The Great Hunt For Hot Ideas

What starts with a bagel may end with another Yahoo!

The art of the deal begins, in Palo Alto, Calif., with breakfast at Hobee's. By 7:30 a.m., Geoffrey Y. Yang, a 38-year-old venture capitalist, has settled into his table, this morning with entrepreneur Kingston Duffie. The two seem like old friends, which isn't so surprising: Yang's Institutional Venture Partners made $10 million, a 250% return, in April when Duffie, a 36-year-old engineer, sold his first company, Whitetree Inc., to Ascend Communications Inc. for $66 million. Now, they are hashing out Duffie's vision for a second startup, another telecom concept, and their conversation bubbles with talk of NSPs, DSPs, and IDSLs.

Even before the bagels and fruit shakes are carted away, Yang, who is hearing the still-fuzzy concept for the first time, offers Duffie $100,000 and an office to help him explore the idea further. His message is clear. "I want to be involved with just about whatever he does," says Yang. "Everyone will be all over Duffie. I'm trying to lock this up before anybody else knows about it." No commitments are made, but Yang suspects his no-strings-attached overture has served its purpose.

Down the road at Il Fornaio, another popular Valley breakfast spot, venture capitalist Gill Cogan is engaged in a similar ritual. His target is Joseph J. Raffa, a 36-year-old marketing whiz who made his name at Hewlett-Packard Co. and software maker Synopsys Inc. Cogan, a partner at Weiss, Peck & Greer Venture Partners, wants Raffa to help run one of the companies in his $205 million fund. He already has bought Raffa a fancy cell phone and given him the unique opportunity to invest in some of the firm's deals. "It will pay off handsomely," says Cogan. "We know he's going to do something good, and we want him to call us first."

Dealmaking, Silicon Valley-style. Nearly every day of the week, venture capitalists, entrepreneurs, and resume-bearing executives pile into the same half-dozen haunts, constantly bumping into one another as they attempt to seal the deal of the day. The object of the game: money. Venture capitalists, in fierce competition with one another for the next Netscape Communications Corp. or Yahoo! Inc., want to multiply it. Entrepreneurs simply want it.

Without their frenetic mating dance, Silicon Valley couldn't be the technological mecca it is today. Indeed, no place else in the world hosts so many venture investors eager to dump money into the untested ideas of young entrepreneurs--all on the off chance that they can overcome inevitable startup snafus to reach powerhouse status. Of some 600 venture firms nationwide, about half call Silicon Valley home, according to the National Venture Capital Assn. These firms establish funds and then drum up the money--no hard sell these days. Money flows in from pension funds, insurers, and endowments around the world, all hoping to achieve annual returns as high as 50%. Then the hunt for hot deals is on.

Outside of Hollywood, this is, perhaps, the business world's ultimate continuous schmooze-fest. Yang's Menlo Park-based firm alone spends some $400,000 a year on networking, with good reason. Competition for the sexiest deals and hottest talent is keener than ever as money flows into the industry at an unprecedented rate. In just four years, venture investments in Silicon Valley have soared 188%, to $2.2 billion in 1996, accounting for 35% of all information technology venture capital investments in the U.S., according to industry tracker VentureOne Corp. (chart). The Valley's share of the total has slipped in recent years, but that's because firms have put relatively more funding into the area's booming startups, which tend to require less capital per deal than young companies in later stages.

HIGH CASUALTIES. Big money, of course, is what oils the Valley's gearbox. "It really turbocharges the development of new ideas into new industries," says David Gleba, chairman of VentureOne. Yet while the flood of capital has intensified, the number of promising deals remains finite. Venture capitalists aim to multiply their money in any one company at least tenfold within four years, but a Seagate Technology Inc., which brought Yang's firm a $56.5 million profit on its $500,000 investment, is rare. Ultimately, one in three investments produces a total write-off.

To separate the gold-plated winners from the also-rans, VC firms sort through reams of prospects, evaluating ideas, management, and potential markets. New Enterprise Associates reviews 3,000 business plans each year and ends up funding just 20 companies. Hummer Winblad Venture Partners culls through 1,600 plans to come up with 10 worth seeding. "We don't want to fund dipsticks," says partner Ann L. Winblad.

But venture capitalists have become more than financial analysts with big checkbooks. Indeed, the best of the lot wear a wide array of hats--from executive recruiter to corporate strategist to networker to salesman. They're aggressive, hands-on investors, demanding an active role in setting the course for their companies. "Our job is to multiply money by a lot, not a little," says Bruce W. Dunlevie, a partner at Benchmark Capital Management in Menlo Park. "You do what has to be done."

After wooing Raffa over breakfast, for example, Cogan heads to Terayon Corp., a cable-modem startup that Weiss, Peck & Greer funded in 1995. The Santa Clara company is preparing to raise its third round of financing. Cogan, whose early-round investment will be affected by the valuation from the new round, wants to preview the pitch. He is not impressed by what he sees--a verbose, poorly organized slide show. So the 43-year-old venture veteran and his partners roll up their sleeves to sharpen the company's message and spice up the graphics. "This is a very exciting company, but nobody would have known from listening to this damn presentation," says Cogan.

