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— Analysis —
Browse other stories in Tech Confidential Special Report: The state of early-stage investing
The time has never been better to invest in very young technology companies, but that doesn't mean it's easy. That's one reason most venture capitalists tend to focus on larger, less risky investments, where markets are more defined and opportunities more obvious. Yet several firms are placing all or a substantial part of their bets on early-stage startups, many of which have not moved far beyond the concept stage. These VCs must be prepared to fail, even more so than those who focus on investments beyond the Series A. Some firms, like venerable Sequoia Capital, even wear failure as badges of honor. Huge exits are rare, but the attraction of early-stage investments is obvious. For one, investments of less than $1 million can now quickly take a product from an idea to launch, making it far easier to discern whether the concept can gain traction or is destined for the dustbin.
"Software is nearly free, bandwidth is cheap, there's outsourcing and offshoring for engineering resources and people don't have to spend $1.5 million for Sun and Oracle equipment," says George Zachary, a venture partner with Charles River Ventures. "It's brought a $2.5 million Series A round of funding down to $250,000 seed funding." The payoffs can be handsome. Madrona Venture Group participated in a $1.5 million Series A for a company that was little more than a university research paper about predicting airline prices. The startup evolved into Farecast.com, which Microsoft Corp. acquired for a reported $115 million in April. Several other firms have achieved similar success or are hunting for it. Tech Confidential looks at 10 technology-focused VC firms with an eye for the early stage. Accel Partners From the digital media provider RealNetworks Inc., which went public in 1997, to the highly valued and enormously popular social networking site Facebook Inc., Accel Partners' Internet investments have represented some of the most transformative technologies. Palo Alto, Calif.-based Accel has always included seed investing as part of its early-stage strategy and three years ago launched a concerted effort to do more of this in consumer Internet and online gaming. Partner Theresia Gouw Ranzetta says the increased focus on seed investments is a nod to the mileage a young company can get on $500,000 as well as the ability to get quick user data feedback from startups' sites that are up and running. Still, this preference for seed investments will not bar Accel from investing in a promising later-stage company. Case in point: Earlier this year, Accel stepped in at the Series D level of funding for Etsy Inc., a three-year-old online marketplace for buying and selling homemade goods. That $27 million funding round exemplified how even businesses that have gained traction on a shoestring budget conclude that a fat later-stage round can help accelerate their expansion. While Etsy had completed three funding rounds by the time Accel stepped in, its management had been opposed to accepting too much venture capital and had raised just $5 million in all its prior rounds. Ranzetta says that competition among venture firms to get in on the best early-stage investments is intense, though it still doesn't quite compare to the frenzy of 1999. Madrona Venture Group The best VCs don't wait for the business plans to arrive at their doors, but the growing pressure to invest at a preliminary stage means more companies are getting funded before they have a formal business plan at all. Madrona Venture Group of Seattle says one of its best investments was in a company so embryonic it was little more than an academic research project. In 2004, Madrona participated in a $1.5 million Series A round of a company that at the time called itself Hamlet Inc. "It was literally a research paper from the University of Washington about predicting future airline prices," recalls Madrona managing director Greg Gottesman. "We were willing to go in at that stage." Hamlet later changed its name to Farecast and built a site to help consumers outsmart the airlines' cumbersome ticket pricing system by predicting when prices were most likely to be low. In April, Microsoft acquired the company. Sources quoted a price tag of $115 million, more than 4 times the $21 million Farecast had raised over three venture rounds. "Our biggest competitors are not other VC firms, but self-funded deals," says Gottesman, who works to illuminate potential investments about the value VCs offer beyond cash. Madrona typically strives to be the first to provide institutional capital to a startup, but after that point, it prefers syndicated deals. "We don't think we have a monopoly on brains," Gottesman says. Among Madrona's other successful investments was the networking site Classmates Online Inc., which Internet service provider United Online Inc. acquired in 2004 for $100 million. Mohr Davidow Ventures There really is no such thing as a killer app; there are only potentially good ideas that might become great businesses in the right hands. Mohr Davidow Ventures of Menlo Park, Calif., takes this a