May 8, 2002 SOMETHING VENTURED: Even Now, VCs Like Chasing The Herd By Mark Boslet NEW YORK - (Dow Jones) - Unlike most entrepreneurs, Ray Schiavone has no trouble attracting phone calls - and money - from recession-wary venture capitalists. His startup, Arbortext, makes content-management software, a hot item in early-stage investment circles, and VCs have been eager to take measure of the Ann Arbor, Mich., company. "They were looking for the next big thing," says Schiavone. Trouble is, "they didn't know what it was." Most wanted to hear that Arbortext was following in the footsteps of industry leaders Documentum Inc. (DCTM) or Interwoven Inc. (IWOV). Many didn't have an easy time understanding the differences between the companies. "Although they're supposed to be high-risk, really they're not," Schiavone says. "They want something that's proven." In today's risk-adverse venture business, most VCs find it hard to run against the herd. Money pours into hot industries and away from those that have cooled. Just the mention of a new company in the category du jour - optics, storage, Web services - can inspire a flurry of VC inquiries, just as "content management" did for Arbortext. The result has been a follow-the-crowd fever in these lean times that is on par with that of the bubble years, when VC-funded copycat Internet companies, like those selling pet food, overwhelmed emerging markets. Streams of money pour into startups making fiber-optic switches, supply chain software, computer storage products, Web services software, 802.11 wireless products and security programs. In nearly three years, $2.5 billion flowed into more than 92 storage startups, says Charles River Ventures' Chris Baldwin, a partner. "There certainly has been some piling on in the storage space." Many of these market categories face hyper competition. Elsewhere in the industry, companies experience blight. First-quarter investing as a whole fell 53% from a year ago as VCs kept tight fists on the rest of their dollars. "I don't think we are as visionary as we would like to believe," says Jonathan Feiber, general partner at Mohr Davidow Ventures. "It is not a new phenomenon to wake up and fund a company and find there are five or six companies in the same space." VCs find trying to gauge sales opportunities for their young companies a challenge. "Everybody is scared they might be wrong in terms of revenue" expectations, says Geoffrey Yang, founding partner at Redpoint Ventures. "I don't think it's yet time to take a contrarian view." To ease the risk, investors look for established markets, or ones that common wisdom perceives to be safe. In the past year or so, biotechnology became one such market. A recent study by market monitor Venture One found that just 28% of venture-backed companies were able to raise new money last year. But 41% of biopharmaceutical companies did. The paralysis in venture circles is understandable. One-year returns on venture funds were a negative 32% at the end of the third quarter, according to the National Venture Capital Association. Public financial markets continue to struggle, dampening prospects for a quick return of the IPO market. Any stability in the public markets will offer a boost of reassurance and independence to VCs. 'No One Wants To Believe Anything' Until then, the fear of making a mistake leaves many VCs sitting on their hands. "There's a huge backlash" in the industry against taking a bet on new technologies, says entrepreneur Farid Dibachi, chief executive of startup Arzoon Inc. "No one wants to believe anything anymore." Perhaps they should. Adventurous VCs say that attractive investments can still be found that aren't at the top of everyone else's list. One piece of the storage market that hasn't been saturated is software that administers and manages the large storage networks and disk farms big corporations are rapidly setting up, says Feiber. Network operators need software that offers security and data back-up features. "We are in the very, very early days of that problem," he says. "There tend to be waves of startups," says Paul Holland, venture partner at Foundation Capital. Several entrepreneurs often see the same opportunity emerge. "You are always concerned when there isn't any competition," he says. "That means there isn't a market." Still, with as many as 15 companies going after the same sliver of the supply chain market, overinvesting is evident. A not-so-busy contrast, says Holland, is an offshoot of Web services. Software designed to manage the programs and services that other companies create to run on the Internet is a market in its infancy, he says. Foundation colleague Mark Saul, a general partner, says he is an active investor in the badly bruised telecommunications market. The traditional phone networks that carriers operate today will be around for a long time. Investing in hardware companies that make them run more efficiently or allow them to generate more revenue is a way of "looking over the horizon," Saul says. "I am convinced there will not be five other companies (like them) funded by the venture capital industry." Robin Vasan, a general partner at Mayfield Fund, also looks for untrodden areas of the software market. He postulates about a new class of software to take advantage of the greater flow of data and messages inside a corporation. This layer of software could sit on top of a messaging or integration program and find and deliver data with greater efficiency, he says. Another promising area is e-mail management technology. Professionals today are drowning in a sea of e-mails, and creating server software is where the opportunity should lie, he says. Many VCs insist that mining proven markets is better than chasing emerging ones. Opportunities are "more about evolution rather than revolution," says Bob Davis, a venture partner at Highland Capital Partners. Davis says he worries less about the number of companies in a market and more about the health of the market and the performance of the company. Far too many companies have not thought out where their sales are coming from. VCs "get away from the bread and butter and go after technologies that masquerade as products and products that masquerade as businesses," he says. Still, unmasking new technology is at the core of a venture community that produced industry-shifting companies Netscape Communications Corp., now a part of AOL Time Warner Inc. (AOL), and Cisco Systems Inc. (CSCO). Contrarian bets are the ones that make real money. Besides, even a healthy market can support only so many companies.