Investing in the internet: Life after is not as we knew it
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Investing in the internet: Life after is not as we knew it

The first major online retailer to go from dot com to dot gone, sports clothes site blunted the eagerness of venture capitalists and internet incubators to back virtually any start-up that crossed their paths. European private-equity investors remain in the race to spot and back the most promising new entrants in the dot com arena, but they are treading much more carefully. Many have given up on business-to-consumer start-ups entirely and only back business-to-business ventures. Other specialist investors are searching for opportunities in internet infrastructure and wireless technology. Crafty internet entrepreneurs are redrawing business plans to fall in with the latest investment enthusiasms. Plenty still dream of making internet fortunes, but most recognize the need to embrace old-economy business disciplines. Britt Tunick reports

Author: Britt Tunick

After having been touted as one of retail's most promising websites, Swedish retailer collapsed in spectacular fashion, having burnt through £80 million ($119 million) of funding in only 18 months to end with debts of £17 million.

The company's demise sparked widespread fear among private equity investors that had been pouring money into the internet area and sent them running back to the drawing board. Concerns were heightened further when, only days after Boo's demise, UK online news service Netimperative announced it too was on its death bed.

Netimperative was ultimately rescued - snapped up at the last minute for a mere £162,500 by the Internet Business Group - but news of the failing operations fuelled concerns that venture capitalists that had found justifications for the provision of large sums of investment capital for new internet businesses to spend on brand-building before they boasted profit, or in some cases even revenues, might have built portfolios of utter junk.

What has followed is a return to simple and old-fashioned investment principles among those seeking investment returns in pre-IPO internet businesses. "People were thinking that you could have a good concept and that would be enough," says Chris Spray, a principal with the London arm of US-based venture capitalist Atlas Venture. "But now they are more concentrated on the fine details of a business model that leads to profitability in the reasonably near term, without huge expenditure before profitability."

A technology investment banker at one leading specialist adviser to new economy companies sees more trouble ahead. "First, valuations had become ridiculous, especially those based on traffic, or page-views alone. We are coming to the point where traffic without revenue will be seen as worthless. A lot of internet businesses are really little more than distribution channels. They can potentially be a good way for certain companies to gain additional revenue, but on its own what's the worth of a distribution channel?" He continues: "Even after recent stock market corrections you see internet companies trading at one times revenue, that really should be trading at no more than 10% to 20% of revenue. Almost no analyst will write that because it might prompt another sharp fall for many of these stocks: one from which there would be no recovery."

Specialist venture capitalists still see plenty of potential in the internet, yet, even if the recent bear market proves to be a mere glitch in the technology frenzy, the smart start-up money will hold onto its new-found scepticism.

Across the board, the people bringing crucial funding to European start-ups blame recent market volatility on the widespread abandonment of tried and true business principles. Over the last couple of years, with the market proving time and again that could generate enough retail investor interest for a successful float, private equity institutions dropped their guards, funding models that one or two years earlier they would have laughed out of their offices. In 1999 and 2000 with the retail equity investor market devouring the most basic public offerings, institutional investors were focused more on getting into deals early than on the long-term viability of what they were actually getting into.

Hillary Hedges, a principal with London-based venture capitalist Arts Alliance, says that, until a couple of months ago, there was widespread belief among investors that virtually any business category could be improved with the simple addition of an e-commerce element. "VCs [venture capitalists] were seeing increasingly illogical high values being placed on companies when they were going public and the public market was fairly indiscriminate with what it had an appetite for," says Hedges. "It was almost as if you were doing your own investors a disservice by not taking on more and more risk in the types of companies you were investing in."

That, however, has changed.

Though the investment community has proven it will take more than the word Boo to scare it from its search for the gems among tomorrow's companies, entrepreneurs can no longer expect to foist any dross onto private equity buyers. Instead, start-ups have seen funding requirements soar virtually overnight and those within sectors that have gone out of favour know better than to even ask for funding.

