Condemned to repeat...?

Just five years ago, the world watched firm after VC firm, confess that they had strayed far from their areas of expertise when investing in online consumer businesses. At the height of the craze, the phrase "grow big fast or go home" seemed to be the sole rationale for wasting billions.
Almost universally, venture firms said, 'You know, we're not comfortable working with consumer stuff, we're really technology- and engineering-based firms, we made a mistake going into these businesses and we promise never to do it again ".

How their tunes have changed.

Today there is probably no hotter sector among venture investors than the same breed of Web companies that had fallen so quickly out of favor.

RazorGator, a site for finding tickets to sold-out sports and music events, received $26 million last month from Kleiner Perkins Caufield & Byers, among others. Also last month, Thefacebook.com, a Web site wildly popular with college students, got $12.7 million in financing from Accel Ventures.

Venture has always been a business in which all but the boldest run in herds, chasing the latest trends. The shift back to Internet ventures serving consumers is also fueled by a paucity of promising investment opportunities in telecommunications and software right now.

The problem is that you've got all these software V.C.'s, they don't know what to do with themselves. They look at the billions Kleiner Perkins and Sequoia Capital made on Google. They see some of their venture capital brethren enjoying large payouts as their Internet start-ups are acquired for hundreds of millions of dollars by Internet giants like Yahoo and Google.

Now they seem to think these are deals that make people a lot of money, and enterprise software is largely dead. By default, they've decided they're consumer Internet venture capitalists.

There are, of course, some sound reasons for the renewed interest in the Internet beyond Google envy. The widespread adoption of broadband, for instance, makes the Internet more useful and more used by consumers than it was, say, five years ago.

In 1999, a Web site that drew millions of visitors had a hard time turning those visitors into profits. Now the same site can do a robust business selling advertising as companies large and small collectively pour billions into Internet marketing.

Another difference this time around is that Web sites like RazorGator and Thefacebook had drawn an impressive number of users before seeking venture financing. By contrast, big checks were written in the late 1990's to finance consumer sites before they had much, if any, traction, while V.C.'s spouted phrases like "if you snooze you lose."

Even now, lots of venture capitalists - many with no experience in Internet consumer ventures - seem little chastened by the past flameouts. Success with online consumer companies depends on a deep knowledge of marketing, among other skills. But that has not stopped V.C.'s, who only a year ago had focused on, say, optical networking, from getting into the Internet.

VCs who swore never to look at non-linear verticals like online consumer businesses are beginning to dial successful internet VCs with proven expertise, wanting to co-invest. The experts think it's great that the Internet consumer space is heating up again. But they as well agree that the consumer is also quickly becoming a space where lots of venture capitalists are diving in without a clue. Will they ever learn…?

But that is the nature of venture investing. An area is underfunded until it grows hot, and then it's quickly overfunded. The venture business tends to be characterized by booms and busts.

There will be some big winners in this round, but many more losers along the way.

Foray into PIPES

Recently I have been approached by a few entrepreneurs seeking expansionary capital from PIPES ( Private Investments in Public Equity ). They came with all kinds of notions, some bizzare, some downright absurd. Since I normally advise them to visit my blog before they approach me, let me try and give them a proper perspective on what is it that we do in PIPE space. More particularly, what they can expect.

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What is a PIPE fund, and how does it work?

PIPES are direct investments in public companies, which means that we negotiate an investment directly into a public company. PIPE investors give the small public company capital in exchange for newly issued stock. Generally, they purchase stock at a small discount from the price that it is trading at in the public market. They may also invest in a convertible preferred or a convertible note, but the conversion price will be at a discount from the price at which the stock sells in the public market. They always receive a warrant kicker. This method of financing has basically replaced secondary offerings. For a small-cap public company, it is a great way to raise growth capital. They don’t buy shares in the open market; they buy from the company, and it’s a highly structured transaction.

It’s a little bit complicated in terms of some of the terms and conditions, but at the end of the day, they are buying stock or a convertible in a company that’s public that we recommend is undervalued. If you’re a small public company raising $10 million, no one’s going to do a secondary offering for $10 million. Maybe a company wants to make an acquisition, and they need $5 million in cash and they want to raise a little more for working capital. Goldman Sachs, Merrill Lynch and Morgan Stanley aren’t going to do a $10 million deal, or a secondary or a PIPE. It’s too small. So the alternative is to approach PIPE investors to raise capital. On the basis of our internal research, we guide PIPE investors to companies that merit investments.

What is your due diligence process?

We have a checklist of things we go through. The key is conducting due diligence focused on management, competitors, the products, and we seek out knowledgeable business and investment advisors can help us conduct due diligence. We’re not interested in doing complete, thorough analysis on all the competitors and the relative valuations. We’re more interested in guys in the industry who can give us insights into the company and whether they’re going to succeed or not. We also examine the use of proceeds. We like the investor’s capital to be used to accelerate growth through acquisition. Another good use of capital is to build, develop or launch a new product or service that’s going to require an investment. We’ll look thoroughly at the capital structure, make sure there’s not a lot of warrants or options that are struck below where the investors are purchasing a stock. One of the things we like to see that doesn’t happen often is, sometimes management puts in money alongside our investors. In today’s world, that’s a novelty. Management’s been notorious for taking options and warrants and forgivable loans, and we have guys who put hard money in. We want to have the interest of the shareholders, our client investors, and management aligned as much as possible. That’s extremely important, because if we see a conflict – if the guy’s taking a $400,000 salary and they’re burning $1 million a month because they’re a biotech, and he’s not willing to take a salary cut and he’s issuing himself low-priced options, that doesn’t cut it for us.

Since you recommend investment in some healthcare and biotech companies, is there a technical aspect to your due diligence process?

Obviously, the technical due diligence is really important. When we recommend investment in a software company, we’re going to have guys who have started, run and sold software businesses. And that’s got to check out, because we really listen to our advisors. It’s a rare day when our advisor says no and we recommend investments. And we try to get consensus. We try to have more than one person looking at a company. If it’s a medical company, we will have a medical advisor assist us with due diligence on the company.

How do you minimize risk?

I think the best way to minimize risk is to do due diligence up front, both from a fundamental and a technical viewpoints, to try to assess historical milestone achievements by the management team of the company, and then to try to blend a scenario for future prospects. For instance, if we were looking at a company that is raising capital and used the proceeds for a strategic acquisition, that would be a very big item of interest to us, from a due diligence perspective. Because obviously, if the company was making that acquisition, and that acquisition is accretive, then we would believe the company would have a higher prospect or a higher probability of growth that would be reflected in the stock price. Nevertheless, we still have to be very sensitive to deploying capital in companies that historically have not hit their milestones, and we assess that as part of the risk-reward scenario.