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VC funding hits all-time high

By Carolyn Duffy Marsan
Network World, 05/22/00

The new millennium began with a bang, as venture capital investments in network firms reached an all-time high of $12.5 billion during the first quarter.

Investments were up 11% over the previous quarter and 14 times more than the $877 million invested in the first quarter of 1999, according to the latest PricewaterhouseCoopers/Network World Venture Capital Survey.

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Among the hottest areas for investment were application service providers, Internet consulting, e-commerce software, broadband and wireless service providers, and optical equipment makers.

Despite the strong showing in the first quarter, industry observers say venture capital investments may be leveling off. The 11% growth for the first quarter compares with increases of 82% and 30% for the two previous quarters. A slowdown is expected in the second quarter because of stock market volatility and a weak market for initial public offerings (IPO).

"The first quarter was another knockout," says Steve Meisel, a partner at PricewaterhouseCoopers and leader of the firm's computers and networking practice. "Although the market grew at only 11% over the fourth quarter, it is still double where it was just a short time ago.

"The question is whether the [venture capital] market will stop and catch its breath in the second quarter. We're already seeing that in the IPO market," Meisel says. "There's still a lot of money in the pipeline, so we don't see any precipitous fall."

Altogether, 886 network companies received funding during the first quarter, with the average investment topping $14 million. While the $14 million figure is consistent with last quarter, it is nearly double the average investment of $7.76 million from a year ago.

The largest deal of the quarter was a $150 million investment in Knology, a West Point, Ga., provider of broadband voice, video and Internet services to small businesses and consumers in the South. Other sizable deals include a $143 million cash infusion for StorageNetworks, a Waltham, Mass., provider of managed data storage services, and $77 million for Yipes Communications, a San Francisco start-up that offers managed IP network services.

Knology will use its funding to expand its network and introduce services in new cities. Company officials say they were able to raise so much money because of the demand for broadband access and their strategy of offering bundled services to cable subscribers.

"We're funded through the end of the year," says Chief Financial Officer Rob Mills. "We're confident that as long as we can continue to execute on our plan and show that we can create value, the capital will be there.''

ASPs all around

The first quarter of 2000 showed an increasing willingness on the part of the venture capitalists to invest in ASPs. What's driving interest in these companies are "new economy" business models that encourage start-ups to outsource all but the most critical functions of their operations. ASPs also allow smaller businesses to take advantage of complex enterprise software that would otherwise be too expensive for them to operate.

"The ASP model allows a company to provide some real value-added services to vertical industries . . . over and above merely renting software," says David Hull, a general partner with Centennial Ventures, one of two investors contributing to the $45 million in funding that ASP Agilera.com's received last quarter (see story, below). "The venture community will continue to invest money here."

Among the ASPs that got funding last quarter were USA.Net of Colorado Springs, Colo., an e-mail outsourcing firm that received $60 million, and Aventail, a Seattle firm offering hosted extranet services, which received $48 million.

Consulting is hot

Venture capitalists also poured large sums of money into consulting firms, particularly those with specialties related to e-commerce. This is a turnaround for the venture community, which in the past was wary of investing in companies whose only assets were their people.

"[Venture capitalists] have not traditionally liked professional services because they didn't think these firms could scale," says Judy Horton, director of research at Venture Management Services in Chevy Chase, Md. "But a number of these companies have gone public and gotten good valuations like USWeb, Viant and Scient, so the model seems to be working and other people are jumping on the bandwagon."

One firm benefiting from this trend is Concrete Media, a New York consulting firm that received $25 million in its first round of funding. Concrete Media provides a blend of strategic, technical and creative consulting to venture- and corporate-funded Internet start-ups. Company President Aaron Cohen says his firm was attractive to investors because it has a track record of building popular Web sites and is profitable.

"The reason everybody is getting in [the Internet professional services] market is that there are very attractive gross margins," Cohen says. But he says that only the leaders in a particular niche will be profitable in the long term. "[Venture capitalists] are going to have to be cautious about how they invest in service providers."

Meanwhile, virtually every software start-up that was funded last quarter offers an option for hosting the application along with add-on professional services.

"The No. 1 trend that we are seeing is for companies to deliver a solution that comprises a set of products and services that are interoperable," says Stephen Andriole, senior vice president of Safeguard Scientifics, an Internet incubator and holding company. Software firms are evolving into services firms, and services firms are evolving into solutions providers, he says.

B2B booming

Business-to-business e-commerce remains a hot area for investment, with lots of money going to industry-specific exchanges, software, tools and service providers. One of the top 10 deals of the quarter was a $75 million investment in Essential.com, a Burlington, Mass., exchange for the energy industry. Meanwhile, Bowstreet Software, a Portsmouth, N.H., provider of software for business-to-business Web sites, received $60 million.

"There's a lot of money to be made in [business-to-business commerce], particularly in the tools, operational systems and the hosting of applications," Horton says. "[Business-to-business] software is going to be the next database. . . . Huge efficiencies can be wrung out here, and the people who can help companies do that will make a lot of money."

Overall, venture capitalists remain bullish on the network industry.

Centennial's Hull says what's fueling this optimism is strong demand for broadband access to the Internet here and abroad.

"We're in the midst of building a broadband network to reach both residential and business customers," Hull explains. "When that connectivity begins to reach critical mass, we're going to see a whole new series of content and services offered. . . . The venture community and the private equity markets are going to continue to see a tremendous opportunity here."