Rookies break into venture capital

Trio raises $15 million for early-stage investments, filling void left by veterans

By Jerry Useem

Time was, to raise a new venture-capital fund, you had to be, well, a venture capitalist--and a seasoned one at that.

Now consider John Kohler, Russ Aldrich, and Robert von Goeben, who in 1996 raised $15 million for their brand-new venture outfit, Redleaf Venture Management, based in Saratoga, Calif. Their collective venture-capital experience: zero.

Never, it seems, have so many raised so much with so little experience. Last year, a record 47 new venture funds sprouted up, many of them headed by neophytes like Kohler, Aldrich, and von Goeben. Industry veteran William "Boots" Del Biaggio laments, "Seems like everybody thinks they can be a venture capitalist."

Rookie funds such as Redleaf are changing the complexion of an industry that only a few years ago seemed perilously close to losing the word "venture" from its name. The more established funds, burdened with a surfeit of cash, were putting larger and larger chunks of money to work in big companies, to the neglect of riskier start-ups. Now the newcomers are staking out that evacuated territory. Redleaf, for example, invests very small sums--as little as $500,000--in Internet-related companies too young and too small to interest the big funds.

If the Redleaf team consists of venture-capital greenhorns, it does not lack an impressive pedigree. Aldrich, once a member of the marketing team that launched the Apple Macintosh, cofounded Simba Technologies. Von Goeben previously ran Geffen Records' on-line division. Kohler, a former executive at Hewlett-Packard, was the 24th hire at Netscape Communications Corp.

But on Sand Hill Road, the Madison Avenue of the venture-capital world, such operating experience has traditionally counted for little. So what's changed? The answer lies in the torrent of money that has been pouring into venture firms in recent years, which has had a dramatic effect on their operations.

Lured by the industry's supranormal returns (averaging 41.2% yearly from 1995 to 1997, compared with 15.4% over the past two decades), investors have magnified their contributions almost ninefold since 1991. Though old-line funds such as Sequoia Capital and Accel Partners have absorbed much of the influx, plenty is spilling over to smaller fry and novices.

Still, Kohler couldn't simply anoint himself a venture capitalist. "Investors wanted to know, 'How do you know you'll have deal flow? How do we know you'll be good on a board of directors?" he recalls. To prove it, Kohler used $2.3 million of his own money to put together a private investment portfolio of five start-ups. That caught the eye of FLAG Venture Management, a group based in Stamford, Conn., that invests in new venture firms. Impressed with Kohler's professionalism, FLAG ponied up $1.5 million, enabling him to coax another $13.5 million out of institutional and individual investors.

Like politicians touting their "outsider" status, Redleaf's partners have tried to turn their lack of investment experience into a virtue. Kohler calls their approach "blue-collar venture management": rather than acting like passive financiers, he and his partners say they plunge themselves into the nitty-gritty of company building. They've donned polo shirts to work trade shows and have even made some sales calls. "The big funds have to spend more money on each company, and less time," says von Goeben. "Internet companies need just the opposite. They need less money, but more partner time."

That pitch doesn't impress everyone. "There's nothing new in that song and dance," says Jesse Reyes of the research firm Venture Economics. Moreover, with so much money competing for the same deals, observers say that novices such as Redleaf risk overpaying for the companies they invest in, and that a cooling of the market for IPOs crimps their prospects.

So far, though, so good. Redleaf is tight-lipped about numbers, but its first investment, a maker of Internet-advertising and direct-marketing software called NetGravity, went public in June, its stock tripling to $27 in its first month of trading. Redleaf's six other investments all have received follow-on rounds of financing from other VC firms. Kohler and the gang are already back on the road to raise a second fund, Redleaf II, intended to be four times the size of the first. Now they've brought on a fourth partner, Lloyd Mahaffey.

And how much venture-capital experience does he bring to the table? Exactly the same amount that his partners did.

M-o-n-e-y spells change

To understand the dynamic changes in the venture-capital world, which is attracting more unseasoned people to try their hand as venture capitalists, it's important to note one factor more than any other. That factor is spelled M-O-N-E-Y. Lots of it. The gush of money into venture-capital funds has been altering the industry's landscape.

Money inflow
Capital raised by U.S. venture funds (in $ billions)
1991 1.2
1992 3.1
1993 4.0
1994 5.5
1995 6.3
1996 8.2
1997 10.4
And the flood of money has produced a bumper crop of new venture-capital firms...
Net new venture firms
1991 -15
1992 -12
1993 -7
1994 -3
1995 9
1996 17
1997 40

Source: National Venture Capital Association 1997 Annual Report.