step further and argues that there is really no ideal time to invest in a startup. Rather, MDV assumes that even relatively mature businesses might be considered "early stage," given the room for growth they have remaining. For that reason, although MDV calls itself as an early-stage investor, it doesn't get too caught up chasing only the youngest, lesser-known companies. Last year, for instance, MDV led a $20 million Series A funding of Hi5, then a four-year-old San Francisco social networking company that boasted 28.5 million unique visitors with no prior institutional funding. "I think the definition of 'early stage' has expanded," says MDV partner David Feinleib. "All our investments are early stage in the sense that they have significant scaling and growing yet to do. They have all reached an inflection point where they really need to scale up." The same year MDV invested in the relatively mature Hi5, it put $2 million into a seed funding of PBwiki Inc., a San Mateo, Calif., provider of hosted business wikis that Feinleib describes as a product of the classic "two entrepreneurs out of Stanford." Himself a Stanford University graduate, Feinleib says he often draws on personal connections to discover promising business plans and to reinforce the teams of these young companies in a way that makes the difference between good and great. "Entrepreneurs will call me and say, 'I thought I knew what great was, but then I found, X, Y, or Z, and they are amazing,' " he says. Bessemer Venture Partners If it takes a lot of self-assurance to own up to your failures, then Bessemer Venture Partners is oozing confidence. The 97-year-old global firm, with offices in Menlo Park, New York, Bangalore, India, and Shanghai, prominently displays on its Web site a list of companies -- including eBay Inc., Google Inc., Cisco Systems Inc. and Apple Inc. -- that it declined to invest in over the years. Bessemer calls this its "anti-portfolio," noting that its long history has given it "an unparalleled number of opportunities to screw up." Laughs aside, the list shows that success need not hinge on participation in one key deal. While Bessemer missed out on many of the most successful exits, its 2003 gamble on the then little-known Skype Technologies SA paid off big when eBay Inc. acquired the Internet-based phone service for $4.1 billion in 2005. A number of Bessemer's top Internet exits, however, date back to the Web 1.0 days, including HotJobs.com Ltd., which went public in 1999 and was acquired by Yahoo! Inc., and eToys, the online toy store that completed an initial public offering in 1999, but later dissolved. These days, Bessemer is investing more selectively in consumer Internet companies as part of a broader portfolio that includes biotech, networking and software businesses and is concentrating more on overseas investments. Last summer, it earmarked $1 billion for investments in India. Still, it continues to see promise in U.S. Web 2.0 startups trying to change an established business paradigm, such as Zopa Ltd., a sort of eBay for banking that operates a community where lenders and borrowers can connect with each other and set their own rates. Sequoia Capital In 2005, Sequoia Capital invested $3.5 million in a video-sharing startup called YouTube that was not only unprofitable but had no clear model for making money. It didn't take long for Sequoia to be vindicated in its investment. The firm only had time for one more $8 million follow-on investment the next year before Google Inc. snatched up YouTube for $1.65 billion in late 2006. For Menlo Park-based Sequoia, YouTube is only the latest in a lengthy string of winning early investments that include Yahoo!, Apple, Oracle Corp., Cisco Systems Inc., Pay Pal Inc. (which eBay acquired for $1.5 billion in 2002) as well as Google. Sequoia's list of past portfolio companies reads like a who's who of Silicon Valley, and its investment strategy favored very early-stage businesses started by inexperienced entrepreneurs -- including the 19-year-old founder of Apple and the two Stanford students who launched Yahoo! -- long before it became so popular to chase these embryonic companies. Some other factors that distinguish Sequoia are a degree of confidence in its investment choices that make it reluctant to syndicate, as well as a willingness, uncharacteristic even in venture capitalism, to fail. The 37-year-old firm boasts that its appetite for risk results in a higher rate of failure than its rivals. But at a time when starting consumer Internet companies has gotten so cheap that a preference for early-stage investments is more common, Sequoia continues to stand apart with its refusal to rest on its laurels. The firm's commitment to uncovering new technologies could be viewed as a slight to other companies it has backed in the past: Some of the early-stage companies in its portfolio today include SearchMe.com, a search engine attempting to improve on Google's search methods; and Funny or Die Inc., whose FunnyorDie.com Web site for user-generated comedy videos competes with YouTube. SoftTech VC SoftTech VC of Palo Alto has in four years built itself into one of the most prominent and sought-after early-stage venture firms, underscoring