Is The Big Bucks Party Over?

With so much venture capital chasing Net startups, disappointments are inevitable

Who can forget the ill-fated LBO of RJR Nabisco? More than a decade ago, an intense period of debt-heavy takeover activity peaked with the $25 billion buyout by Kohlberg Kravis Roberts & Co.

Memorialized in the book Barbarians at the Gate, the takeover became synonymous with excess and signaled the end of a business phenomenon. Well, these days, some venture capitalists are fretting that another speculative bubble may be getting too big--the financing of Internet startups. And they worry that the dismal post-IPO performance of one company in particular, Webvan Group Inc., could signal the end of a sky's-the-limit mood for the booming venture-capital business.

Like RJR Nabisco, Webvan's is a tale of extremes. The company raised $275 million in venture capital last year, the most by any company that went public in 1999. Thus far, though, the online grocer has failed to deliver for stock traders and late-round venture-capital investors. At a recent price of 9, the stock is down from its top of 34, achieved shortly after it went public in November. That means the current market cap has sunk well below the last private-round valuation, leaving investors such as Softbank Capital Partners holding stock that's worth less than they paid for it. While Charles Lax, a Softbank general partner, is still optimistic about Webvan's future, in retrospect, he's not happy about the terms of the financing. "We did not get as good a price as we'd now like," he admits.

Deluge. As other late-round VC investors face similar fates, the days of free and easy big cash infusions for startups may be numbered. This would be a far cry from last year when investors eager for rich returns poured an unprecedented amount of money into startups--bloating their valuations and setting the companies up for bucking-bronco initial public offerings. Venture capitalists sank $39.7 billion into information-technology companies in 1999, up from just $7.8 billion two years earlier, according to market research firm Venture Economics. And, most startling, 23 private companies raised $100 million or more in venture capital--including one, Zhone Technologies Inc., that raised a stupendous $500 million (page EB108). Some companies are even turning away capital. Veridian Corp., a private information-security outfit based in Alexandria, Va., last year raised $150 million, chiefly to finance acquisitions. Says Chief Executive Officer David H. Langstaff: "Raising the capital was never a concern. We could have raised more."

Where's all the money coming from? From every corner. With leveraged-buyout action scarce, players like KKR and Hicks Muse Tate & Furst Inc. are investing in pre-IPO startups. Former mutual-fund managers like Larry Bowman of Bowman Capital Management and Jay Hoag of Technology Crossover Ventures have raised war chests to apply their stock-picking skills to startups. Now, add increasingly aggressive corporate venture funds and investment banks, cashed-out technology entrepreneurs, and European money. Not to be outdone, traditional VC firms also have set up their own late-stage funds. Last year, $9.4 billion was invested in later-stage fundings, compared with less than $1 billion in 1995, according to Venture Economics.

Until now, the money has produced eye-popping returns. Venture funds delivered a 62.5% return on invested capital through the first nine months of 1999. Early-stage funds did still better, yielding 91.2%, Venture Economics says. It used to be that seasoned venture capitalists could expect to hit "home runs"--a tenfold or better return--maybe 1 in 10 times. Now, "4 or 5 out of 10 deals currently return 10 times or more," marvels Bob Kagle, general partner with Benchmark Capital in Palo Alto, Calif.

Sounds great, but it actually may be too much of a good thing. The flood of capital is raising the price of deals, particularly in the later rounds. "There's so much capital available it's creating inflation," frets Ed Glassmeyer, co-founder of Oak Investment Partners LP in Westport, Conn. And it's in the late rounds where capital is in such profusion that the most costly mistakes are made. Webvan was a great early-round investment, producing a 100-to-1 return on Benchmark's $3.5 million, according to Kagle. But the last-round investors who put up $275 million have seen the value of their investments decline by roughly 25%.

And it could get worse. Some believe Webvan was grossly overpriced in the last round. Richard D. Frisbie, a general partner with Battery Ventures in Wellesley, Mass., questions whether online retailers--even companies such as Webvan that are building extensive distribution networks of their own--will ever have adequate margins. "I'm not terribly sanguine about their prospects," he says. Jim Swartz, a founding partner with Accel Partners, questions the wisdom of huge investment in what he terms "brave new world" companies such as Webvan. "You're talking about modifying human behavior," he says of an outfit that's betting shoppers don't need to smell or squeeze the produce. In a sign of weakness in the e-grocery business, online grocer Peapod Inc. announced on Mar. 16 that its chief executive had resigned for health reasons and investors had withdrawn a $120 million package of funding. Now the company is up for sale.

Bad habits. Other online retailers have left late-round investors disappointed, too. Inc., an online seller of vitamins backed by incubator CMGI Inc., received $42 million in a pre-IPO round last May that included new European and corporate backers. With the stock trading at $6 a share in the wake of a December, 1999, IPO, that $42 million investment is now worth roughly $17 million. Inc. raised $50 million in a pre-IPO round, but the stock has been a dog since going public. Paul Manca, the company's chief financial officer, acknowledged late-round investors are below break-even now. He blames his company's poor stock performance on a general downturn for e-tailing stocks. "There are a lot of companies out there who are private right now who may have their valuations up higher than the public market will support," he says.

Inflated valuations and poor returns aren't the only problems. The venture glut puts so much money in the hands of entrepreneurs that some investors worry they're hard put to spend it wisely. "Too much capital can lead to sloppy habits," says Benchmark's Kagle. Dozens of e-tailers spent large chunks of their venture money on advertising for the holiday shopping season, and analysts say it's not clear if those bets paid off. And how about startup, which collected $280 million in 1999 funding? It's debatable whether the year-old online auto seller will get payback from the $2 million it spent in March to sponsor a NASCAR race in Las Vegas.

While it's an accepted strategy for e-commerce companies to remain profitless while they build market share, some are taking the practice to dangerous extremes. They're actually losing money on basic operations--before they spend a cent on sales and marketing. Inc., for instance, has negative gross margins. Nevertheless, it poured $70 million into sales and marketing last year. reported $5.7 million in revenue last year and $13.4 million in cost of goods. Atop that loss, it spent $42 million in marketing.

The potential for more stumbles like Webvan's has many venture capitalists fretting that the current venture boom may be topping out. They're incredulous at their recent returns, and skeptical that they can be sustained. "It makes for a wonderfully enjoyable environment that isn't going to last. It won't last. It can't last," says Battery Ventures' Frisbie.

What could burst the bubble? Nasdaq investors shying away from tech stocks. "The risk is if the public stops playing the game," says C. Kevin Landry, chief executive officer of venture capitalist TA Associates in Boston. This has already happened with consumer e-commerce offerings. "Today, you can't give them away," says one venture investor. The collapse of the price of, for instance, is making it difficult for a number of other online pet companies to go public, says Softbank's Lax. Now other business categories may be in for a fall, too, says Matthew Cowan, a general partner at Bowman Capital. "In certain sectors, valuations are going up in frightening ways," he says. "The same sense of boundless optimism that previously existed in the business-to-consumer space is now there for business-to-business e-commerce and communications."

With the future direction of their marketplaces held in the balance, both public and venture-capital investors can only hope Webvan's stock performance is not the beginning of the end of a great run.