VENTURE CAPITAL
Enabling innovation
While not normally a wellspring of innovation, the suits on Wall Street and Sand Hill Road remain crucial to pushing technology forward.
By Julie Landry
June 20, 2002

Where does innovation happen? Ask technology entrepreneurs, and they'll give you answers like Lucent Technologies' Bell Labs, IBM's Almaden Research Center, and garages in Palo Alto, California. Nobody will name Sand Hill Road or Wall Street.

That, in a nutshell, is why we chose to exclude venture capital firms and investment banks from the Red Herring 100 in 2002. Still, we understand that financiers are often instrumental in helping innovative products make it to market, so we thought it might be useful to illustrate exactly what role they play in breaking theoretical limits. To do this, we went straight to the source--the 60 private companies in this year's Red Herring 100 and "Ten to Watch"--to ask them how financial services firms nurture innovation.

Nearly every respondent credited the financiers with providing the cash resources to get going and the business know-how to turn science experiments into real businesses. Innovators, per se, they are not. But by dint of their influence, VCs and investment banks have a major impact on which technologies move forward--and which get stuck in the lab.

WISE GUIDES

Entrepreneurs say the No. 1 function their VCs and investment bankers serve is to provide strategic guidance. (We'd wager they'd take a few million dollars over a helpful phone call in this market, but it was a poll, and they say guidance wins.) Respondents say they look to their investors for help in refining business plans and products, which most VCs have done with other portfolio companies or in past lives as entrepreneurs themselves.

"It's just like sports--most of the best coaches are former players," says Paul Albright, CEO of SeeCommerce, a supply-chain software company. For that matter, nothing beats a whole team of coaches, says Morris Miller, managing director of Rackspace Managed Hosting, a managed-hosting service backed by Norwest Venture Partners and Sequoia Capital. In March 2000, prior to raising his second round of funding, Mr. Miller gave a presentation to the entire Sequoia board, which included partner Michael Moritz (founder of Technologic Partners and a former Time Warner executive), former Yahoo CEO Tim Koogle, and legendary VC Don Valentine. Afterward, he received feedback from several of these well-respected business moguls in one sitting.

Advisers' strategic influence can range from the use of a handy Rolodex full of top lawyers and accountants to a complete product overhaul. After seeing its wide area network reference designs in 1999, investors in Hyperchip persuaded the firm to change from designing chips to making high-throughput switches and routers. Hyperchip has since raised more than $200 million in funding.

Other actions have a direct impact on the bottom line. Mr. Albright says his backers, including Amerindo Investment Advisors and Integral Capital Partners, are actively courting at least 12 prospective customers on behalf of SeeCommerce. (Introductions to partners and customers ranks fourth among VC and investment bank functions, although startups clearly look to VCs more than they do to bankers for such help.)

INVESTED INTERESTS

Entrepreneurs rank money as the second-most important thing VCs offer. "Venture capitalists bring money to the table, and their 'value add' is the ability to bring more money later at more favorable terms," says Rod MacGregor, the CEO of NanoMuscle, which makes nano-scale motion devices. (Introductions to other investors comes in third among the functions of VCs and second among those of investmentbanks.) Investment bankers, too, are valued for their money, sometimes through participation in venture rounds, but more often by facilitating private placements or public offerings.

As capital has become more scarce, access to it has increased in value. Two years ago, when the money was flowing like wine, it probably would have ranked lower. But in 2001, only $37 billion in venture capital was raised, and the IPO market netted just $3.2 billion, according to Thomson Financial, a research firm. By contrast, in 1999 and 2000, startups raised $156 billion in venture capital--more than the total of the prior ten years--and $39 billion through IPOs.

A newfound focus on profitability and customer return on investment has steered funds toward those areas most likely to produce significant revenue in a relatively short time. More than 80 percent of companies surveyed say that engineering--including recruitment, salaries, and research and development--devours the most money. Sales and marketing come in a distant second, now that marketing and advertising budgets have been slashed in the quest for profitability.

CHANGING LANES

The VC's of 2000 were essentially junior investment bankers, passing companies on to the public markets as soon as they could. Now the reverse is true: investment bankers are encroaching on VC turf. Entrepreneurs say the top four things their VC's provide--guidance, money, introductions to customers and partners, and introductions to investors--are the very same things their investment banks do.

This is partly because investment banking teams can no longer offer easy entry into the public markets. Hoping to replace lost IPO revenue, bankers are courting public and private clients with their research and advisory expertise, and looking to generate additional fees through private placements and merger-and-acquisition transactions.

Entrepreneurs say investment banks bring a useful perspective to the table because of their frequent interaction with large public companies. Mike Homer, the founder and CEO of Kontiki, says he began briefing analysts about his firm's huge distributed content-delivery network well before the product was finished, looking for insight into competitors' offerings and customer needs.

Bankers still use the sales skills they exploited in the late '90s to polish a company's appearance for customers and investors. "A great investment bank has that rare ability to understand your business in incredible detail and then parlay that business into a set of very simple messages and metrics that an external investor can understand," says Annraí O'Toole, the CEO of Cape Clear Software, a Web-services startup.

SOLO FLIGHT

But VCs and investment banks are not always necessary in the quest for innovation. Four of this year's Red Herring 100 companies have never raised institutional funding. Platform Computing, a distributed-computing company, has been profitable and growing for the last nine years, and pulled in $46 million in revenue in fiscal 2001 (ended July) from customers like the U.S. Department of Defense, the National Aeronautics & Space Administration, and Prudential Real Estate. The only outside capital it raised was less than $1 million from board members John McLennan and Bruce Anderson, who joined as directors in 1999.

Some argue that it's not truly the role of VCs or bankers to stimulate innovation, just to nurture it. "Venture capitalists, at their best, accelerate and enable innovation," says Jedidiah Yueh, cofounder of Avamar Technologies, a storage software startup. "It's the labor and inspiration of entrepreneurs that's the substance of innovation itself."

In the end, entrepreneurs still want what they've always wanted from their backers and advisers: strategic advice, money, and the time to prove they're breaking the mold. Most innovations worth anything take time to be proven in the marketplace, and even the most intrepid entrepreneurs fear getting stuck with an investor that lacks the right perspective. Let's hope this year's Red Herring 100 know some patient suits.

Write to Julie Landry.