April 2001

Dear Member

Formational Ventures remains positive about the future. Our lean and effective operating structure has just the flexibility necessary to continue to identify where our investing members can maximize their returns, either in a market downturn or a market boom. The fv team, unencumbered by the restrictions of managing a specific fund, are able to concentrate on identifying  opportunities, and tailoring the investment procedure to best suit the market conditions. Over the long run there is still no better place than investing in businesses seeking to employ disruptive technologies that can change the world. FV’s Michael McLaughlin takes an overview of the market and explains in detail how FV is positioning itself whilst the market is unsettled, and what its investing members can expect now and in the coming months.

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A View From The Valley   -    Michael McLaughlin

Now may be the best time to invest in early-stage technology.  Valuations are low versus previous years and the needs of these companies to “go public” are certainly not immediate.  Read this article to learn more about investing in early-stage technology businesses.

With the burst of the Internet bubble last year and the continued downturn in NASDAQ, there has been a change in the venture industry.   Although some of our members already have a  complete dynamic understanding of the present market dynamics, we thought it would be valuable to articulate what we see going on in “the valley” and what Formational Ventures is doing as a result of these recent conditions.

  Although ‘Mark Andreesen’s company’ Loudcloud managed to go public, the IPO market has been virtually turned off.  There has been a wave of companies that have “filed” with the SEC and have had to withdraw their IPO applications.  Many companies planned on raising funds via an IPO and, with cancellations, are forced to raise money from “private” sources that often include their existing investors, namely venture capital companies and investment banks.   Other companies, not so fortunate, have gone out of business after canceling their IPO plans, and are unable to raise additional money from private investors inevitably go out of business

  As corporate valuations on NASDAQ have dropped sharply, many companies have “lost” their ability to use their stock to purchase other businesses.   Certainly mergers and acquisitions continue, but the rate and values of acquisitions have naturally cooled off substantially.   In previous years investment banks (e.g. Goldman Sachs, Morgan Stanley, J.P. Morgan, Bear Stearns, etc.) have had outstanding years recently from earnings via commissions and fees from IPOs and M&A activities.  As a result of the current downturn, many of these financial institutions have revenue fall-offs and have recently announced staff reductions and other cost-cutting measures.  Even Schwab announced sizable layoffs due to a downturn in trading, and hence commissions.

  Investments can be categorized in a range from early to late stages.  Companies progress through these stages, early to late, as they grow and mature.  Early stage investing represents “seed-stage” or Series A and is the highest risk, though delivers the highest returns when successful.  Later stage investing often includes co-investing with other large institutional investors and can be during an IPO round or pre-IPO – sometimes called Mezzanine round.  Such deals are typically lower in risk and return.   As the two important liquidity exits for investors in private companies (IPOs and acquisition by a public company) have slowed, the pace of “later-stage” investing has slowed also.

  This pattern of the IPO market slowing, then later-stage private investments slowing, etc. “backs-up” all the way down the private investment chain, as investors often don’t want to make investments without being comfortable that adequate funds will be raised in future rounds by larger and low-risk investors.   This is why there is often said to be a “herd-mentality” in the venture business.  Investors “buy” in order to “sell off later, and  investors may not feel comfortable about future investors coming to “buy” shares in a company after them, investors naturally avoid buying shares altogether.  Investors move in herds, as there is naturally safety in numbers… and today’s buyer is tomorrow’s seller, and this requires additional buyers tomorrow.

  As a result, venture investing has slowed substantially. However statistics of venture investing trends don’t adequately tell the story of what’s going on.  Why?  Because most of the reports that we’ve seen from companies that track the industry (e.g. PriceWaterhouseCoopers) only measure venture dollars invested by quarter, and not venture dollars invested by quarter in NEW deals.   Also, valuations have dropped dramatically, so investors can buy a lot more of a company now than they could one year ago.

  Many venture capital companies have spent the past year working with their portfolio companies rather than undertake new ventures.  They have had to do this because their portfolio companies require more capital, and these companies find that it’s more difficult to raise money from new investors and because venture companies cannot afford to add many new companies to their already taxed portfolios.  As a result, many venture funds continue to invest in a sub-set of their portfolio companies and given that venture funds are so large and that there are many companies requiring substantial funding, the venture dollars being invested statistics show a sizable decline, but one that does not completely tell the tale for an entrepreneur starting a new company.

  How does this effect Formational Ventures?  We are dedicated to the interests of our investors, at all times.  As we are transactional in nature and have no established “fund” that must be invested in two or three years, we are not pressured to offer our members investment opportunities where we do not feel comfortable.

What are we at Formational Ventures looking for now?   As always we look for new businesses where there was a strong team with outstanding domain knowledge and connections, a technology or service that was unique and defensible against other competitors, and the opportunity to build large profitable businesses. We used to feel more comfortable investing in a seed-stage round where these conditions applied if we felt that the deal would be highly attractive to other venture companies.  We would offer to our members the chance to invest, then work with the company to raise additional money with leading venture companies.  This risk was often rewarded with a sizable price increase between our early investment and the first venture round.  However, given the changes to venture behaviors cited above, Formational has decided to offer investments to our members in new deals that also include other, larger lead investors.   As such, we often work with companies and make introductions to other venture firms before we offer such opportunities to our members, not after.

 We are also offering our investors access to later stage deals.  These deals have the benefits of having other investors with “big pockets”, but have lower returns vs. seed-stage deals and may be problematic if they require a near-term IPO in order to raise additional funds – as the IPO market has not yet “returned” and may not be thriving in the near-term.  Seed-stage deals will likely have no plans to “go public” in the near-term and therefore these opportunities have less near-term risk due to the currently slow IPO situation.  However, these deals still require subsequent rounds of capital to feed their accelerated growth objectives and therefore Formational continues to work with deals where we can co-invest alongside other venture funds which have adequate capital reserves to feed growth in subsequent rounds.