Playing the begging game

During his 12 years as a partner at Southwest Venture Partners, an established venture-capital firm in Austin, Tex., John Long spent his days listening to entrepreneurs beg him for money. But when Long departed in late 1995 to launch his own venture-capital firm, Trellis Partners, suddenly he was the one doing the begging.

The role reversal wasn't fun.

It took Long and his partner nearly 18 months to raise a comparatively modest fund of $20 million--"a long time," Long concedes. They had hoped to raise the money from the same big pension funds and banks that invested in Southwest. ("Since we had contacts there, we thought that we'd visit with them first.") Bad idea: the big institutional investors, it turned out, weren't about to entrust their money to a puny upstart. "Until you've experienced raising a first fund," says Long with a sigh, "it's tough to know how hard it's going to be."

Yes, it's easier than ever to raise a venture fund these days, but that's not to say it's easy. Even in an environment flush with cash, even with ever-greener venture capitalists obtaining money, a strong bias against first-timers remains.

Take the experience of Frank Greene, whose New Vista Capital began operations in early 1997. Greene has an impressive résumé: an engineer with three decades of business experience, he had started two software companies. But his credentials didn't exactly propel investors toward their checkbooks. "I found there were more ways for people to tell me 'no' than I knew were possible," says Greene. Before getting the fund off the ground, he had to take on a seasoned venture capitalist as a partner, and it still took four years to raise the fund's initial $36-million bankroll.

Joining forces with a veteran venture capitalist is not the only expedient to which tenderfoots have resorted. To raise his New World Equities fund in 1996, former Chicago investment banker Chris Girgenti felt compelled to offer investors a sweetened deal. Instead of the standard 80-20 split, by which investors receive 80% of any payout, New World offered a highly unusual 85-15 split.

To boot, he and his partner invested $5 million of their personal money in the fund to assure investors, in Girgenti's words, "that whatever we're doing with your money, we're doing with our own."

Stooping to terms that conciliatory, says a veteran venture capitalist, is "deadly" because "if you're having to compromise to get money, then you probably shouldn't get it."

Train wreck ahead?

As one who raises money from investors to create funds that invest only in venture-capital funds, Diana Frazier is closely tied to the venture-capital industry. In 1994 she cofounded FLAG Venture Management, based in Stamford, Conn., which exemplifies a new kind of financing entity known as a "fund-of-funds." Frazier, a former president of BancBoston Capital, has a front-row seat for the explosion of new venture-capital firms. She recently spoke with Inc. senior writer Jerry Useem.

Q: What's the point of an intermediary, such as FLAG Venture Management?

A: All our investors are individuals, who are also entrepreneurs and members of the Forbes 400 list of the wealthiest families. They want to start investing in venture capital. But it's nigh-on impossible to invest in top-tier funds today. People are vying to invest so much money in them that the funds get to pick and choose which investors they invite into their hallowed halls. So people who are left out invest with us, and we get them in on the ground floor of the best early-stage funds.

Q: Are a lot of inexperienced venture capitalists cropping up?

A: We've been astounded at how easy it's been for first-timers to raise money in the past year. It's a trend that we don't like.

Q: Why not?

A: Venture capitalists aren't born overnight. The mechanics of running a fund often elude them. People say, "Wow, this is a smart person, he founded a company, of course he'll be a good venture capitalist." But it takes experience, it takes mentoring, it takes seeing 20 other small companies fail. Smart is a necessary--but not a sufficient--condition.

Q: What mistakes do first-time venture capitalists make?

A: They sometimes are very reluctant to look in the mirror and be honest about what their portfolio looks like. We invest in a firm called Information Technology Ventures, and one of the key signals for us was when they wrote off their first deal. We thought that took incredible guts. Most first-time funds pretend that a loser still looks good and hide the problems under the rug.

Q: How will the newcomers fare in the long run?

A: History has it that they won't do well. What we're seeing now reminds me a lot of 1982 and 1983, the last time the number of first-time funds skyrocketed. A lot of inexperienced investors were investing in a lot of inexperienced venture-capital funds. It was just a disaster. A lot of those funds never saw the light of day again.

Q: Will the current frenzy end badly, too?

A: The gap between the premier funds and the rest will grow even bigger.

Rookies' angles: A sampler

Among venture-capital firms started since 1995 are these, each with its own investment angle:

Foundation Capital
Menlo Park, Calif.
$185 million
Provides hands-on help for entrepreneurs
New Vista Capital
Palo Alto, Calif.
$50 million
Invests in companies owned by women and minorities
Arbor Partners
Ann Arbor, Mich.
$6 million
Finances E-commerce start-ups
Voyager Capital
Seattle, Wash.
$49 million
Finances information-technology companies on the West Coast

Venture capital is just one way to raise money. Explore other options at .