Fighting to Get in on the Next Little Thing
September 20, 2005
By Gary Rivlin

San Francisco - FOUR months to six months. Only a year or two ago, that was how long start-up companies generally had to cajole, fret and act nonchalant while waiting for venture capitalists to part with money - if they proved willing to write a check at all. Even during robust times, the period between a first pitch meeting with a venture capitalist and financing typically spans three months.

So imagine the surprise of those behind a start-up called XenSource when they started shopping for cash this summer on Sand Hill Road in Menlo Park, Calif. - the venture capital equivalent of Wall Street - and had seven firm offers within three weeks.

XenSource, which has developed software that runs several operating systems simultaneously on a single computer chip, is 18 months old. It has yet to book a dime in revenues. But so different is the current venture climate when compared with just 18 months ago that the company was able to raise $17 million. "If we had gone up and down Sand Hill, we could have had 25 offers," said Nick Sturiale, a partner at Sevin Rosen Funds. "There was that much interest in the company."

Not every company is that fortunate, of course. But XenSource is hardly unique, and scores of start-ups are finding that venture investors in recent months have been receptive. After several years of caution and hesitation, if not outright fear, the venture capitalists are again opening their wallets to the start-ups.

Technology companies are primarily the benefactors of the current venture boom, but if the past is any indication, that portends good news for start-ups of all shapes and types now that Sand Hill Road, a font of cash primarily for technology concerns but not exclusively, is once again pumping lifeblood into new companies each week.

Most will fizzle, but the fear of missing out on the next Google or Skype, the two-year-old Internet phone company that eBay plans to buy for as much as $4.1 billion, is causing something rarely seen since 2000: fighting among venture capitalists to own a piece of the hottest properties.

"We're hearing much more about elbows being thrown, especially if you're talking to people in Silicon Valley," said Mark G. Heesen, president of the National Venture Capital Association. "There's a lot of competition out there." And venture capitalists are once more showcasing their successes and providing references to entrepreneurs they want to impress.

Any number of Silicon Valley venture capitalists will attest to the new competition, including Tod H. Francis, a managing director at Shasta Ventures on Sand Hill Road. "Over the last six months, we've seen a general increase in activity," Mr. Francis said. "And we fully expect there will be another jump in activity as we move into the fall."

Shanda Bahles, a partner at El Dorado Ventures, also based in Menlo Park, has also seen a marked increase in competition in recent months. "Today, if you see an opportunity you like, you have to move quickly," Ms. Bahles said. "Because you know that it won't stay on the shelf long." She contrasts that with the state of venture capitalism after the bursting of the technology bubble in 2000. "Two years ago," she said, "if you saw something you liked, you could watch it for a few months, see what kind of progress they're making and take your time."

The partners at the Woodside Fund, a venture fund in Redwood City, Calif., certainly know firsthand about increased competition.- and they're inclined to set the starting date as the fall of last year. That's when they began talking to their rivals to find two firms willing to help them finance an Internet consumer company they found compelling - but not so compelling they wanted the entire deal themselves.

"We put it out there and suddenly we had seven firms wanting in on these two slots," said Thomas A. Shields, a partner at Woodside.

The firm had worked with several of these investment firms in the past and hoped to work with all of them in the future. In theory, the choice of the other two firms was for the founders of the start-up to make, not theirs, but of course the view of the Woodside crew counted a lot. The partners there needed to decide about whom they would recommend, but their decision became that much easier when they heard from the company's founders: one of the venture capitalists apparently viewed the deal as so enticing that he tried to convince them they should forget Woodside altogether.

"There were backdoor conversations where the V.C.'s were telling the founders, 'Don't work with these guys, work with us,' " said John C. Occhipinti, Woodside's managing director. The start-up, which Mr. Shields and Mr. Occhipinti declined to name, had signed a term sheet with Woodside, but such deals typically expire after 60 days if the two sides do not come to an agreement.

"The V.C. industry is very gentlemanly," Mr. Shields said. "But there are certain deals that a lot of people want in on, and at that point people get very competitive."

There are many reasons things have gotten more competitive, starting with a spike in the money the professional venture capital set has raised from foundations, university endowments, rich individuals and others. Venture capitalists raised more venture money in the first half of 2005 than they did in all 2003, and the $6.1 billion they raised in the year's second quarter bests any three-month period since 2001.

"People have fresh money," Ms. Bahles said. "They've figured out what went right and what wrong the last time. And they're in a position again to make new investments."

