Venture Capitalists Eye New Tech Targets

Venture funding increasingly targets evolutionary, not revolutionary, developments in technology

Silicon Valley, CA—March 20, 2006
Venture capitalists investing in IT will make their fortunes by understanding the evolutionary nature of technology and business, not by investing in revolutionary technologies. "It's been a misnomer that venture capital creates technology," says Brian Farrar, managing director of Innovation Advisors, an investment banking advisory firm. VCs will fund companies that provide products and services that build upon the existing technology infrastructure and take it to the next level. It's the closest thing to a sure bet these days. Asheem Chanda understands that. He's a partner at VC firm Greylock Partners. After months of scrutiny, Greylock, along with another VC company, Sequoia Capital, invested $13.4 million last year in 4-year-old security software vendor PortAuthority Technologies. Chanda likes that PortAuthority is taking software that monitors systems intrusions and evolves it so it also enforces policies to halt leaks of confidential information. That's especially important, he says, at a time when complying with arduous federal regulations and protecting intellectual property have become a burden on many companies. Greylock's PortAuthority investment represents another trend in VC funding: the penchant to invest at a later stage. Last year, late-stage funding represented 37% of VC investments, up from 20% in 2000, according to the Ernst & Young/VentureOne Venture Capital Report. At the zenith of the go-go years, VCs made nearly half of their investments in first-round financing; over the past five years, that percentage has slid to 32%. After experiencing the irrational exuberance at the turn of the century, many VCs now wait until a new company has a track record with a product or service that customers buy before investing. Another benefit of later-stage investing: There's less time before VCs can cash out, either through an initial public offering or a merger or acquisition. Yet, later-stage funding doesn't reap as large a reward as a first- or second-round investor whose early investment means more risk that a payday may never happen. New Focus Other differences in VC funding compared with investments made just a few years ago are the preponderance of deals involving on-demand and personal technologies at the expense of companies developing products and services for businesses. Last month, two VC firms--General Catalyst Partners and North Bridge Venture Partners--raised $22 million in series B funding for Demandware, a provider of an E-commerce platform based on the concept of software as a service, which provides retailers with tools to price products. And this month, the year-old company unveiled the 14th customer for its E-commerce platform tools. General Catalyst managing director Larry Bohn sees businesses moving to on-demand services rather than buying and installing software. Online retailers don't want to become IT companies, so he envisions great potential for businesses offering software as a service. "It creates the opportunity for a recurring revenue business because you're selling technology as a service rather than just as a license," Bohn says. With the opportunity to pick from among hundreds of companies seeking venture funding, why Demandware? It goes beyond market potential. The company has a leadership team with a proven track record. A big asset for Demandware is president and CEO Stephan Schambach, who in the early 1990s was among the first entrepreneurs to recognize E-commerce as a major software market. In 1992, Schambach founded the German company Intershop, a provider of E-commerce tools to centrally manage online business channels that now trades on Nasdaq. "You're looking for the best entrepreneurs," Bohn says. "The best entrepreneurs will find the best markets and the best technologies to build significant companies. We're looking for the best entrepreneurs, the best technologists. Because at the end of day, those are the people who build great businesses." Be The Trailblazer Like much of business, a herd mentality can be found in VC investing and the shift toward funding of on-demand and personal-oriented technologies. "When folks see a successful investment, then a number of other compa-nies will spring up to try to attack the same market in a different way, and investors will follow into that market," Innovation Advisors' Farrar says. Cash Flow Most-active IT investors in 2005, ranked by number of deals in U.S. companies Company No. Of Deals Draper Fisher Jurvetson 43 U.S. Venture Partners 42 New Enterprise Associates 40 Sequoia Capital 37 Intel Capital 33 Menlo Ventures 32 North Bridge Venture Partners 31 Redpoint Ventures 30 Accel Partners 30 Mayfield 28 Austin Ventures 28 ComVentures 27 Sevin Rosen Funds 26 Venrock Associates 25 Foundation Capital 24 Data: Dow Jones/VentureOne But someone must start the trend, and the successful venture capitalist is one who can identify it before it gets overcrowded. General partner Tim Connors likes to think his firm, U.S. Venture Partners, is a trailblazer, not a follower. "It's interesting to watch the collective wisdom shift ... as certain areas come in and out of favor," Connors says. "To some degree, you want to be fairly contrarian to what groupthink is about. You want to get to a market opportunity before everybody else, or after somebody else has given up on an area." Connors says U.S. Venture Partners was ahead of the pack three years ago when it took the lead to raise $9.2 million for Spoke Software, an online social network for sales reps. "We funded that company in the business-social networking space long before the term social networking was something that venture guys understood," Connor says. "And it's been interesting to watch that go from a contrarian deal to [where] everybody and his brother have social networking in some way, shape, or form in their investment pitch." Two decades ago, a dozen or so VCs invested in high tech. Last year, more than 1,000 U.S. venture investors funded beginning tech projects, though nearly half invested in only one deal, according to the MoneyTree Survey by PricewaterhouseCoopers, Venture Economics, and the National Venture Capital Association. Under The Rocks With so many investors out there with large amounts of capital available, it's both a seller's and a buyer's market. Last year, VCs invested nearly $21.7 billion in American ventures, according to PricewaterhouseCoopers. The top VCs get to pick the most promising ventures. "It's still a business of brand names," says Kirk Walden, PricewaterhouseCoopers' national director of venture-capital research. But with so many VC firms trying to establish themselves, entrepreneurs with a promising business plan that either evolves or exploits existing technologies should be able to find financing. "VCs and private equity firms are looking hard under rocks and around corners to find deals," says David Brophy, director of the Center for Venture Capital and Private Equity Finance at the Zell-Lurie Institute for Entrepreneurial Studies at the University of Michigan. "This is a great time for entrepreneurs to come up with the next big thing."