how unknown investors still win against the much more established firms that line Sand Hill Road. Of its 23 investments, mostly in groundbreaking Web 2.0 businesses, SoftTech has completed five exits. For founder and managing partner Jeff Clavier, that winning strategy rose from the ashes of the technology collapse, a period when so much value had been lost in the first wave of Internet companies that dot-com had become a four-letter word. "In 2004, people were still not convinced it made sense," recalls Clavier. "Web 2.0 did not exist at that time." Having recently left a position as president of Reuters Group plc's Greenhouse Fund in Palo Alto, Clavier had acquired both an appreciation for the plummeting costs of building an Internet company and an extensive circle of friends in Silicon Valley. Those friends were continuing to build consumer Internet businesses, even though investors were scarce. Clavier started investing his own money in increments of between $25,000 and $100,000 in many of these businesses, which addressed new and emerging areas of interest on the Internet, such as blogs and video. "The cash requirements were so modest that it created a unique opportunity for the angel investors to jump in," he says. Fast-forward to 2008 and the Web 2.0 industry on which he gambled has become firmly established. Truveo, a Web search engine that was one of Clavier's earliest investments, was acquired by AOL LLC in 2006 for a reported $50 million, while Kaboodle Inc., a site that combines social networking and shopping, was bought by Hearst Corp. for a value reportedly exceeding $30 million. Clavier, who has since those early days formalized his personal investments and formed a $12 million seed-stage fund, will not comment on the sale prices of his portfolio companies other than to say the reported price tags are usually accurate. Flybridge Capital Partners David Aronoff, a general partner with Flybridge Capital Partners of Boston, admits he isn't sure what the exact business model will be for Internet video-related companies, but says startups that can help move and manipulate this kind of content will be valuable. To that end, the firm, formerly IDG Ventures Atlantic, participated in two rounds of funding for Blackwave Inc., a maker of Internet storage and delivery for video distribution, and Transpera, which enables users to send video between the Internet and their phones. "The Internet is changing consumption, delivery, preparation, the entire life cycle of video," Aronoff says. "We saw ... some that were terrific investments, but not terrific companies. The situation is a lot different now. Bandwidth capacity has exploded worldwide, and the price of that bandwidth is cheap." The other major change driving the market for video delivery providers is quality content. "The first time around there was no content. People were transmitting stuff of very little interest over a narrow band," Aronoff says. "Now you have professional, first-run content in terms of production and viewing technology." But Aronoff adds that too many companies do similar things, and some parts of the sector are overfunded. Because broadcasters still look to find the right model, they're experimenting with a number of companies, making it difficult to predict which ones will be widely adopted. Because of those issues, he says VCs are seeking later-stage deals to reduce their risk. "I'm just trying to get as educated and as smart as I can," he says. "Some of it is backing great people with unique insight and unique relationships. But in some situations, we'll look to see how the race is going and be willing to pay up." Spark Capital Calling itself "stage agnostic," Boston's Spark Capital has set its sights on a very wide swath of investment sizes. The firm, which originated in 2005, will invest anywhere from $300,000 in a seed round up to $20 million in a later-stage round. Spark closed a $260 million fund three years ago and raised a $360 million fund last year. It will invest its latest in companies that sit at the conflux of media, entertainment and technology. Among its early-stage investments are social networking technology firm KickApps Corp., mobile media company SendMe Inc.'s SendMe Mobile site, and Tumblr Inc., a Web-based service that allows users to publish files or brief blog posts to one online location. "The whole thesis for why we raised this fund was that the Internet was changing the way content was distributed, and hence there would be a lot of opportunities," says general partner Dennis Miller. Spark takes a hands-on approach with its portfolio companies, doing a lot of heavy lifting in the early development stages, while understanding the risks of backing very young companies. "You try to make the best investment you can, but these are by definition highly risky investments," he says. "You try to look for some sustainable unfair advantage the company has, a remarkable management team, a big market they're going after or a unique product. "It is a risk business and you have to go into it knowing that," Miller adds. Browse other stories in Tech Confidential Special Report: The state of early-stage investing
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