The phenomenal market for initial public offerings is what propelled the venture boom of the late 1990's. The current market remains sluggish, enormous successes like Google notwithstanding. But by all accounts that other inspiration for venture deals, big-money acquisitions, is once again hot. Deals like Skype and the $580 million that the News Corporation paid in July to buy Intermix Media, the parent of MySpace, a social networking Web site popular with the under-30 set, are proving inspiring to venture capitalists.

"We're on track for our best year for mergers and acquisitions since 2000," said Richard J. Peterson, the chief market strategist for the research firm Thomson Financial. There have been $7.16 billion in mergers and acquisitions through mid-September, according to Thomson, compared with $5.5 billion in 2003 and $8.3 billion in 2004.

"All of us are noticing that smaller companies are being acquired by larger ones at reasonable and healthy valuations," Mr. Francis of Shasta said. "It's like a better party, and it encourages more activity."

There is also the widespread growth of broadband Internet access, the popularity of Web-based cellphones and the emergence of a second generation of start-ups that are building on the successes and failures of the first. These and other factors are ushering in a renaissance of new start-ups, and venture capitalists are eager to take part in this second wave of Internet innovation.

"It's a really good time to be an entrepreneur," said Peter Thiel, who helped found PayPal, which eBay bought for $1.5 billion in 2002. "If you have a halfway decent idea, you can get it completely funded."

Mr. Thiel, who runs a hedge fund called Clarium Capital, has invested in more than a dozen start-ups over the last several years. "I don't know if there's even been a time quite like this," he said, "when it's been so great to be an entrepreneur but not so great to be an investor, given all the competition out there."

Some are ready to compare the current period with 1999, as far as heady prices go. Mr. Thiel is convinced that's the case, at least at the earliest stages of the venture game, when he tends to play. And certainly one comes across stories that call to mind 1999. Paul S. Kedrosky, a professor at the University of California, San Diego, does consulting work for venture capital firms, so he declined to be specific. But he told of four top firms vying for a piece of a company with three part-time employees, and willing to plunk down $8 million for the deal. "Competition is definitely up out there right now," he said.

Any resemblance to 1999 is strictly isolated, more what might be called bubblets than outright bubbles. Open-source software, podcasting, social networking, security - these and other areas have been so hot at different points over the last couple of years that occasionally prices have inflated wildly.

Open-source technology companies in particular are in demand, with the widespread adoption of the software by corporate users. The group behind XenSource includes a pair of faculty members from Cambridge University and two software industry veterans. The young concern, in Palo Alto, Calif., received a first round of $6 million in January from Sevin Rosen and Accel Partners, also in Palo Alto, and Kleiner Perkins Caufield & Byers, on Sand Hill Road. But by midsummer, the start-up needed more money. "We wanted to scale this up faster than originally planned," said Mr. Sturiale of Sevin Rosen.

"I know of open-source deals being funded almost automatically right now," he said. Many venture capitalists, he added, are convinced that the open-source phenomenon represents a fundamental shift in the software market, "so they want to have a play there." That's what happens, Mr. Sturiale added, echoing others, when there are too many venture capitalists pursing a small pool of ideas.

"When there's a hot deal in a hot area, the scrum around them is something to see," he said.

The difference between today and the time of the Internet bubble, however, is that far fewer mediocre deals are getting money now. "We're not seeing mediocre teams get funded just because they're in a hot space," Ms. Bahles said.

Another difference: fewer cases of start-ups so much in demand that venture capitalists bid up the price as in an auction, which happened in the past. The competition for deals might be keen, said Jim Breyer, the managing partner at Accel, but that hasn't caused valuations - the paper worth a venture capital firm assigns a start-up when making an investment - to spike. "The valuation ranges are generally plus or minus 20 percent, even when a pool of traditional V.C.'s are competing for a deal," Mr. Breyer said.

Which means that venture capitalists are mainly competing less on price and more on what they can offer an entrepreneur. "Entrepreneurs are not always picking the highest valuations," Mr. Occhipinti said. "That's one big difference with five years ago."

So now venture firms find themselves playing both a seller and buyer's game. Accel, Mr. Breyer said, receives 10,000 pitches every year. The firm will seriously consider investments in a few hundred of those and join only a dozen to 15 in a year.

At the same time, Accel must sell itself to the founders of the start-ups once they think they want to invest. "We not only ask entrepreneurs for references, we provide references to them," he said. "In almost all cases, savvy entrepreneurs are asking us to provide us with names of contacts" - people at important companies who can vouch for Accel's brain power, connections and usefulness.

That's nothing, Mr. Sturiale said. He has seen firms - top ones - print promotional materials to make their case. "Some of these firms will get two or three partners involved and call everybody attached to a project to make their pitch," he said. "When people really want in on a deal, they'll really pull out all the stops."

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