- The Washington Times - Monday, August 27, 2001

A year ago venture capital seemed almost free for all, with entrepreneurs of all sorts from makers of wire-

less phones to retailers trying to sell glow-in-the-dark bubbles online getting funded.

The market has changed dramatically since then: The dot-com bubble burst, leaving hundreds of companies kaput, and the amount of money investors are pouring into companies has been cut by more than half.

This tightening in the market has left some clear winners and losers: Internet retailers and content companies are out. In are biotechnology and software or hardware companies with products to make the World Wide Web faster and smoother.

Internet specific companies, those that would not exist without the Internet, saw a dramatic decline in venture capital backing in the first half of this year compared with the comparable period a year ago, according to the National Venture Capital Association in Arlington.

Such companies collected 28.42 percent of all investments, compared with 48 percent last year.

"Internet companies with advertising as their business model do not even get a first look, let alone a second look," says Frank Adams, managing partner at venture firm Grotech Investment Group in Timonium, Md. "It's abundantly clear that model doesn't work, yet there are still companies being built on that basis."

Now more than ever, venture capitalists insist that companies have a product, some sales at least, and a fast plan for profitability before they are considered for funding.

"A couple of years ago, everyone wanted to be like Amazon.com and lose tens of hundreds of billions of dollars before eventually figuring out the business model," says John Backus, managing partner at Draper Atlantic, a venture firm based in Herndon.

"Generally, we're looking at companies with a few specific characteristics, like more technology-heavy as opposed to just business-model ideas. So if someone had a very good improvement on a router technology on a network, that would be technology-heavy versus someone who wanted to sell diamonds on the Internet."

Among the most recent companies to get money from Draper Atlantic are Trancentrix, Inc., an online financial services company; AppForge Inc., a company with a software that creates applications on personal digital assistants and Palm pilots; and InphoMatch Inc., a provider of wireless messaging.

Compared with startups in previous years, the latest and most successful candidates for funding have more complete management teams, already developed products, and existing customers, says Draper Atlantic partner Thanasis Delistathis .

The firm has invested about $10 million so far this year in companies, the same as last year, but in fewer deals.

Biotech wins big

The biggest winner in the depressed money-raising market has been the biotechnology industry, rated as the most favorable investment by 72 percent of venture capitalists polled recently by Deloitte & Touche.

One local company benefiting from this trend is Advancis Pharmaceutical Corp., of Gaithersburg, an 18-month-old company that seeks to improve therapies for antibacterial and anti-viral agents.

"Once we'd secured the initial round of financing, the others were relatively easy," says Dr. Edward Rudnick, founder and president of Advancis, formerly Advanced Pharma.

Advancis closed its first investment round for $2.5 million in November 2000, and a second round for $2 million in January. It also struck a $6 million fund-raising deal in April and expects to close on another $15 million round within two months.

Advancis' plan is to develop products and put them on the market within four years in partnership with pharmaceutical giants. Then, through the fees and royalties it earns through these deals, the company wants to begin marketing and distributing its products alone.

Currently, Advancis has three products in human clinical trials, with another seven in early testing stages. Dr. Rudnick expects the company's first product to hit the market by 2004, after getting all the required Food and Drug Administration approvals.

"We're currently talking with several large pharmaceutical companies and many mid-tier pharmaceutical companies that all have significant sales and market capacity," Dr. Rudnick says. "We expect to have at least one and possibly as many as three significant corporate deals completed in the next nine months."

"We've been fortunate … to be able to follow through and meet performance goals on both the business and the technical side of the company and that has made our ability to raise capital a little bit easier than some of the other companies out there," he says.

The lead investor in Advancis was HealthCare Ventures, a Princeton, N.J., firm that has previously backed local biotech giants like MedImmune, Inc., and Human Genome Sciences Inc.

New environment

Draper Atlantic made a partial investment in Quantum Photonics Inc., a maker of amplification devices for fiber-optic telecommunications systems.

The founders of the Jessup, Md., company two engineering professors from the University of Maryland found the fund-raising experience to be quite different from a year ago, when they first sought venture capital backing.

"It took ridiculously long," says Terry Browne, the company's general counsel. "It took a lot longer to get [the $20 million round] closed because basically VCs don't have the same urgency about investing that they had a year ago."

In July 2000, Quantum Photonics was able to raise $8 million in a first round without much hunting for investors. The venture firms leading that round were Optical Capital Group Inc., and the Grosvenor Funds.

