Apax Partners Worldwide LLP, Patricof also took stakes in media assets, including New York magazine, the Village Voice and Details magazine, while taking time to advise the Clinton-era White House on small business affairs.

In 2001, Patricof stepped back from Apax to concentrate on early-stage investing, forming early-stage venture fund Greycroft Partners LLC, based in New York, in 2006. The firm, with a modest $75 million fund, has nevertheless invested in a range of media, wireless and Internet startups, such as politics and culture site The HuffingtonPost.com Inc. of Los Angeles and virtual world operator Doppelganger Inc., that have helped shape the Web world's latest phase. An investment in ContentNext Media Inc., the publisher of tech news blog PaidContent.org, has already produced an exit -- U.K. publisher Guardian Media Group plc paid $30 million for the startup this summer.

Patricof, 74, is now drawing on that experience in preaching calm as the financial crisis buffets tech companies nationwide. "It is in times like these that great opportunities are created," he told The Deal recently in response to the growing storm, which threatens to stifle funding in tech startups and seal markets for initial public offerings and mergers and acquisitions for years to come.

EDITOR'S NOTE: Also see our separate video interview with Alan Patricof about how VCs and entrepreneurs are coping with the fallout from the financial crisis.

In this interview, Patricof suggests that new-media companies are better prepared for an economic downturn than startups seeking to develop new technologies. Some may even be prepared for exits, as media companies take advantage of consolidation to buy, rather than build, additional features. And while he advises startups to proceed with caution as the economic clouds darken, Patricof urges investors and entrepreneurs not to panic and to look for the business opportunities that inevitably arise with each passing storm.

The Deal: You've been in the growth capital business long enough to have survived other downturns. Now that fallout from the financial crisis is hitting the tech industry, what's your prognosis for venture capital investment and for industry startups?

Alan Patricof: I think people have to recognize there's a fundamental difference between, say, the environment from 1998 to 2002 and today. We don't invest in young companies today with the concept of taking them public. That possibility has been foreclosed at least for the last three to five years, if not longer. Most investment banking firms, if not all of them, have gotten to the level where if you don't have a market value of a quarter of a billion dollars to support a public offering of, say, $50 million, made up perhaps of a few selling shareholders and mostly new capital being raised, you can't establish liquidity.

In addition to that, most of the small investment banking firms known for creating the new-issue market -- the Unterberg, Towbins, the Hambrecht & Quist of the old days, Robertson [Stephens], the old Montgomery Securities -- have gone away. So the fact that there haven't been any new issues for this year has had
no impact.

We have 24 companies in our portfolio, and when we were considering investing in any of them, we didn't say, "We're going to take this public in two years or three years and try to extrapolate a public valuation."

We approach the market on a very realistic basis, and I think most people in the business do. For the most part, our companies are either going to make it on their own as freestanding enterprises that generate their own profitability and cash flow, or they're going to be sold to another company.

I think if one approaches the market for venture opportunities in that context, keep valuations at a reasonable level and keep the amount of capital commitment at the earlier stages to a limited level, then one can do very well in a shorter time frame than existed before. And that's because there are a lot of corporate buyers around that are interested in acquiring young companies that have shown some traction and fit in with their overall strategic objectives.

Does that imply that, despite the lid on IPOs and challenging M&A environment, younger technology companies are fairly well insulated from all this?

No one's insulated. And I should add, we're really focused on applications, Internet and wireless markets rather than any breakthrough in technology -- I mean by "technology" to imply the creation of new inventions.

From our standpoint, we're able to find opportunities that can get pretty far along with reasonable amounts of capital -- $2 million to $5 million -- compared to what we'd done in the late '90s and early 2000s, with initial capital structures of $5 million to $15 million.

Because of the advancements of technology and because of perhaps a more cautious approach on the part of entrepreneurs who saw what happened, entrepreneurs are being more realistic in their capital needs at the younger stages of development until they have really proven the commercial potential of their projects. And I think that will serve them in good stead during these difficult times.

So entrepreneurs who have learned to keep their burn rate low are better prepared for an economic crunch. What other qualities do such startups -- let's call them the "survivors" -- have in common?

It's anyone who focuses on having enough capital to get through the period when they can demonstrate solidly that they have a commercially viable enterprise. But if you say, "I'm going to finance for the first year and be in the middle of development," that's an invitation to disaster, particularly in this environment. I don't think that makes sense.

I think you've got to make sure that as an entrepreneur, you've financed your operation sufficiently to get someplace where you've proven something. And for a venture capitalist, that means you've financed it adequately to get to that point -- say, someone's bought what you've got and perhaps will come back for more.

