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 RedHerring

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.

http://www.redherring.com/vc/2002/0620/innovation062002.html