Investors Tighten Grip On Venture Capital

As sources of money dry up, potential backers demand that science startups have prototypes to show off, if not products ready to roll PALO ALTO, CALIF.--For much of the eighties, software engineer Eric Hannah rode the roller coaster of venture capital funding for new high-tech startups in northern California. But after one rocketing success and one crashing failure, he's promised himself never to risk another ride. In fact, one of the things he likes most about the Silicon Valley company he's now with is that it's not being bankrolled by venture capitalists. "The problem with venture capital is that it's impatient money," says Hannah, a physicist who is now vice president of engineering at Palo Alto, Calif.-based Savitar. The two-year-old company, which designs software for electronic imaging with an emphasis on high-resolution color, relies on the personal assets of its founder, computer scientist Rudolph Burger. Not every entrepreneur has sworn off venture capital. But Hannah and many others have learned that today it's a new world for a scientist dreaming of becoming a successful entrepreneur. What once worked in starting a business--a new idea and a couple of hundred thousand dollars--is no longer enough. The formula for success in the nineties, say investors as well as those looking for capital, is a solid game plan, a seasoned team on board, a prototype of the product, and enough cash--a few million dollars--to get an idea out of the lab and into the hands of some customers. In other words, an idea worth investing in these days is one that offers tangible evidence that it can succeed. "Ten years ago it was easy to get a few hundred thousand dollars," says Lucien Ruby, a San Francisco venture capitalist. "Genentech was started on $200,000, for example." Ruby has been involved with such startups as Teradata Corp., a computer hardware company in Los Angeles that went public in 1987 and does $250 million a year in sales, as well as Calera Recognition, the enterprise that Hannah founded in 1982 to build equipment that enables computers to recognize command characters. Thinking back to the legendary team that founded Apple Computers Inc., Ruby says, "I bet you that [Steven] Jobs and [Steve] Wozniak would not even get listened to today." For many years, Ruby and others like him have risked modest sums of money in exchange for partial ownership of these high-tech startup firms. Their support encouraged thousands of talented young Ph.D.'s from California Institute of Technology, Stanford University, and here to forsake a life in academe and industry for a chance to make it on their own. The success stories fueled the area's economy, and even failures were seen as temporary setbacks, the price of playing the game. But it costs more to do business these days. Increased international competition and a tighter economy have made venture capitalists more conservative about investing the larger sums that are needed to begin a new company. While there are still a few firms that specialize in tiny startups, most companies believe that they must land bigger fish to obtain an acceptable return on their investment. "Venture capitalists are looking for larger deals," says Tim Draper, a Harvard MBA who founded the venture firm of Draper Associates in Menlo Park. Calif. "They're not going to fund a couple of people coming out of Stanford as easily as they would have in 1983. Instead, they're going to wait until these people have succeeded for a while." Eric Hannah, twice CEO of a Silicon Valley startup, has learned from experience how venture capital can be a snare as well as an advantage. His apprenticeship is a typical one--a Ph.D. in physics from Princeton University, followed by eight years at Hewlett-Packard Co. In 1982 he founded Calera Recognition, with the goal of building a general-purpose text reader capable of recognizing letters and characters regardless of typeface. A group of venture capitalists at Sevin Rosen Management decided that this was something the world needed, and one of them--Roger Borovoy--took the lead in raising $4 million. So far his hunch still looks good. Although the company has not yet gone public, it's reportedly breaking even. But Hannah, then 36, knew that he lacked the experience in marketing and sales to stay on as CEO at Calera. So a few years later, in 1986, he left and founded another company, called Marlstone. Its goal was to service the growing biotechnology industry by using mathematical methods to determine the shapes of protein molecules. Such methods would be a tool for the rapid analysis of peptides as part of research leading to the design of possible new pharmaceuticals. Toward that end, Hannah created an advisory board of five of the world's leading experts in protein folding. Cray Research offered 1,000 hours of computer time to test his methods, and Merck Sharp & Dohme, a subsidiary of the world's largest pharmaceutical company, offered them a contract. Marlstone quickly went through $1.5 million in initial venture capital funds and was looking for another $2 million when the stock market crashed in October 1987. "I saw the ashen faces of investors," he recalls, men and women in no mood to take a risk after the recent debacle on the stock market. Marlstone needed a lead investor to organize a new round of financing, but nobody stepped forward. Strapped for cash, the company folded in May 1989. Hannah survived financially because he hadn't invested his own money. And he can hold his head high professionally because he knows he was trying to push ahead with the latest technology. But he admits that the failure was an emotional shock from which it took him quite a while to recover. Today, as vice president of engineering at Savitar, Hannah has