Goodbye to B2C

Business to consumer (B2C) services - basic online product offerings such as that captivated investors only months ago - are now no longer welcome. Though venture capitalists were previously falling over one another for a stake in these companies, the money has since moved on to the business to the business (B2B) sector. B2B platforms - online trading exchanges that have sprung up in major industries to offer lower procurement costs by replacing the middleman - are the latest sector to capture the investment community's attention.

For Matthias Allgaier, a managing director with the European arm of US-based Internet Capital Group - an internet company that invests exclusively in B2B e-commerce - the investment community's interest in B2B is entirely logical. The Internet Capital Group claims to have identified at least 50 markets ripe for B2B platforms and is prepared to do whatever it takes to enter these industries. And with B2B's potential highest in fragmented and inefficient markets, the company is avoiding sectors that are efficient or already have a high degree of sell-side or buy-side purchasing power. It is not, however, ruling out industries where others may already be planning exchanges.

"Contrary to B2C, this is not about first-mover advantage, and it is not about the 25-year-old with a nose ring setting up to form an exchange. It is about hooking up with the right partners to make it work," says Allgaier. Among the companies in ICG's portfolio are EumediX, an online exchange for hospital supplies, and VerticalNet Europe, a provider of industry-specific web-based communities.

But while many investors such as Allgaier see endless opportunities in the B2B arena, others believe it is an area that has already attracted too much investment interest and is already close to being played out.

For GorillaPark, an Amsterdam-based venture capital firm that funds companies at the seed level, the B2B sector has already passed its prime. "B2B exchanges are now right in the middle of the VC community, so for us, as a seed financer, that window is closed," says Karel Vanderpoel, GorillaPark's vice-president of strategy and research. "There are a lot of portals out there in Europe and we already see consolidation among the big vendors, so if we're starting up companies in that area it's too late."

Instead of following the general trends of investors, Vanderpoel says GorillaPark is looking for areas that have yet to be exploited - those such as wireless technologies and application service providers for general internet companies. He believes the B2B sector has not only seen too much attention but that, with little need for multiple industry exchanges, there are few opportunities remaining. Vanderpoel predicts consolidation looms in the near future for many B2B players.

Indeed several venture capitalists and incubators have also ceased investment in B2B start-ups, sharing the belief that the strong opportunities were few and snapped up early. Opinions diverge sharply. Although some investors say that the B2B sector is already a has-been, a good number of investors still see opportunity and believe it is merely the dumb money that has pulled out. Those remaining say they are actually quite pleased that B2B has become yesterday's news, hoping a mass exodus will free up competition for the strong business propositions that still remain.

According to Merrill Lynch analysts, B2B marketplaces are expected to generate revenues of between $400 billion and $500 billion by 2003. Even the sector's proponents concede the likelihood of consolidation among B2B platforms, though most believe the trend will remain limited to the US, with European B2B activity still only in its infancy.

Investing from experience

For Richard Sharp, a managing director with Goldman Sachs's European venture capital operation, the B2B market is attractive because it is an area easily understood by mainstream institutional investors - many of whom have already experienced its benefits first-hand. So, while the collective may already be on to the next "hot" sector, Sharp says Goldman will continue pursuing B2B models, focusing specifically on those within technology. Among the firm's recent investments is Scandinavia Online - Denmark's second most popular B2B. It also holds a stake in the recently floated Egg - UK financial services company's online banking operation.

With many early-stage investors moving away from B2B everyone is asking what will be the next hot area to surface? The answer, though primarily within technology, covers a range of sub-sectors.

According to Sharp, Goldman Sachs believes the smartest opportunities lie amidst wireless applications, telecommunications and infrastructure - the software and systems behind online businesses and operations. For Atlas Ventures, broadband is the area with the highest potential, having only recently opened up for investment in Europe. Wireless infrastructure and mobile commerce are also quite prominent on its radar screen. And for Elderstreet, another venture capitalist that is also looking at wireless, promising opportunities exist in software, location servers and content - on the assumption businesses will soon turn to information as a way to add value and create the much sought after stickiness online purveyors crave.

Among Elderstreet's recent investments is Digital Octopus, an online information service from Octopus Publishing which aims to provide data and content to enhance websites.

