Start-Up Your Engines!

By Eric Roston

Venture capitalists are the NASCAR racers of entrepreneurship, injecting fuel--private investment dollars--into new companies that are exciting but may come apart at high speeds. It's a high-risk profession. They have driven important new technologies to market, creating new jobs and new industries. Apple Computer, eBay, biotechnology pioneer Genentech, Federal Express and, most notable of late, Google, all grew out of daring private investments. In the 1990s "suddenly venture capitalists became rock stars," says Mark Heesen, president of the National Venture Capital Association. Since 1970 venture capitalists (VCs) have pumped $339 billion into start-ups; these companies have created 10.1 million jobs and collected $1.8 trillion in sales. But stars tend to flame out as quickly as they ignite. By the time the Internet-bubble burst, "vulture capitalists" were tainted as part of the lunatic feedback loop that sent valuations of newly public companies into the stratosphere. After three years of retrenchment, the community of some 900 U.S. investment firms is eager to lend a hand to what it hopes will be the next generation of giants.

Heesen and four other veterans visited TIME last month for a talk that served as an epilogue to the Internet era and a prologue to innovation to come. Brenda Gavin, managing partner of Quaker BioVentures; John Preston, associate director of the M.I.T. Entrepreneurship Center; Gary Rieschel, managing partner of Mobius Venture Capital; and Susan Woodward, founder of Sand Hill Econometrics, joined Heesen on our Board of Technologists.

TIME: What lessons did you learn from the Internet bubble?

GAVIN: The No. 1 lesson is we have to make sure we have a market for our products. Who cared about a website for a dry cleaner? I don't think the health-care area was hit hard by the bubble. We have waveswe don't have bubblesin health care. It's very capital intensive, which works against that trend.

HEESEN: The last thing we want is irrational exuberance going back into this market. We invested nearly $106 billion in the year 2000--a total aberration historically. A lot of press reports use that inflated figure as a benchmark, which in our opinion is very wrong. We wouldn't mind seeing that year erased.

PRESTON: I would say the biggest single problem we have is a tendency to follow what others are doing. A lot of me-too venture funds are nearing the end of their investment cycle, so the venture capitalists are returning to their roots. But because new technologies aren't ripe yet or there's a lack of people to make companies out of them, venture investors are not putting their money to work as aggressively as they should. They have an "overhang" to the tune of $50 billion. Others are still overpaying for some investments.

RIESCHEL: One example from last year is social networking. That was ridiculous from a moneymaking perspective.

TIME: Like Friendster?

RIESCHEL: We looked at five sites and passed on everything. In '99 everyone got in trouble when maybe 17 companies were all trying to sell pet food online. At Mobius, now if we identify more than four venture-backed start-ups in a sector, we won't bite. There are at least 14 social-networking sites.

PRESTON: I look at deals, and I try to look at what I call the hype-to-substance ratio. If the hype is up here, and substance is down here, I avoid getting involved.

WOODWARD: Start-ups are bouncing back. Our index of venture firms is up about 40% from its trough in late 2000.

TIME: There has been much concern this year about technology jobs and sources of innovation moving abroad. How has globalization changed the venture community?

HEESEN: You can't find a venture-capital community like the one we have in America anywhere in the world, except for, some people would argue, Israel. It's important to look at basically how American this industry is. You cannot duplicate this. Other countries have tried. That said, a number of European pension funds have just gained the right to invest in these kinds of funds, and there is great interest in Scandinavia, Australia and Singapore.

RIESCHEL: On the other hand, you can't take for granted that the next round of technological leadership is going to come from the United States. Intel is one of our strongest companies, but other than that, semiconductor manufacturing pretty much now resides outside the United States. In terms of manufacturing complex products, the new Chinese companies have a leadership stake.

Governments overseas are just now starting to favor a very, very strong set of policies that I believe will ripen the environment for venture-backed start-ups. Until about a year ago, Japan outlawed stock options, which is a significant means of compensation in many young companies. They weren't legal. Pension plans could not invest in private equity in Japan.

HEESEN: By contrast, in the U.S. public and private pension funds make up about 43% of our investors.

PRESTON: There are cultural differences in play all over. Many of the reasons Europe lags the U.S. in venture investment are cultural. The average American works about 1,978 hours a year, vs. 1,525 for a European. Europe is trying to protect jobs by lowering hours. But reducing hours to create new jobs is a different approach than we have in America, where there is a rich tradition of taking on risk and trying to build new job-producing companies from scratch.

GAVIN: One unique thing about the U.S. is the $27 billion National Institutes of Health budget, which funds incredible amounts of creativity. That's one thing other countries don't have.

