New Cash Concerns

How a few little market blips sent chills through the venture capital lifeline

When the Nasdaq had its wings clipped in late March, no group of companies fell to earth harder than the sexy startups with a certain ubiquitous suffix after their names.

“For a while there, it became almost dizzying, seeing the lookalike business models coming through the door,” said Robert Egan, a partner at the entertainment arm of Gotham venture capital firm Chase Capital Partners. “A lot of online businesses were getting funded whose models didn’t make much sense over the long term.”

Total venture capital funding for Internet companies, while still robust, has slipped into a slow ebb that would have seemed inconceivable a year ago. In the second quarter of 2000, VC firms pumped $14.75 billion into ‘Net-based ventures, down from $15.4 billion in the first quarter, VentureOne said. Still, the latest figures represent a nearly threefold increase over the $5.7 billion invested in the second quarter of 1999.

Judging from recent research from VentureOne Inc., a venture capital research group, VC firms are waking up to the fact that some Internet models aren’t worth the funding. VentureOne found that initial public offerings of VC-backed Internet companies made up only half of the total IPO market in the second quarter of 2000, after comprising two-thirds of the total in the first quarter.

The current percentage sets the Internet IPO market back to 1998 levels, before things really started to heat up for the sector, the firm said. And since VCs make much of their often stellar profits by spinning their investments off to the public, a lousy IPO market can have a substantial chilling effect on the venture community.

Among the hardest hit by the freeze on venture financing are Internet companies that rely primarily on a single revenue stream — say, selling advertising — to support themselves. And online entertainment sites, which often fall squarely in that category, took more than their share of lumps as the market cooled, said Jerry Colonna, a managing partner at Flatiron Partners, one of Gotham’s most prominent VC firms.

“Some of the reaction to entertainment or content companies has been overreaction, but that wasn’t really that unexpected,” Colonna said. “The question now is whether content will continue to get the ‘Internet premium’ in the future — and the answer is probably ‘no.’ ”

The closing of the easy money spigot has also precipitated a rash of belt-tightening among content companies, and has even left a few bodies in its wake over the past several weeks.

The most spectacular flame-out was, of course, the Digital Entertainment Network, which was felled mainly by its own profligate spending habits, with which even the most deep pocketed VC patrons weren’t willing to keep pace. But several other sites have been forced to make less-than-fatal cuts in staff and strategic ambitions.

Gotham-based Pseudo Networks handed out nearly 60 pink slips in June and slimmed down from 10 video channels to just one 12 hour-a-day feed. Web literary magazine Salon.com shed 13 staff members, including several writers whose stories weren’t garnering sufficient page views to satisfy the brass. And netcaster Wirebreak.com in July passed out pink slips to 7 of its 45 employees amid efforts to recast the company as a content syndication house.

That many of the cuts made by online entertainment concerns are coupled with efforts to retool their operations and trim down their expenditures comes as little surprise, says Colonna.

“There’s still so much capital available out there but people aren’t as eager to part with it,” he said. After the shakeout, “You will definitely see a faster separating of good ideas from bad ideas.”

Phil Kleweno, a VP at Internet consulting firm Bain & Co., says the criteria that VCs will be using to sift the wheat from the chaff include a company’s ability to grab and maintain substantial market share early on, as well as its ability to function without too many massive cash infusions up front.

Beyond that, Kleweno adds that Internet-based content and entertainment companies are going to have to come up with creative ways to wring more value out of their products than they’re currently getting with pure advertising models, which so far have proved less than reliable in producing profits. That has, in large part, been the factor that’s kept the larger old media companies more or less out of the game to date, he maintained.

“A whole lot of people in all these traditional companies are thinking about this non-stop,” he said. “But the reality is that these are all profit-driven businesses; in order to get (online ventures) funded internally, they have to justify them to management.”

Chase Capital’s Egan agreed with Kleweno that companies that can moderate their burn rates are becoming more and more appealing to VCs. His personal experience reflects that: one of Chase’s most recent investments is an online entertainment company called Eruptor Entertainment, which offers original shows, gaming and news.

Eruptor “is a very low-key company,” in terms of business development, Egan said. “They are original content producers, but they’ve done it in such a cost-effective way.” The company is also focusing on producing content that can be sold to several platforms, both on- and offline, to leverage the cost of production, he added. Companies, like Eruptor, that keep their feet on the ground will be the ones to find success in the post shakeout world, he asserted.

“The bar may be set temporarily too high,” he said, “but in the long run, the firms at the top of the heap are going to just fine.”

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