It is clear that every venture capital firm and incubator has spent considerable time and effort identifying and staking out the areas each believes will be most lucrative - areas viewed as up and coming and under-exposed.

Arts Alliance's Hedges says smart investors are actively avoiding industry-wide hype about broad trends, deciding for themselves which investments fit best into their portfolios. Going against the grain may seem daring, but it is often the wisest move an investor can make says Hedges, pointing to the notion that the B2C sector is dead and buried. "You really do need to challenge those categories, because the consumer is not dead. There's still hundreds of millions of them on the earth walking around needing to buy some stuff, so to say we're not going to invest in B2C companies is not very logical," she says. Still others point to the fact that the entire internet is in early stages and that, by definition, so too are the sub-sectors that have so far developed.

But, while each investor is treading its own chosen path, there is a large amount of overlap and industry-wide buzz-words clearly remain powerful in an immature sector. Many entrepreneurs still dream of internet riches and are willing to do almost anything to land backing. They are quick to abandon sectors that have become taboo, and to latch onto new industry buzz-words as a means of catching investors' attention.

Barnaby Terry, a partner with London-based Elderstreet, says he has seen a number of start-ups scrapping the images they initially pitched to investors in favour of labels closer to the industry's current focus. As sectors such as B2B fall by the wayside, start-ups are simply giving themselves makeovers, adopting more timely tags such as infrastructure companies.

Entrepreneurs, however, are finding it takes more than the right label to land funding these days.

For the first time in months, venture capitalists are not merely evaluating the content of plans they receive, they are placing them under a microscope. As part of their return to traditional business measures, investors say they are no longer willing to back start-ups simply because of unique or creative plans. Issues such as burn rates - the speed at which companies will burn through their funding - potential resilience to new competition on the horizon and even the possibility of attracting additional backers are now among investors' top considerations.

The primacy of cashflow

The return to old-world skills has also brought heightened awareness about the need for basic understanding of issues such as supply chains and the logistics of marketing. Early stage investors need to be convinced that they are investing in viable businesses, rather than taking comfort that they can simply sell out to dumber money.

"The focus on cashflow for these businesses has really come right to the top of the agenda. Common sense says you're ability to IPO in particular, but probably your ability to exit those companies, really can't be assumed to be short term because, at the moment, the IPO market is effectively closed," says Martin Gagen, president and CEO of 3i. "People are looking for investors that can commit to funding the next round after the one that's being raised."

Heightened expectations have also led to a reduction in the timeframe investors allow before they expect a return on their money. At the same time entrepreneurs are being forced to think further ahead, as the prospects for speedily cashing in on new business ideas diminish. Virtually overnight entrepreneurs have moved from seeking only three to six months of funding to looking ahead 18 months and further. Having awakened to the fact that even retail investors are now very discriminating about where they place their money, infant companies realise it is no longer possible to rely on early IPOs as the backbone of their funding plans. They are also beginning to get the message that investors no longer view strong business plans and management teams as added benefits, but as basic requirements for anything they will even consider funding.

"We're more focused on our own profitability, low capital spend, low cost of customer acquisition and getting revenues and profits earlier and it's something that we're working with the companies to create," says Hedges. While competition has clearly been heightened, she says there is no starvation of capital for qualified candidates and that solid business propositions will continue to get funded.

According to Michael Whitaker, CEO of venture capital group New Media Spark, one of the biggest changes among the investment community is its sudden coldness towards youth. Whereas only months ago a few twenty-somethings could band together behind a new idea and land funding without much business experience, Whitaker says investors are now demanding grey hair on the management teams of the companies where they invest. He says a creative idea is great, but with two or three similar ideas likely to be coming through the venture capitalist's door just a step behind, investors have woken up to the fact that much of the reason for the demise of start-ups such as Boo is the simple inexperience and naivety of their managements.

The sudden dearth of funding has also spurred a bit more realism among entrepreneurs seeking funding. Though the major players backing start-ups are still being inundated with anywhere between 400 and 1,000 business proposals weekly - nearly 99% of which are binned after a mere glance - investors report a slight improvement in the quality of requests they see.