TIME: What kind of technology companies do you see on the horizon?

GAVIN: We are swimming in technologies. There are more technologies, more potential things to fund than anyone could possibly fund. Health care makes up 15% of the gross domestic product, and it's growing. I've sometimes wondered how long will it be until every person in the country works in the health-care industry and spends every dollar on health care. What keeps me awake at night is that we have to find somebody who can and will pay for the wonderful things we can create.

WOODWARD: In 1850 we spent 80% of GDP on food. Puts things in perspective. It is under 20% now. Is it impossible that we get to where we put 80% on health care? No, not at all.

PRESTON: M.I.T. is generating two inventions every day. We are licensing two a week. That is pretty impressive. But we do have more inventory than we know what to do with, than we could reasonably part with.

GAVIN: Our limitation on company formation is not technology, and I am not even sure it is capital, though there are some stages of companies that are probably short on capital. It is really a shortage of management.

RIESCHEL: A lot of investment overseas is based on technology that is way ahead of the laptops or desktops that we use. I don't travel with a laptop anymore. My shoulder is two inches lower than the other one after 15 years of traveling with it, but it is not necessary anymore. I carry a device made by Danger that has e-mail, a keyboard, phone, camera, calendar, games and instant messaging. Only a venture-backed company could be named Danger.

Everyone in Japan uses their cell phone for data; in China, about 70%. Cell phones are fashion statements, and people buy new ones every six to nine months. Shanda Interactive, which operates online games, went public last week in New York. It generates $33 million a year in profit just three and a half years into its existence. The funniest example of a niche market is Neowiz, which sells virtual clothing for the virtual person you steer through cyberspace. That's a $100 million-a-year market. Profit margins are pretty good on virtual clothes. Ring tones for cell phones is now a billion-dollar business. Technology is fashion.

We talk about how great it will be to have high-speed-Internet connections across the U.S. For the moment, the average connection for broadband here is under 300 kilobits per second. Compare that with average connection speeds in Korea of 4 megabits per second and up to 8 megabits per second in Japan. Those speeds are driving innovations that we can't compete with here. So when you begin to fund an information-technology start-up here--and you won't know if you're successful or not for four or five years--it is incumbent on us to understand what is happening in China.

TIME: Wi-fi [wireless Internet] is big and getting bigger in the U.S. But have mobile devices just rendered it totally irrelevant outside the U.S.?

RIESCHEL: Yes.

TIME: What doesn't get as much venture attention as it should?

PRESTON: I sort of lament the fact that less than 1% of all the VC investments go into energy.

HEESEN: It has tripled in the last year.

PRESTON: It's gone from zero to three times zero. [Laughter.] There are barriers to entry there. It costs a lot of money to get started. The big energy companies have made those barriers pretty severe.

HEESEN: Talk about wasting energy. More energy is lost in buildings than anything else--cars, you name it. "Smart buildings"energy-efficient buildingsis a hot area.

TIME: Average investors--who by the way shouldn't try any of this high-risk investing at home--watch their portfolios quarterly, daily, even hourly. How long does it take you to know if you have made a good investment?

WOODWARD: You can get a read on it in two or three years. Life sciences is definitely longer. But almost every year the most successful successes are the first comers. That seems to be the case because the best ideas are also the most obvious from early on. When we look at the life cycle from birth to the exit of the venture investors, first comers have the shortest run to making a public stock offering.

TIME: Nanotechnology--the science of building molecular-scale materials--is enjoying a wave of popularity. How do you read the sector?

WOODWARD: Has it made a difference in your life?

TIME: I can buy nanoenhanced tennis balls.

GAVIN: I am taking the cheap seats. In other words, I am sitting on the sideline because I don't want to fund basic research. I think that is where it is right now, even in the medical area, which may be one of the earlier applications.

PRESTON: Much of nanotechnology is an example of overinflated pricing. Having said that, I have seen some wonderful nanotech companies. Nanotech in sensors can be used very intelligently. I think those will win. If there's a product, a customer and money to be made, that's a different story.

TIME: Is Google's initial public offering [IPO] a one-of-a-kind event or a sign of things to come?

WOODWARD: It is just wonderful Google has chosen to do its IPO with a public auction of its shares. An auction is the clearest and fairest and most efficient way to set the price for it. And the fact that it has chosen to use the Internet as a part of its IPO will open it up to millions of people who otherwise wouldn't be able to participate.

RIESCHEL: But I think it has no legs. Is this heralding an age where it will be easy to go public? I don't think that is the case at all.

HEESEN: We think there may be a psychological boost by the Google IPO, but by and large we have seen a pretty conservative market thus far.