Often, it's the VCs' Rolodexes that make deals happen. At a recent meeting with Com21 Inc. in Fremont, C. Richard Kramlich of New Enterprise Associates promises to hook up the cable-modem company with John Sidgmore, a top exec at potential customer WorldCom Inc. Another investor, Will Hearst, a partner at Kleiner Perkins Caufield & Byers, already has introduced Com21 to senior execs at Tele-Communications Inc. and to Thomas A. Jermoluk, CEO of @Home Corp., a cable-based Net service. "They have opened the door for us," says Com21 President and CEO Peter D. Fenner.

Who you know counts for a lot in the Valley. But what you're willing to do for them counts for even more. VC legend L. John Doerr a self-described "recruiting animal," logged tens of thousands of miles over nine months, shuttling to Austin, Tex., Washington D.C., Los Angeles, and Aspen, Colo., to win Michael Long, head of software maker CSC Continuum Inc., for the CEO job at Palo Alto-based Healtheon Corp., a startup funded by Kleiner Perkins. When it came to finding a CEO for @Home, Doerr interviewed 55 candidates in hotel rooms across the country before settling on Jermoluk.

Benchmark Capital's Dunlevie took a different tack to snag James Jordan. In 1992, Jordan, a successful 57-year-old networking expert, was reluctant to take the helm of Kalpana Inc., a networking company that sorely needed seasoned management. Dunlevie, who had funded Kalpana in 1990, persuaded Jordan to try it for three months. When Jordan grumbled about missing his favorite pastimes, Dunlevie arranged for the exec to go salmon fishing in Alaska and (though a nonhunter himself) went dove shooting with him in New Mexico.

CHEAP CAR. When Jordan later worried about not having time for personal matters, such as selling his wife's car, Dunlevie stepped in again: "I bought this guy's car just to remove an objection to running the company," recalls Dunlevie. His efforts paid off: Jordan revived Kalpana, and in 1994, sold it to Cisco Systems Inc. for stock now worth more than $1 billion. Dunlevie's return: about $61 million on a $3.8 million investment.

The maneuvering, indeed, is ceaseless. Executives in demand can name their price. And startups with the right technology and team can play VC firms against each other to win ever-higher valuations. Who, for instance, will bag Tumbleweed Software Inc.? The Redwood City-based startup, which makes software that allows companies to send documents securely over the Internet, has pitched 20-plus Silicon Valley firms to raise $6 million. Now, 30-year-old CEO Jeffrey C. Smith gets to handpick his investors. "At this point, everyone's money is green," Smith says. "Now, it's about who would be the best partner."

On a whiteboard, he divides his suitors into five categories: in, hot, warm, cold, and out. The first cut is easy: Hambrecht & Quist, which manages a fund for Adobe Systems Inc., will win a lead position with Bessemer Venture Partners and original investor Draper Fisher Jurvetson. He dismisses the "colds" and "outs," including tony Mayfield Fund, which will invest only if Smith agrees to relinquish the helm, a request often made of bright but inexperienced entrepreneurs. The "warms" are largely axed, too--one simply because the partner on the deal got sick, another because of too few connections.

Days later, the action escalates. Venture newcomer Generation Partners raises the ante with a valuation worth $4 million more than H&Q's. At the same time, Microsoft Corp. board member David F. Marquardt, who runs August Capital, offers $3 million less but brings access to his blue-chip contacts. "Marquardt is right about his value," says Smith. "But I'm not sure he's $3 million right." When the dust clears, Smith snags a higher valuation than originally expected, and a total of $7 million in capital. H&Q kicks in $3.5 million; Bessemer puts in $2 million, with Draper Fisher taking the remaining $1.5 million. Generation, late to the party and lacking marquee value, loses out.

Will Tumbleweed prove a winner? Who knows? The sobering reality of the Valley is that much of the wooing leads to failure or mediocrity. Winblad's firm lost $1.2 million investing in Slate Corp., a pen-based computing software startup. Atherton Technology, an object-oriented software company launched by entrepreneur William G. Paseman and funded by Kleiner Perkins and Mayfield, went bust after five years in business.

Still, up and down the Valley, at Hobee's and Il Fornaio, in conference rooms and on car phones, the pursuit persists. Paseman, in fact, soon went on to form Calico Technology Inc., another software venture--funded by the same VC firms burned by Atherton. Why? Amid the bagels and shakes, across the phone lines and on E-mail, entrepreneurs and venture capitalists alike sense a glimmer of the next dazzling technology. The Big One. Says Neal Margulis, a 32-year-old who's pitching a home-computer networking company to Benchmark Capital: "It's easy to come up with $50 million niche ideas. But they aren't worth doing. When you start thinking of the ones that could be $1 billion companies, that's when it becomes interesting."

Indeed, that's when the Valley's money starts flowing.

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