pulled back a little from the cutting edge of computer technology. But he isn't complaining. Reflecting on his experiences with Marlstone and Calera, he says, "I wouldn't want to start a new company today that has a large R&D component to it. It's just too difficult." --T.A.H. As a consequence, those in search of financial backers are beginning to look beyond venture capital toward other possible roads to success. For some new companies, the answer is a link to an established company in the same field and people who understand what the new enterprise is trying to do. For other budding entrepreneurs, it's working two jobs, or becoming a consultant to the industry, as they try to meet the higher standards that investors now demand. Ken Gardner knows just how high those standards can be. The president and chief operating officer of Viewpoint Systems in San Mateo, Calif., Gardner was a manager of software engineering for Tesseract Inc. of San Francisco when he figured out a way to simplify the task of producing the on-screen displays that control a computer. Gardner thought the designer should be able to specify how those displays ought to look and then have the computer, using programming techniques that Gardner already knew, automatically write the necessary code. Viewpoint Systems, he reasoned, would develop and sell this software tool. After Gardner left Tesseract in 1988 and began making the rounds of venture capitalists, he got his first exposure to the new investment climate. "We were having a lot of trouble getting people to understand what we were talking about," he recalls. It was then that he learned Lesson No. 1: Have something tangible to show investors. A partner, software designer Marti Johnson, crafted a set of 20 illustrations that demonstrated how the process would work. "By stepping through these pictures," he says, "she [Johnson] could simulate the behavior of the resulting product." The drawings were enough to convince two companies--Alpha Partners and Hillman Ventures--to put up a total of $600,000, and in March 1989 Viewpoint Systems was on its way. Then came Gardner's Lesson No. 2: Develop a prototype. The company's backers weren't willing to put up the next $1 million until Gardner could offer them a working prototype of the software. After five months Gardner came up with such a model, and his investors agreed to pay for the salaries, overhead, and equipment needed to take the next step. On to Lesson No. 3: Sell some product. By May of this year, Viewpoint Systems had built a track record with increasing sales of its software to scientists. That entitled it to jump to the next level of support--a total of $3 million from its original partners and another firm, Mohr, Davidow Ventures. Gardner is following a path that many experts believe is the right one for a successful startup in the nineties. But there are variations that can be equally successful. In biotechnology, for example, budding entrepreneurs have a chance to parlay existing federal support from NIH or another agency into a new company. It's an opportunity that isn't available to scientists in such fields as computer science, in which the government is less likely to support the type of basic research that's needed before a company can take off. Kin-Ping Wong, a biochemist at the University of California, San Francisco, for example, is building a new company called Ribogene. His basic research on protein folding has been supported generously with grants from the National Institutes of Health. But Wong needed support from other sources to build the bioreactors that he hopes to sell. So far, the Menlo Park, Calif., firm of Sierra Ventures has agreed to put up $2 million, and the company has also entered into a joint venture with a team of Soviet scientists in Moscow. Another startup method has scientists at their present jobs laying the groundwork for their future companies. The advantage of this plan, of course, is that they are still earning money. The disadvantage is that it requires holding two jobs. Gardner, who worked about 30 hours a week as a consultant during part of the time he and his partners were setting up Viewpoint Systems, compares that approach to sprinting a marathon. "You can't expect to start a company by working a 40-hour week," he says. 'You are signing up for several years of 60- and 70-hour weeks." Craig Stouffer, chief executive officer of Mobius Computer, looked here for financial backing: He asked his friends. A 1985 graduate of Indiana University with degrees in physics and computer science, Stouffer was working for Hewlett-Packard Co. when he thought of using high-performance microprocessors to build workstations that would use the Unix operating system at half the cost of competing systems. He turned to Jeff Webber, now a partner in the consulting firm of Edgar, Dunn, and Co., for the initial support he needed. As Webber describes it, "I put five-digit sums into people and outfits that I've known a long time." In Stouffer's case, it was his friendship with a long-time client of Webber's that put the consulting firm onto Mobius Computer. But even that friendship didn't relieve Stouffer's need to have his company's fundamentals in place. Louise Kirkbride, president and founder of Answer Computer in Sunnyvale, Calif., has been doing things her way since she was a teenager in Philadelphia. "I had determined that, since Caltech was the hardest place in the country to get into, I was just going to go there, no matter what," says the 37-year-old electrical engineer. She was admitted in 1970 to the prestigious university in Pasadena, Calif., and landed a scholarship--but still faced the opposition of her parents, who wanted her to attend college closer to home. So she literally ran away. "I took off in the middle of the