"They talked to three VCs then and all three wanted to give them money, so they basically had a lot of leverage in negotiating a pretty favorable first round transaction," Mr. Browne says.

Quantum Photonics executives say this year the leverage has shifted to the venture capitalists.

"I think VCs seem to be behaving a lot more like bankers," Mr. Browne says. "They tend to be a lot more risk-averse and much more careful."

He does not disclose financials, as Quantum Photonics, but says the company is betting on its proprietary technology to attract big clients and their money.

Mr. Delistathis, of Draper Atlantic, says that the venture firm put its money in Quantum Photonics because it was backed by a strong syndicate of investors, making this round large enough to push the company into profitability.

That is much the same attitude that attracted Draper Atlantic to ReturnBuy.com, an Ashburn, Va., company that sells returned and overstocked goods from manufacturers, distributors and retailers.

"It was extremely difficult to get funded," says Jeffrey Rogers, the company's chief financial officer and co-founder. "In December of 1999 economy-wise we were still kind of at the height, one of the peaks of VC raising. It was so very different in the sense that more people were willing to take a look at you [before]."

ReturnBuy.com raised $15 million in March. The lead investor in the deal was venture firm Draper Fisher Jurvetson EPlanet Ventures. It was backed by several companies like EBay, Reicon and Abacus, the fund associated with the Sears Roebuck family.

Mr. Rogers says the company would not have been able to raise the funds had it not demonstrated its plan for profitability.

"We could say there are our clients, these are our sales, and you can easily project our future sales, you can see we are going to become profitable," Mr. Rogers says.

Although he would not name clients, he says they include a major retailer and numerous manufacturers.

The company's model was explored in connection to EBay in a June 12 report conducted by Goldman Sachs Global Equity Research. The report said ReturnBuy.com saves big retailers and manufacturers both time and money.

"ReturnBuy provides a value-added services to retailers like Circuit City that are not in the business of loading and watching individual auctions," the report said. "By handling the auction management process, one-to-one shipping, payments and so forth, ReturnBuy brings a greater supply of products to EBay from larger power sellers that might not otherwise use EBay as a sales outlet."

While knocking on doors this time around, the executives of ReturnBuy.com ran into many venture firms that weren't interested in making new deals.

In fact, 54 percent of venture firms are choosing to nurture previous investments rather than look at new ones, according to a recent poll by Deloitte & Touche involving more than 2,000 venture capitalists in Silicon Valley and the East Coast. Only 41 percent were seeking to back new ventures lower than in previous years.

"The actual process to find optimal investment partners while maintaining high standards for the appropriate valuation was at times grueling," says Steve Schaefer, senior vice president of business development at RewardsPlus, a provider of online benefits and administration services for businesses.

The Hunt Valley, Md., company raised $67 million in its last round of fund raising from investors like Credit Suisse First Boston, the Prudential Insurance Company, and Provident Life & Accident Insurance Company, and Grotech.

RewardsPlus officials would not discuss financials. They say, however, that more than $1 trillion is spent annually on employee benefits, which gives them a huge market to explore.

No shortage of ideas

The venture funds may be tightening their purse strings, but that has not dampened entrepreneurial vision. In some cases, the ideas being pitched now are even better than a year ago, says Ginger Ehn Lew, chief executive officer of the Telecommunications Development Fund (TDF) in the District.

"The quality of the deals we are seeing now is better," she says. "It's higher quality either in the technology, or the quality of the management team as well as the valuation."

"We're seeing a real broad range of deals, everything from equipment, software, hardware, wireless, storage," Ms. Lew says. "We're also getting more; We've seen a 45 percent increase through June."

In TDF's portfolio are companies like Synovial Inc., which is creating a content delivery mechanism for the wireless Internet space; Netilla Networks, which supplies secure Web access to office applications; Kobalt Interactive, an interactive TV provider; and Elisar Software Corp., the maker of a secure digital media software.

TDF has closed three new deals this year, has three that it hopes to close by mid-September. Ms. Lew says she'd like to find two more new investments by the year's end.

Likewise, Draper Atlantic is looking to make a few more deals. And while the number of incoming new business plans has dropped from 500 a month last year to about 300 a month this year, Mr. Backus agrees that there still are great ideas to be found.

"If last year we only received 50 plans that were interesting, this year we have the same number," he says.

"There's not a shortage of truly brilliant and breakthrough ideas to back. And I'd suggest that this year and next year we're going to see some of the biggest companies five years from now get started … real entrepreneurs with drive and ability to change the world actually get out there and do it and they are not competing with all the fluff that was out there a couple of years ago."

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