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Venture Funding's Vanishing Act

Entrepreneur Phil Soran was stunned this year at how much cajoling and convincing it took to obtain funding for his new data-storage venture, Compellent Technologies. After all, Soran was one of the founders of XIOtech, a storage-networking pioneer, which Seagate bought in January, 2000, for $360 million. He expected venture capitalists to line up for a piece of his new company, partly because he believed his startup was built on a good idea and also because "we had made a lot of VCs a lot of money," he says. "We thought that would carry the day."

In July, Soran and his partners eventually got $9 million from VC firms, plus an option for $9 million more, to get Compellent off the ground. But he had to give up more of the enterprise in return than would have been the case only a couple of years ago.

FUNDING SQUEEZE. In truth, Soran is one of the lucky ones. According to research firm VentureOne, only 15 storage-related technology outfits received funding in the first half of this year, raising just $189 million among them. That compares with the 46 businesses that rustled up $837 million last year. And it's a trickle compared with 2000 -- a record year for all VC funding -- when 112 storage concerns raised nearly $2.6 billion. This year is shaping up to be almost as bad as 1996, when Soran first approached VCs about XIOtech.

Back then, the smart-money guys called Soran's plan for networking storage "snorage" -- and that year, 19 storage outfits raised just $98 million. But in what has become a traditional feast/famine cycle, venture funding for storage players caught fire in 1998, and, by 1999, it was burning out of control, thanks to Internet mania and a red-hot market for initial public offerings.

"For VCs, the flood of investment in storage was triggered by Brocade's success," recalls James Wei, co-founder of VC firm Worldview Technology Partners in Palo Alto, Calif. Brocade Communications (BRCD), which makes switches for storage networks, went public in May, 1999, at $19 a share. Six months later, it had reached $290, and the stock split 2-for-1. Three months after that it was back up at $311, and the stock split again.

"MASSIVE HANGOVER." Now, Brocade, which split once more in 2000, is trading at under $8 a share. And the venture capitalists who poured billions into startups have done triage on their portfolios, identifying potential survivors and cutting loose the outfits they now say should never have received money in the first place. As a result, the storage industry's 77% drop in funding from 2000 to 2001 was even steeper than the 63% decline in investments for the overall VC industry, according to VentureOne statistics.

"We're living with a massive hangover when you look at the amount invested the last three years," says Alex Mendez, co-founder of VC firm Storm Ventures, in Palo Alto, Calif. He has looked at more than 500 businesses this year but has invested in just three. The valuation of startups has fallen by 90% (comparable to the stock slump of publicly traded storage companies). An outfit that would have been able to attract a $30 million initial investment three years ago would now be lucky to get $3 million, says Mendez.

Even at these cheaper prices, moreover, many VCs aren't investing all the money they have raised. Instead, they're keeping cash in reserve to provide second rounds, or third rounds, of financing for players they see as eventual winners, Mendez says. So, NearTek, which makes backup and media-management software, recently obtained $27 million in a third round, topping off its funding at $72 million. CEO Peter Smith notes that one reason VCs were attracted to the deal is that NearTek also has some mature businesses, such as a storage-integration company, that the VCs could get a piece of for a bargain valuation.

NO QUICK EXIT. The venture crowd says it continues to have great hopes for the future growth of the data-storage industry -- and the startups they're betting on. Mendez is focusing mainly on Sanera Systems, which is developing a high-powered switch for storage networks. In fact, he's the company's interim CEO. Worldview Technology Partners' Wei is betting on 3Par, which produces storage-management software that will launch commercially in early October. Geoffrey Baehr, a partner at U.S. Venture Partners in Menlo Park, Calif., is looking at concerns that plan to combine commodity hardware and custom software to build lower-price storage systems with the attributes of high-end storage-area networks.

The problem is that, even for good businesses, VCs have no near-term exit strategy to recoup their investments. "Why should I put money into a company just to keep it alive when there's no revenue, no exit scenario, no IPO market?" asks Mendez.

Indeed, the weak stock market has pretty much slammed the door on IPOs. NexSan Technologies, which makes storage networks for backup and disaster recovery, had gained the necessary approvals from the Securities & Exchange Commission and was about to go public before last year's September 11 attacks. The IPO has been postponed ever since because of market conditions. "We're still going to come out," declares Diamond Lauffin, NexSan's senior executive vice-president, who adds that the outfit is profitable and working with investment bankers.

BIG GET BIGGER. A startup being bought by a larger corporation -- another possible exit strategy for VCs -- is increasingly an option. The problem is, such deals tend to be done at such low prices right now that VCs can't make back their investments. Big companies that are licking their chops over struggling startups can afford to wait for the prices they want. "They're going to be able to buy great technology for pennies on the dollar," predicts Mendez.

Among giants on the prowl, EMC announced on Sept. 25 that it was buying software maker Prisa Networks for $20 million in cash. Sun Microsystems said on Sept. 19 that it's acquiring storage networker Pirus Networks, and Cisco Systems announced Aug. 20 that it's snapping up storage-switch maker Andiamo -- with both of the deals done for undisclosed amounts of stock.

Wei thinks that the slowdown in VC activity in storage -- which he calls "a healthy thing" -- won't end until late 2003 or 2004. Mendez agrees on the timing but worries about setbacks in innovation because the outfits with the best technology won't always be the ones that make it. "The folks getting the brunt of this are the entrepreneurs," he says.

ONLY THE BEST? Soran sees an even bigger problem: He thinks the overall economy will suffer a few years down the road because businesses that could have been creating jobs and helping to increase overall productivity won't get off the ground.

Venture capitalists who invest in data storage say the best new concepts will still be able to get funding. It's just the weaker ideas that won't. In only two years, "the world has changed dramatically," says Mendez. But, he adds, the renewed focus on the most promising ideas "is really the way it should be." By Amey Stone in New York

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