Even Hotshot Startups Are Feeling The Chill

Michael D. Goldberg is the proud father of a six-month-old girl -- and a three-year-old company. He boasts about his daughter. But when talk turns to how Access Biotechnology Inc., a company in South San Francisco that arranges clinical trials for the biotech industry, recently snapped up $2 million in venture capital, Goldberg turns sheepish. The reason: Amid a lot of doom and gloom over how hard it is to pry loose venture dollars these days, Goldberg raised the money in just three months. "I feel like my wife does when other women ask her how labor went, and she says 'five and a half hours,' " he says.

Indeed, it's a rare company that can slide so easily through the venture-capital wringer nowadays. Last year, U. S. venture firms handed out $ 1.9 billion, a head-spinning 43.4% falloff from 1989, reports Venture Economics Inc., a Needham (Mass.) consulting firm. The future looks worse. So far this year, venture firms have attracted just $870 million from new investors -- vs. 1.8 billion last year. Insiders blame the slump largely on the scores of iffy venture outfits that sprang up in the early 1980s and threw money at virtually anyone spewing technobabble. While only a few of those firms have gone under, they've generated disappointing returns for years. Now, asserts Gib Myers, a general partner with the Mayfield Fund in Menlo Park, Calif.: "They've run to the end of their funds -- and they won't get refunded."

SHARPER EYES. In short, a good old-fashioned shakeout may be starting. As befits such a development, the venture industry should emerge stronger once weaker firms are weeded out. Indeed, despite the slump, optimists like Myers insist that there's plenty of money for good companies: This year, for example, the Mayfield Fund will more than triple the $7 million it laid out to new companies in 1990. And those who believe that venture capital's role as the incubator of technological growth isn't in jeopardy point to hot new areas such as wireless computer networks and "green" software that tracks environmental contamination. They also note this year's record amount raised in venture-backed initial public offerings (chart).

Nevertheless, the freewheeling days are over -- for now. The fiscal crunch has forced changes in the way even the strongest venture firms operate, prodding them to bring a greater scrutiny to deals. In recent years, they've hired more experts in such key industries as biotechnology and software -- then demanded more unique ideas, more knowledgeable entrepreneurs, and a more thorough evaluation of potential markets before opening their wallets. Such changes may mean that fewer new companies will make the grade. But if an enterprise passes muster, venture capitalists are eager to bankroll it -- as Access Biotechnology's story illustrates.

The pullback in spending has several other symptoms. Many venture firms, for instance, are circling their wagons around existing portfolios. In the past, Boston-based MVP Ventures would have turned to other firms to help raise funds as its current crop of companies grew and needed more financing. But with today's capital crunch, says partner Jonathan J. Fleming, most of that financing now has to be done internally -- leaving little money for new startups.

As venture firms stop trying to be all things to all people, many have also begun serving only companies at specific stages of growth. Some, such as Mayfield, shy away from later financing rounds, where capital demands rise as companies take on workers and gear up for full-scale production. Others, such as TA Associates in Boston, try to avoid risky early rounds of financing. Each dollar there buys a bigger share of the pie, but the risk of a startup's slouching into oblivion is high.

GREATER PRESSURE. So far, on a percentage basis, the disbursement falloff is split almost evenly between early and later stages -- indicating no clear preference for either philosophy. But because the later growth stages typically require more than three times as much money as the early rounds, the financial pressure is greater on more mature firms. The ebullient IPO market has taken some of the heat off. Some biotech companies have eschewed venture financings that might raise $5 million in favor of public markets, where they have raked in $30 million overnight, notes Cynthia Robbins-Roth, editor of Bioventure View, an industry newsletter.

Few experts, however, think the IPO market will remain hot. That means later-stage financing could be even harder to come by. More and more, growing companies turn to large corporations, which not only may provide big chunks of cash in exchange for marketing and distribution rights but even change venture capitalists' minds. Neurogenetic Corp., a four-year-old biotech company in Paramus, N. J., found how crucial a corporate partner can be when it sought to raise $7.5 million last May. Despite its unique gene-splicing techniques that promise to help deliver drugs precisely to where they're needed in the brain, the company found venture capitalists wary until it signed a research and development deal with Eli Lilly & Co. Suddenly, such big hitters as ABS Ventures and New Enterprise Associates also took the plunge, and Neurogenetic ended up with $9.3 million.

Large companies such as Lilly have long pumped money into hot young companies. Now, this trend is growing as the high costs of research make it harder for big companies to do everything in-house and the drop in the venture pmol makes small firms more amenable to these sometimes constricting alliances. Recently, startups have looked to big Asian companies, which are often easier to work with than U. S. counterparts. "They've got money, they're patient. They're very nice to deal with. And the cost of capital is lower," says Mayfield Fund's Myers, who has helped small U. S. companies forge links with Toshiba Corp. and Sumitomo Metal Mining Co.

NARROWING DOWN. For venture capitalists, adjusting to the new, leaner climate is just part of the battle. They must also keep up the old hunt to identify both hot new areas and the companies that might, in a few years, reach the ranks of the 25 fastest-growing enterprises (table). In the past year, the broad categories of what's hot haven't changed much: software, biotech, communications. But more important than the categories are the distinctions within them.

In software, for example, data-base programs have become passe. The new darlings are products such as SitePlanner from ConSolve Inc. in Lexington, Mass., which helps managers of hazardous-waste sites visualize contamination patterns and predict cleanup costs. Venture capitalists today also shy away from biotech companies developing costly new drugs. They prefer to back companies working on ways of delivering drugs more precisely to where they're needed -- increasing their effectiveness and avoiding side effects. And in communications, forget about cellular phones. Now, it's microcellular: pocket-sized phones or systems that link computers over wireless local-area networks.

Of these categories, software boasts the widest appeal. It isn't just that computers are pervasive. Given today's economic blues, venture firms find that it typically requires less than $5 million to take a company from seed stage to a product, vs. tens of millions for hardware outfits, says Ann L. Winblad of Hummer-Winblad Venture Partners, a software-only firm in Emeryville, Calif. True, money is still there for more costly ventures if they're hot enough. But that money is getting hard to find.

Before it's here, it's on the Bloomberg Terminal.