Examples of later-stage Formational deals include Simplexity (we co-invested in Series C with MicroSoft Corporation who led the round), CopperCom (we co-invested with Morgan Stanley, TCV, Granite Ventures -formerly H&Q and others).  We have recently offered our members the ability to invest in AirFlash’s Series C (led by UBS with participation from Inktomi, others). 

We are presently working on new and exciting opportunities where our members will be able to participate in early investing with other major venture companies and substantial corporate backers as well.

What are we seeing?  We’re seeing a lot of companies that hope to raise their second round, Series B.  These companies already have investors and are seeking to raise additional money from new investors.   These companies, in general, are not well suited for Formational, as they are not “seed-stage” companies, nor do they have substantial participation from larger, institutional investors.   There are exceptions, of course, and these include companies in our portfolio where they have already secured major participation from leading tier-1 venture firms.  We will offer our members the opportunity to co-invest along-side these leading venture companies as these opportunities come up over the course of this year.  An example includes eMadison, which will have participation from its current investors, Sequoia Capital and Sandler Ventures in New York.

Over the past few quarters, we’ve noticed that corporate financings are taking a long time to complete.  Often, companies cannot wait long enough to complete their financing rounds and are executing bridge-loans, typically from their current investors.  These bridge-loans are meant to help companies operate until their next round can be completed.  We have had many opportunities to offer our members the ability to participate in bridge-loans from a variety of companies, but except for companies that are already in our portfolio, we feel that we should avoid such opportunities for the time being.  This investment strategy is identical to that employed by other venture capital firms.

Naturally, the most exciting opportunities are those companies that can already pay for themselves and where they can also scale with little follow-on investing.  That is to say, the best opportunities are those businesses that don’t need money!  Naturally, everyone else is also looking for such gems, and such deals are extremely rare.  It takes capital to build corporate infrastructure quickly and become a leader in an emerging marketplace.  But ultimately, each business must execute efficiently and “add-value” that leads to growing revenues and profits.

Luckily, unlike so many other venture companies, Formational Ventures has never invested in Internet stores, consumer e-commerce “web-sites” or experiments in branding.  Many venture firms have literally dozens of such companies, all seeking additional funds without having any valuable differentiated technology or service.

Formational has generally targeted businesses with unique technologies and strong teams.  Certainly, times are tough and not every company will thrive.  Although technology investing has been taking it’s bumps and bruises recently, we feel that long-term value is achieved via rapid -growth and that there is no better place over the long-run than investing in businesses seeking to employ disruptive technologies that can change the world.  Offering you the ability to invest into a variety of these opportunities is our mission.

Thank you for being a Formational Ventures member.

Michael McLaughlin
Managing Member

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FV investments are hanging in there   -    Richard Frawley

Although we see a lot of bad news, there is not one company that is not being affected in some way by the changes in the business practise that the web brings about. The efficiencies and cost savings that the web brings to business will become very apparent to the investment community over the next 2 years and those companies that do not make the shift to using these systems and networks as the basis for running their business, will indeed get left behind in the competitive race.

Of course there is a pull back in corporate technology spending today, many companies are now taking a breather and taking some time to assess the technology investments they have made to date. The outcome is that they will make better informed decisions on what they invest in over the next 2 years, but they will continue to invest, lets face it, they have no choice if they want to stay at the competitive edge. Companies in this softer economic cycle will be investigating every way possible to cut costs, but at the same time the desire to be at competitive forefront will also be strong. Tools that enable the sales force with the most competitive weapons, tools that service customers needs, tools that keep customers coming back, tools that making a company easy and quick to do business with. 

In an economic world, where competition is the basis for success, investing to remain competitive is a fact of life, it will never go away. So a key question for technology investing today, as it always has been, is what technology innovations will be key in the race to remain competitive. 

What we are going to see is a shift in spending, less may be spent on new PC platforms (have you thought about buying a new PC lately...hmmmm) , enterprise networking investments will reduce in the areas of LAN switching, focus will shift to data storage, data management and applications, the pipes are not the bottleneck. Telco WAN infrastructure investments, both in the core and the edge will increase, the pipes at the edge are still a bottleneck. DSL will happen, we may have another round of technology development on the modulation side. Voice will move totally to a packet based infrastructure. Unified messaging will become prevalent, although it will still take some time. Wireless applications will roll out with 2.5G , 3G will not be here for quite some time.

Yes, there will be a lot of fall out, a lot of consolidation, a lot of things were funded that never had a hope in hell. Apart from e-lingo, FV investments are hanging in there, the other still live and in this current market, that is saying a lot. Most VC's have had a horrible attrition rate and every day many more wither on the vine.

Richard J Frawley
Managing Member

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"This is the time to get better returns, as valuations have dropped significantly. There will be a shake-out in the traditional Venture Capital companies over the next two years."

Mark Housley
Formational Ventures Associate

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"Now traditional VCs are focused on their existing investments. This is driving down the valuations of new start ups who now have fewer places to turn for financing."

Thomas Rota
Managing Member

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"Whilst most markets and investors are regrouping and focusing on minimizing downside risk, the few opportunities that clearly demonstrate strong teams and maturity of business model can still attract some interest, albeit at reduced pricing levels from those experienced. Clearly Formational Ventures Australia retains contact with these companies to be able to offer them to investors when circumstances dictate it is appropriate.