Focus: Billion dollar brains behind the Net

JOE SCHOENDORF has every reason to be happy. His Silicon Valley venture capital company, Accel Partners, floated four Internet-related companies on the public market in May - generally regarded as a slowdown month in the great Internet stock bonanza - and all are capitalised at between $1bn and $3bn.

"Any one of the four could be regarded as a career event," he said. "Having this kind of success is like a 10-0 win in the World Cup." The four included a communications equipment company (RedBack Networks), an Internet billing service (Portal Software), and service specialising in live audio chat (Mpath Interactive).

Despite broader fears that the great Internet bubble might be bursting, all four had "the juice", a marketable product, solid financial teams and the prestige of one of Silicon Valley's most sought-after backers.

Accel is one of four or five venture capital firms that stepped out of the shadows to superstar status in the brave new world of online economics. Over months, it has raised $600m in new investment capital, including a notable chunk from Microsoft, and enjoyed the luxury of refusing a further $400m, picking and choosing among its willing backers.

A few years ago, the few companies providing start-up funds to Silicon Valley were small concerns rarely moving or thinking outside the immediate circle of technology and engineering graduates from Stanford University who came to them for a leg-up.

Thanks to the Internet, everything is suddenly within their reach. Because the Web touches every sector of the economy, they are effectively the driving force at the forefront of the US economy, and the rest of the globe cannot be far behind.

"The whole world east of Oakland is opening up for us," said Mike Moritz of Sequoia Capital, the venture company that discovered Apple, Oracle, Cisco and Yahoo! "In the past, the media and retail worlds would have chuckled if we contacted them. I tried to set up a deal with Time-Warner, and they didn't return my calls. Now we are fending off calls from them."

The total market capitalisation of the 50 companies launched by Sequoia since 1980 is about $400bn. With the promise of untold riches in almost any direction, these venture capitalists don't share the Cassandra visions of analysts who believe the Internet bonanza is facing a crashing halt.

"We're in the second-longest boom cycle since the end of the Second World War," said Roger McNamee of Integral Capital Partners. "Logic would suggest this market would have ended four or five years ago. But anyone following logic would look foolish today. The fools are dancing, but the greater fools are just watching."

The frenzy of direct investment interest in nearly any company with a "dot com" after its title has been astonishing. The latest Pricewaterhouse- Coopers Money Tree survey shows venture capital funds invested $1.84bn in Silicon Valley in the first quarter of the year, more than triple the $501m in the similar period in 1998. For every $100 invested in businesses across the United States, an astonishing $40.20 went to Internet-related companies. The size of computer-oriented investments - $8.1m per company - was significantly higher than the $5.9m average across the whole economy.

"This thing is underhyped, not overhyped," said Mr Schoendorf. "People say the bubble is about to burst, but I wouldn't be surprised if we saw a 5 per cent increase in investment next year, and every year for the next five to 10 years. That's just as likely as a market crash."

Venture capital's traditional enclave on the Sand Hill Road in Menlo Park, a leafy suburban backwater a few miles from the Stanford campus where the offices look more like safari park lodges than financial powerhouses, is one of the world's most precious pieces of real estate. Food and other amenities are brought in because restaurants, shops and sports clubs could not afford the rent.

The venture capital world has become a curious mirror of the Internet phenomenon. Those at the top of the profession, with proven track records, can afford to pick their clients and take their time before launching IPOs. The rest are falling over themselves to grab the most promising- looking second-tier ventures, often entering auctions to offer the most favourable terms to really hot properties. The number of Silicon Valley venture funds has mushroomed from 156 a year ago to 210.

That is not to say there are no rumblings of trouble. A crowded equity market - May saw a record 38 Internet-related Initial Public Offerings, and June almost that many - is beginning to raise serious concerns over the durability of investment interest, the quality of companies coming to market and the sustainability of share prices.

Also in May came the first visible clump of IPO failures - many of them replicating services already available to online consumers or, in the case of the online magazine Salon, which slumped on impact, failing to demonstrate a compelling model for generating business, or profits. At the same time, share prices of established Internet companies such as Yahoo! and America OnLine went through a vertiginous dip, losing up to 40 per cent of value before starting to recover.

Several analysts, particularly in the media, have read the tea leaves and believe the Internet bonanza might be coming to an end.

Investors might have been willing to flutter their money on less than rock-solid companies up to now, the argument goes, but the market is now flush with its full capacity of cash and the day of reckoning has arrived. "Demand down, supply up: that spells trouble in paradise," said a recent piece in the Los Angeles Times.

But venture capital companies including Sequoia, or Accel, or Kleiner Perkins don't need to worry unduly about market dips because the chances are their clients will ride out the storm.

Generally they spend several months, if not years, preparing a company for a public offering, fine-tuning the business plan and hiring the best management team available. If there is a market correction, or even a bust, it will be the little guys, the latecomers to the Valley, who will be eaten, with their fly-by-night clients.

