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Money still loves the Internet

Money still loves the Internet

Typically, the third quarter is a slow time in the high-tech venture capital (VC) community of the US. But in the past month, electronic-commerce security company enCommerce raised $US15 million, manufacturing-industry e-commerce site Click Interactive raised $11 million, online auction-service company AuctionWatch raised $9.6 million, and consumer-service startup Tellme Networks raised $6 million, to name but a few deals.

Is anyone taking a vacation this year? Certainly not Internet investors. New funds are flooding into startups at an unprecedented rate, abetting hypergrowth in Internet software and services. In the second quarter of 1999, US venture capitalists invested a record-breaking $7.67 billion in companies, a 104 per cent increase over the $3.77 billion invested in the second quarter of 1998, according to a Pricewaterhouse-Coopers survey. Internet-related outfits alone grabbed 56 per cent of the total second-quarter investment dollars in 1999, according to VentureOne, and companies that create components for the Internet's underlying data networks snared much of the remainder.

Despite Internet companies' recent rocky ride in the stock markets, more venture capital companies are investing only in Internet startups.

Even brick-and-mortar stalwarts are shovelling their extra cash into Internet newbies. North American office-supply giant Staples became the most recent example of this trend recently when it announced its $6 million equity stake in HotOffice, a Web-based intranet service.

The cash bonanza affects IT professionals in several ways. Often the well-funded startups innovate more quickly than big, name-brand vendors. That is good news for technologists who are looking for new tools to help their companies' e-commerce drives.

Also, the capital infusion accelerates the creation of `e-versions' of every business found in the molecular world. IT managers at traditional companies are on the front lines as their companies battle for market share with the Net startups. This new competition is a mixed blessing: it can boost tech professionals' prestige, but can also heighten their risk of being canned if their companies' e-commerce projects fail.

And of course, the startups offer a treasure trove of job opportunities for experienced technology managers tired of the corporate grind and ready for the excitement, risk, stock options, and heavy workload of young companies.

The Internet startup scene is not just about happy new billionaires and their corker ideas. Investors say that between half and three-quarters of Internet start-ups, mainly the ones the other guys invest in, fail.

`The reason you only hear about success stories is because they're unique. It's just like [how] you read a lot of stories about Michael Jordan, not third-round draft picks for the Bulls,' says Guy Kawasaki, CEO and chairman of Garage.com, a Web-based company in California that links investors with entrepreneurs.

But venture capitalists, who are under enormous pressure to earn high returns for their clients, know how to analyse business plans, and they reject most deals that cross their desks. By paying attention to where venture capitalist companies place their technology bets, IT managers can weed through the dizzying number of new companies and technologies to select likely winners. Managers can then use this information to reduce the risk involved in working with a startup as a supplier or employer, and to better assess a startup's role as a potential competitor.

Hot markets

Perhaps the hottest market for venture capital heading into the last quarter is outsourcing. In particular, many investors believe the application service provider (ASP) market has outrageous growth potential. ASPs' core service - renting out Internet-accessible versions of business applications - taps into management trends, such as speed to market and the focus on core competencies. Companies that are trying to quickly ramp up their e-commerce efforts can rent the applications they need rather than implement the applications in-house.

Indicative of VC companies' enthusiasm for the outsourcing market is LivePerson.com, an ASP for the customer service market that closed $19 million in second-round financing this month. LivePerson runs chat software that allows e-commerce companies to answer buyers' questions right away.

`What I loved about LivePerson was that they [changed] the decision maker from the IT person, who's already overloaded trying to keep the site up, to the marketing person or the customer service person,' says Ed Sim, senior vice president at Dawntreader LP, currently a $20 million New York-based investment fund that is raising an additional $200 million to invest in Internet startups.

Business-to-business e-commerce sites are also hot commodities among VC companies. Of particular interest are online marketplaces where buyers and sellers in a defined industry segment gather to barter.

One example is Noosh.com, an intermediary between printers and corporate buyers of expensive printing services for promotional materials and financial reports. Noosh.com recently closed $12 million in financing from Accel Partners, Advanced Technology Ventures (ATV), and individual investors.

Although retail consumer sites such as Amazon.com once captivated the money folks, investors expect business-to-business activity to pick up and ultimately to surpass consumer plays. Investors say it takes longer to build business-to-business companies because they take longer to adjust to an Internet model than do consumer practices. But B2B sites, as they are called, require less seed capital because they do not have to build the same huge brand awareness as consumer retail sites.

Old favourites

One investment area that has attracted big money for a few years and will continue to absorb funds into the foreseeable future is bandwidth-enhancing technologies. Particularly appealing to VCs are data-communications and telecommunications companies that offer products that increase bandwidth at the core of the Internet, at the edge of the Internet, and inside enterprises that access the Internet.

Kestrel Solutions makes wave-division multiplexing systems that help carriers transmit more high-speed data across their fibre lines. Kestrel is typical of the type of data-communications startup that ATV, a $350 million venture fund, likes to finance, according to Michael Frank, an ATV partner.

New investment territories include miniature computing devices and open systems, as enabling technologies pave the way for a boom in new business. For instance, Dallas Semiconductor offers Tiny InterNet Interface, a computer and operating system that is smaller than one cubic inch, runs Java applications, and connects to the Internet.

`You're going to see all these people who have developed expertise writing Java applications being able to use fairly standard platform elements for embedded systems that no longer look like a com-puter or are stuck where computers were,' says Daniel Seltzer, a managing director at Alterity Partners, a venture bank in New York. `And if you blend that with other things like wireless connectivity, you get room for lots of new ideas.'

Where's the money coming from? The capital invested in startups originates from private and public pensions, endowments, foundations, wealthy individuals, and foreign investors. In other words, it is coming from the usual suspects.

Also, every major technology vendor has a venture fund for startups that can help build the vendors' markets. Intel, Microsoft, Dell, Compaq and IBM are among the companies that cultivate startups.

Early Internet winners are getting in on the act. Lycos, for instance, recently announced a $70 million fund for investing in companies that can advance its business objectives.

The trailing edge

What's fast falling off investors' favourite pick lists are new business-to-consumer e-commerce sites. These sites require large investments to build the traffic and consumer brand awareness necessary to succeed; and unless they are the first in their markets, the prospects are not so great.

`Characteristic of what's not hot is another restaurant Web site or another career-oriented Web site, like [ones for] rŽsumŽ posting,' Pennell says. `I've seen eight of those in the past two years, and two years ago that [idea] was already old.'

Also falling off the top-picks list are new Internet-access and Web-hosting companies. `That game is mostly played out. You're not going to see a lot of new money going there,' says Whitney Bower, a principal at GeoCapital Partners, a venture capital fund in New Jersey, that has $500 million under management.

Whether or not the startups are in the hot investment categories, potential customers and employees should keep in mind that most of the startups will not exist in their original form three years hence. Some will go public. Many will be bought by larger companies that are looking to beef up their own research and development with purchased innovations, which is not necessarily bad for customers.

`In the vast majority of cases, the acquirer has a strong economic incentive to keep customers happy,' Bower says.

However, half to three-quarters of them will vanish in three years or less, leaving their customers hanging. `That's the risk you take. As a user, you're trading off the potential for the innovation against the risk of it vanishing tomorrow,' says Kirk Walden, director of venture capital research at PricewaterhouseCoopers.

Despite the risk associated with Internet startups, IT managers are committing a major career folly if they do not consider the young companies' potential role as suppliers, competitors, or employers.

`The Internet revolution has just barely begun,' Garage.com's Kawasaki says. `The ship has just left the port, and it still has a whole world to travel around.'


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