The Pizzo Files

Internet IPOs: High Flyers or Hindenburgs?

A Conversation with Two Venture Capitalists

by Stephen Pizzo

After years of talk about the rules of the new economy, it's beginning to look like the chickens are coming home to roost. And of everyone who's been talking, no one has put their money where the mouth is more than the venture capitalists.

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In 1999, VCs invested $35.6 billion in Internet startups in more than 4,000 individual rounds of funding. This is even more remarkable considering that few of the companies they funded have even a passing familiarity with the term "positive cash flow" or expect to anytime in the foreseeable future. In fact on April 11 Forrester Research issued a report predicting that within the next year most dot com retailers would be out of business.

Is this any way to run a capitalist economy?. In some ways this new-economy looks a lot like the old state-funded Soviet system where money-losing enterprises were placed on perpetual life support in order to provide entire system with the veneer of success and accomplishment.

And when it comes to new-economy accounting methods, well, there's nothing new here either. The savings and loan industry of the 1980s used the same flexible definitions of profit, loss, and assets to create the biggest financial crater in U.S. business history. Charlie Keating would love the Internet startup game. Many of the same smoke and mirrors accounting methods that got Keating in hot water with federal banking regulators 15 years ago are celebrated as "thinking outside the box" in the new economy.

But wait, the story has yet to unfold entirely. Unlike the savings and loan industry and former Soviet Union there are no federal umbilical cords pumping freshly minted money into these startups.They are burning through real money, much of it venture capital.

The Pizzo Files

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VCs take enormous front-end risks, putting money into startups long before these companies go public. Their payoff comes when one of their little wards makes its debut on Wall Street as a public company. Over the past three years this game has been unusually lucrative as The Street seemed to have an insatiable appetite for these cute little money-losing Internet companies. But in April all that changed. Suddenly it seemed no one wanted them anymore. There was even (gasp!) wild talk on Wall Street about applying traditional measures of success and failure to Internet businesses.

So, how do venture capitalists feel about that? In early April, we talked with two venture capitalists from Wakefield Partners, Steve Nelson, and Michael Elliot. They didn't pull any punches. Their verdict: The party is over. It's time for Internet companies to grow up.

Highlights from the Interview

Michael Elliot on the game mentality:

I think this market has clearly pulled a lot of us into a little bit more of a game mentality than is healthy for anybody. A lot of money has been made by a lot of different types of investors as the revenue multiples have gone up and that has become the measure versus some sort of estimation of future earnings.

But I do think that days like today are going to refocus the venture guys, in particular on the fundamental issue of building long-term value in these businesses. And that all sounds pretty, but what that means is ignoring the gaming aspect of what's been going on in terms of the market, and really getting down to some of the basics which do come out of MBA classes.

Michael Elliot on ramp-up time:

There has been a paradigm of more and more capital as the reward for faster and faster growth ... I remember in the late 80s, it took a little while to build a company to a billion-dollar market gap.

There's the go fast model: Collect as much ammunition as you can in terms of capital and just go and grow because it's all about getting market share. And there's still a piece of that that is absolutely valid, but if you go back in '85 and '86 when the deals those days were all about specialty retailing and you started adding up retail square-footage for all these new specialty retailers that were launched with tons of capital and grew and grew and grew. A lot of those companies obviously didn't make it. Several did, which are nice, fundamentally sound companies. Today I think we're going through the same thing in the Internet world, especially on the consumer side.

Michael Elliot on the long term:

The thing that has been so fun and interesting about the venture business that you do to some degree get to ignore the ups and downs of the flavor of the month, and you're all about recruiting people, building great teams, and building companies, and we have really focused -- because of the way that this has turned into a little bit more of a financial game on these markets, and what I hope that days like today do besides take a ton of value out of our portfolio is sort of bring folks back to the reality of what we are all about. It's a long-term game. It's not an invest and 24 months later you're public and out.

I think a lot of folks today are in a way hoping that the metrics have changed or would like to see them change, but I think at the end of the day there's got to be not only ROI [return on investment] but ROA [return on assets].

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