"A market correction would actually be healthy," said Jeff Brody of Brentwood Venture Capital, a market leader that has raised more than $1bn in investment funds. "It would be much better to build sustainable businesses as opposed to those based on concepts or hype. Now the barrier of entry is so low, and the number of players so huge, there is plenty of money to be lost." For savvy players, there has been much to gain from the Gold Rush mentality.

Mr McNamee of Integral Capital, said: "Throughout the history of the United States, almost all great industrial cycles have been supported by a financial mania, whether we're talking about canals, or railroads, or cars, or biotechnology, or personal computers, or the Internet.

"It's like the Manhattan Project, developing several ideas in parallel hoping some will work out. As a use of resources it may not be efficient, but as a use of time it is, and this gives the country a huge competitive advantage it wouldn't have had. At the end of the cycle, the speculators may lose their shirts but they contribute a lot of net worth to the greater glory of society as a whole."

Among the good ideas coming out of the Internet sector are online medical services (including the controversial notion of a virtual doctor issuing prescriptions), online stamps to save trips to the post office, a number of other specialised retail services and, on the technical end, the development of new DSL - digital subscriber line - technology.

This is a world where new companies can thrive because of their flexibility, and traditional businesses are likely to founder because of the unfamiliarity of the new landscape. The only significant traditional company now a strong online player is the brokerage firm Charles Schwab, which was plugged into online day trading from the start, thanks to its eagle-eye view over Silicon Valley from its San Francisco headquarters.

The big media corporations have been trying to muscle in. Rupert Murdoch's News Corporation has set up its venture capital fund called epartners with $300m, headed by Mark Booth, formerly chief executive at BSkyB. He is interested in spreading the Internet revolution to Europe, announcing a $50m joint venture with Japan's Softbank, including plans to bring the online mortgage lender ELoan to Britain.

Even a slowdown in the stock bonanza would not mean opportunities would dry up. Mr McNamee represents the new wave of venture capital that looks beyond start-ups to provide "mezzanine financing" for established companies wishing to expand in new directions. Increasingly, firms such as his are also looking at mergers, buyouts and ways of spinning off promising divisions of successful companies, the sorts of activities that will be at a premium if stock prices fall significantly.

"There are tremendous opportunities to do buyouts," he said. "The top 25 per cent of companies in this sector might be expensive, but the bottom 75 per cent are cheap by historical standards. Even now, the market is indifferent to a lot of perfectly good businesses."

One big headache for the venture capitalists is the lack of decent business managers. The few good ones were snapped up long ago, and the rest of the industry is hungrily searching for others. Again, this is not a problem the venture capitalists lose too much sleep over.

"We have kids coming here from college and asking for summer jobs in the 'cool' companies," said Joe Schoendorf. "They understand instinctively which are the good companies and which are not. It's the next generation that will define where the Internet is taking us. They'll be flocking here from universities and business schools, and we'll be able to put the best of them to work. This is the future, and they know it."

For Mr Schoendorf, the Internet is almost a religion. "This is a tectonic plate shift. Up to half the companies on the Fortune 500 list are going to be replaced," he said. "It's going to affect everything in our lives, from the way doctors and hospitals are chosen for our gestation and birth to the choice of casket for our funerals.

"Some professions will disappear and others take their place. I have trouble imagining a stockbroker sitting behind a desk for much longer. People are going to read about insurance agents and think they were some piece of Java code. Bricks and mortar retail outlets will be restricted to luxury goods and some perishables because they will be an untenably expensive distribution system."

Such faith explains why it doesn't make much sense, from the venture capitalist's view, to worry about a bubble effect of excessive Internet investment.

"Billions are flowing into publicly floated companies, many with little prospect of a profit in the near-term, or at all, but with an economic revolution of boundless proportions exploding all around, who's going to quibble about a few miscalculated equity speculations?"

THE INTERNET FORTUNE HUNTERS OF SILICON VALLEY

Accel

Partners

Recently set up a $310m fund for Internet companies, and a $275m general fund. The partners refused offers of $400m in investment capital, which indicates its success in preparing firms for initial public offerings. Biggest triumph: UUNET Technologies, one of the world's biggest ISPs. Accel's $3.9m investment in October 1993 now worth more than $500m.

Sequoia

Capital

Invested in Apple, Oracle, Cisco and Yahoo! Size of investment fund unknown, but market capitalisation of the 50 companies it has launched since 1980 is now totalling about $400bn, which is based on an initial investment of "a few tens of millions".

Kleiner Perkins Caufield & Byers

Company best known for setting up the so-called Java Fund in 1996 to launch commercial ideas stemming from the computer language developed by Sun Microsystems. Kleiner Perkins also owns the intermediate venture fund Integral Capital Partners. It does not disclose financial details of its funding.

Brentwood

Venture Capital

Has raised more than $1bn, including a $300m fund which closed last November. Recent investments include Nextcard, which sells credit cards over the Internet, and stamps.com, which aims to make physical trips to the post office a memory.

Benchmark

Capital

In business since 1995, the company has invested nearly $250m. Its biggest coup was buying a 22 per cent stake in the online auctioneers eBay Inc. Its $5m investment is now worth about $2.5bn, a 49,900 per cent return, figures that almost crashed the company's computers.