Harpal Randhawa, chairman and CEO of Netherlands-based internet incubator Antfactory, says one reason for the change is that, until now, the investment market has simply supported the unrealistic expectations of entrepreneurs. Only months ago the market willingly accepted duplicated business models and venture capitalists eagerly backed at the same time many very similar business plans, such as pet sites. Today, however, the bar has been raised. "People's desire to become rich does not make them an engineer and everyone's come to the realisation that a couple of smart people in a website does not constitute a business," says Randhawa.

New out of old

Some investment bankers see a potentially interesting reversal here of the US and European internet business communities. The US is widely regarded as the birthplace of the internet and the market from which leading internet companies will inevitably emerge. It is clearly the home of many pure internet start-ups. In Europe, there has been a trend for existing old economy businesses to give birth to internet companies - UK electronics retailer Dixons' creation of internet service provider Freeserve being just one example - and in the process to provide them at birth with an inheritance that might include brand, content or basic business experience. It remains to be seen whether such hybrid old economy/new economy models may be more successful than pure internet start-ups. But it is noticeable that certain US internet companies seem keen to acquire their values: AOL's purchase of Time Warner's content being an example.

Antfactory is among a number of investors seeking e-commerce opportunities within old-world companies. By looking to partner online businesses with their bricks and mortar counterparts, the company believes it can tap the value of both existing brands as well as the worldwide potential of an online presence. These companies also have more grounded valuations and can often back their claims with strong management and performance histories., the online operation of the bricks and mortar retail tea and coffee specialist, is one such company in which Antfactory has recently invested.

Dafna Israeli, CEO for London-based internet incubator, says the move towards bricks and mortar businesses is one that will become more common, driven by investors' search for real valuations. Since the market values gross revenues, turning to established bricks and mortar businesses is a natural move. Bringing the revenue of an offline business into an online operation is an immediate way to boost the values of both, establishing value based on whatever the market allows. Merging the two worlds also provides a way for bricks and mortar businesses to immediately boost their profiles and to reduce the high costs of offline customer acquisition. is currently seeking businesses with innovative ways of using the internet and technology for online marketing. The company is also looking beyond traditional PC access and believes opportunities will begin arising among growing media such as interactive television.

According to Israeli, the potential for interactive television far outweighs traditional online marketing. Most websites are still battling to resolve performance issues such as speed and the quality of graphics they can provide. But rising usage of broadband technology and services such as interactive television provide an overnight solution for these problems, as well as a larger, more focused audience. In the UK alone, women comprise nearly a third of internet users and control nearly 80% of family budgets. According to Israeli, since women are also more likely to spend longer periods of time in front of the television, moving towards these outlets is just the next logical step.

It remains to be seen how quickly internet companies from the US and Europe will become truly global companies and, if they do, what implications this might have for their funding. US and European internet venture capitalists still tend to fish in their own ponds. Though several US-based websites have begun expanding overseas, when it comes to building pan-European operations, the majority of the American venture capital market is out of contention.

A clash of cultures

Though several US-based companies have begun setting their sights on the infant European internet market, those that have begun moving over have found that it takes more than simply developing a European branded site. Many US-based operations are finding that establishing a European presence is both time-consuming and costly, because of such challenges as dealing with 17 different sets of regulation and different cultures.

"In Europe, the whole process of consumer purchase habits doesn't necessarily lend itself to some of those American models and I think there's been a series of replica deals attempted in Europe that really haven't worked," says 3i's Gagen. However, he does believe pan-European businesses are where the money will be.

According to Gagen, 3i is actively seeking international investments it can take a stake in at the earliest possible point, but only companies whose plans are internationally focused from day one. He says start-ups should also realise the importance of pairing with the right partners and that well branded, old-world companies with international connections could prove the underpinning for online businesses focused on pan-European operations.

Picking apart the plans of start-ups has also forced investors to look within their own community. Much speculation surrounds the longevity of funding among start-up venture capitalists and incubators. Though most argue they are financially secure, everyone agrees the investment community will see heightened consolidation itself. In mid-June, London-based incubator caught the market by surprise when it announced lay-offs of two-thirds of its staff and said it would restyle its operation in a less hands-on way. Shortly after, Swedish-based incubator 1cubator ceased operations altogether, citing overcrowding in the UK market.