night," she recalls. Eventually the family was reunited when her parents moved to Los Angeles. Kirkbride began her undergraduate years majoring in astrophysics. But after concluding that "all astronomers are poor," she switched fields, graduating with a master's degree in electrical engineering. Because space science was still her first love, it was an easy decision to join NASA's nearby Jet Propulsion Laboratory. And in 1976 she applied for a coveted slot as mission specialist for the fledgling space shuttle program. One of 200 (out of 9,000 applicants) invited to Houston for extensive interviews, she had an eye-opening experience. "Oddball that I am," she says, "it was kind of frightening to meet people who were just like me." Kirkbride failed to make the final cut, however, a rejection that she calls "the worst thing that had ever happened to me." Back in California, working for a company called Hydro-Aire that designs aircraft brake control systems, she found that engineers faced long delays in getting equipment for computer-aided design and manufacturing jobs. So she formed a company, Cadri, that bought such a system and leased time on it to engineers and scientists. In 1983 she was bought out for $1 million by Bishop Graphics. After moving to Silicon Valley and taking a job at another software design company, she was at it again. She and her husband decided there was a need for a company that provides informational support for people using computer graphics. Working evenings and weekends, they put together a business plan and pieced together a prototype. The result was Answer Computer. But when they landed their initial $1.25 million of venture capital in July 1988, her response was, typically, low-key. "We had a beer," she recalls. "Then we went back to work." --T.A.H. "We had a business plan and a preliminary prototype [built] with off-the-shelf components," he recalls. That convinced Webber to offer the company seed money in April 1989. By the end of the year Mobius was shipping product, and it's now seeking $1 million to expand its operations in Palo Alto. For some scientists, the perfect backer may be an established company that is familiar with the field and understands the long lead time that some discoveries require before they yield a commercial product. Since it is "playing the same game," such a backer is "a more intelligent investor that understands the issues of the market and the technology more acutely than does a venture capitalist," says Savitar's Burger, who has founded startups with this kind of support. In 1986 he launched Avalon, which like Savitar produces software for use in electronic imaging, with the help of $1 million from a Boston company called Data Translation. "They [Data Translation] were looking for an opportunity to expand into the market," Burger says, "and they felt that the best way was to fund a startup, rather than take some of their engineers and somehow seed them with the creative impulse." With Avalon's help, Data Translation moved from building circuit boards to electronic publishing. And Burger says that Avalon is breaking even with some additional support from Data Translation. Established firms also give a budding entrepreneur an initial market to tap into. When electrical engineer Louise Kirkbride (see Close-Up on page 5) was forming Answer Computer, she built a prototype that could present realistic data displays even if it could not perform true computer manipulations. With such a model, Kirkbride was able to line up commitments from three larger companies to buy her firm's software once it became available. "There's nothing like selling something to make people believe," she notes. Armed with that confidence builder, she obtained $1.25 million in 1988 from Alpha Partners. The pursuit of a corporate connection is particularly important to biotechnology startups, says venture capitalist Ruby, because the regulatory climate for those products is so uncertain. "You put money into a biotech deal after you've signed up some corporate partner, who will join it later," he says. That partner often is a large pharmaceutical company that expects to benefit from the startup's technology and that, in the meantime, promises to help keep the new firm afloat as it navigates the treacherous regulatory waters. Indeed, the line between established firms and venture capitalists is becoming increasingly fuzzy. "Venture capital groups have established expertise in certain niches of industry and are becoming more specialized," says Martin Behr, a mechanical engineer who is president and CEO of Spacebridge Broadcasting in Palo Alto. The firm, which provides private television networks for corporations, is hoping to set up a similar network for the electric power industry. "We are getting the best reception from a group of venture capital firms that specifically focus on ventures that market to this industry," he notes. Despite the new face of venture capital, one thing that hasn't changed is the doggedness with which scientists must pursue their dream. The ones who have succeeded--at least for the time being-- say that the long odds are just part of the game. "It takes blind persistence," says Kirkbride. "If `no' means something to you, then you won't raise venture capital because you're going to be told `no' a lot of times." She compares her struggle, and that of hundreds of scientists like her, to a salmon swimming upstream. "If you've got enough drive, you're going to get the money," she says. "Remember, a venture capitalist is looking for people who will make [the company] succeed, no matter what it takes." T.A. Heppenheimer writes about science and technology from Fountain Valley, Calif.

Investors Tighten Grip On Venture Capital

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