So what does that mean for the legions of "Web 2.0" companies that have yet to generate much revenue and are focusing on attracting a critical mass of users?

There are lots of companies that have registrations and unique visitors and page views that haven't worked through their commercial model. And it's critical that they're adequately financed to test out their assumptions and get to the point, realistically, where they can have a demonstrable revenue model.

What I was referring to are ones that will have difficulty, that have long-range development plans that they can't adequately fund on a reasonable basis up front. And that's one of the reasons why we avoid specific new technology. We leave that to the Silicon Valley guys who are prepared to put larger amounts of capital into longer-range development programs for new semiconductor applications or new optic designs -- new inventions, in other words.

Some prominent VCs have sounded the alarm in recent weeks about the need for startups to conserve cash, and a number of emerging tech companies have announced layoffs. Do you see a difference in the way things are playing out between the startup and innovation culture in Silicon Valley and what you find on the East Coast?

We think it's too early to have any conclusion about that. I have certainly canvassed all our companies, counseled them to be cautious in their spending. And we've particularly focused on the fact that there's a great tendency among young companies to have new features. It's never enough -- you always have to add something that makes the product better and better.

And I think this is a moment when, if you don't hear the customer saying, "We're not buying because you don't have this feature," this is a time to cool it on adding every bell and whistle and focus more on selling the product that you have with modest refinements. You may not want to undertake any long-range development programs that won't translate into revenues in the near term, meaning the next 12 months.

For years now, many big VC funds have been moving away from early-stage investing to concentrate on later-stage deals in pursuit of more lucrative exits. Do you see any trends in the capital markets that might reverse that trend?

I don't think so. Later-stage companies that are running out of capital are therefore more likely to be affected by these economic cycles. They're in revenue stages and need working capital lines or venture leasing. If they haven't reached profitability, they're the ones who are going to have more difficulty finding money because they're in that
middle ground.

That'll make for a tighter, tougher market for the companies that are further along and haven't reached profitability.

Given the dire predictions for consumer and enterprise spending in the U.S., what longer-term implications do you see for startup companies, whether full-fledged developers of new technology or makers of applications or features derived from those innovations?

For a new company with truly innovative technology that has a lot of research, development and experimentation involved, it's going to be harder to finance those kinds of enterprises because of their long development cycle.

If you're dealing with companies with applications that can be translated into a product in a shorter time frame that can make your customers do something faster and cheaper, you'll be fine. You're going to be relieving a pain point and there's a real need for your product regardless of the economic environment.

What about on the fundraising side? How serious are the fears raised in some quarters that limited partners will shy away from investing in new funds or even fail to honor capital calls?

Our LPs don't call us. We try to keep them up to date on what we think is happening in the market.

In general, I would say almost without exception that we don't expect any defaults -- we don't foresee any indications of that. No one has expressed concern about funding. I'm not living in a dream world, but I don't foresee this happening, not with the kind of people who are participating in this marketplace.

I'm sure there will be an exception, but it will be the exception and not the rule.

What are some of the key trends you see emerging under the next presidential administration that are likely to affect VCs and entrepreneurs?

One important trend is that we're certainly going to have more regulation. They'll be careful to avoid over-regulation, but we're not going to be as foot-loose and fancy-free in a lot of areas.

I also think that carried interest is going to be taxed as ordinary income, which is something that is of interest to a lot of general partners. The capital gains rate will probably also go up. On a macro basis, we're going to see a lot more public assistance.

As for innovation and technology, particularly under a Democratic administration, there'll be more money for the National Institutes of Health. I think research and development will be emphasized and that any programs that will result in job creation are going to have a high priority.

What sorts of companies or entrepreneurs will be best positioned to capitalize on the ongoing economic malaise to build important new businesses?

It depends on the individual company; I can't speak for all of them. But something to look at are people who can deliver a product that will save people money and time, and efficiently. Buyers are now looking for things that they need -- they're going to be a lot more careful and less casual about what they'll buy. If you have something that has a good story attached to it and a good benefit in the near term, you'll be in a good position.

Where do you see this latest economic cycle fitting into the larger story of the venture equity and growth capital industries?

I don't think it's going to change that much. We've been through so many of these cycles; everything doesn't go in one direction. Most people will be survivors in the venture business. The major difference is that public markets will no longer be the principal exit.

I think it's a question of running your business carefully. Perhaps there'll be a few more casualties -- investors won't support every company until the end of time. They'll be a little more careful. But long range, the business will come out of it, and we'll be fine.

We came out of 2000, the so-called nuclear winter, after companies had overexpanded, venture people put too much money in, the losses were too big and nothing was appropriately scaled. And today the situation is more rational.- Paul Bonanos

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Marathon Man: A conversation with Alan Patricof

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