There are more than 100 active incubators in the UK alone, a number continuously increasing. According to Money for Growth, a recent report from consultancy PriceWaterhouseCoopers, in 1999 alone, the European venture capital community poured approximately e6.8 billion ($7.4 billion) into 5,000 technology start-ups, with the average investment size around e1.9 million.

Venture capitalists agree that consolidation in their community is inevitable and will spur mergers among internet companies. This will likely begin amidst the smaller funds and those that have taken on very large numbers of seed companies. With seed-level companies previously quite attractive - promising cheaper access to larger stakes in an easy IPO market that seemed to be booming endlessly - many investors backed multiple companies in beginning stages. As these same start-ups find less and less receptivity for follow-up funding from new later-stage investors, their initial backers are being forced to scramble to salvage their portfolios. And as more of these seed companies begin running low on funds, investors predict venture capitalists, themselves in similar circumstances, will begin seeking one another out, joining forces and merging similar portfolio companies they have backed.

The trend is already under way. Antfactory recently announced a strategic alliance with Whitney&Co, CVC Capital Partners and Citicorp Venture Capital: a move that opened it to an additional $350 million investment capital. Goldman Sachs has also spotted the benefits of partnering, having announced its own consortium membership. Goldman Sachs, General Atlantic Partners, a venture capitalist focusing on internet and e-enabled businesses, and The Boston Consulting Group have joined forces and funds to form the iFormation Group. The new group, started with a combined $300 million investment, will target bricks and mortar businesses that can be enhanced with an e-presence.

Tim Hammond, CEO of UK Internet incubator Ideas Hub, believes there will also be a weeding out among investor models, with more and more venture capitalists likely to wake up to the benefits of the incubator approach. His own incubator consists entirely of employees who have successfully exited start-ups themselves, a factor Hammond says allows it to forgo investment trends and instead rely on the pooled experience of its employees. And though he believes there will still be room for specialist and boutique firms, he predicts they will quickly become the exception instead of the norm.

At least a portion of this rings true for Goldman Sachs. Though the investment bank sticks to later-stage investments, Sharp says its success has clearly been aided by the added value it can provide companies where it invests. "I think we are more than just a capital investor and that's one of the reasons that we're successful as an investor and is one of the reasons that we're feared," says Sharp. "What we offer is help with companies in managing the value creation curve. We can bring strategic advice to companies, we can help them with their customer relationships and our involvement can also help them attract management." The bank also has the benefit of a wide-ranging international presence - yet another factor investors believe will separate the winners from the losers.

Ironically, while the technology bear market has burdened the European investment community with capital concerns, it has also given it a bit of breathing space as it races its US counterparts to build international operations.

According to Atlas Venture's Spray, the investment industry is being forced to globalize alongside its investments, and venture capitalists that don't have a pan-European presence will find it difficult to support their holdings that do. Atlas Venture is among a number of venture capitalists currently working to enhance accessibility for its local investments, offering regional incubator-type services such as recruitment, marketing and aid with business development. Following from its focus on pan-European plays, Atlas Ventures recently took a stake in citikey, a mobile information service that provides city-specific information and booking access to WAP-enabled phones and personal digital assistants.

3i's Gagen agrees that a pan-European focus is becoming increasingly important not just among start-ups but among the investment community itself. Pointing to the beginning of the trend, he notes that several venture capitalists and incubators have already begun efforts to recruit European teams and that qualified and experienced people are already proving to be few and far between. "I just don't believe in the future that a small bunch of guys in a room in one city can actually provide the real added value that these entrepreneurial technology companies need," says Gagen. "You can't do everything from one locality, even if it is Silicon Valley."

And in this area it would seem the US lead is not a real threat. With American investors facing equally problematic portfolios, many are so consumed by their need for cash conversion and preservation that they don't have the resources to focus on becoming global internet investors. So, with one less worry on their plates, European investors can now focus on recovering from the effects of the industry's recent setback.

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