Business Impact

What VCs Are Investing In

Virtualization and data-management companies still show potential.

Financial conditions for technology startups have been cool, to say the least, since the economic crisis began. But now, buoyed by two recent public offerings, venture capitalists are showing a renewed interest in fledgling technology firms.

The fourth quarter of 2007 saw 17 venture-backed technology companies go public, one of the biggest spikes in stock offerings in a single quarter since the height of the dot-com boom in mid-2000. In contrast, the last quarter of 2008 and the first of 2009 saw no venture-backed public offerings in any industry, according to the National Venture Capital Association. Mergers and acquisitions have also slowed, and the number of venture funds raising money at the beginning of the year was smaller than at any time since 2003.

Two recent public stock offerings have, however, lifted the industry’s spirits. SolarWinds, a network-management software company based in Austin, TX, went public Wednesday of last week. Online restaurant reservation company OpenTable, based in San Francisco, went public the following day.

Venture capitalists attending Venture Summit East last week in Boston saw these developments as a positive sign for the industry as a whole, and they were optimistic about the potential for other startups.

“SolarWinds is evidence that software-as-a-service works,” says Sunil Dhaliwal, a general partner at Battery Ventures. Instead of selling physical software, the company’s products are distributed and maintained via the Internet. Some observers have questioned whether this approach to selling software is economically viable, especially when faced with competition from more established companies. The answer, Dhaliwal says, is “yes across the board.”

Enthusiasm for Web startups has, however, clearly changed since the height of the Web 2.0 boom. This is due partly to tighter economic constraints, but also to plummeting costs of starting Web businesses as cloud-computing infrastructure has spread. Since less capital is required to start a company, there is less need to turn to outside investors.

“I think most [Web] startup companies should not take venture-capital money,” said Jeff Fagnan, a partner at Atlas Venture, during a panel discussion. He cited, in particular, companies building lightweight Web applications or software for portable devices like the iPhone. In some cases, Fagnan said, venture capital may damage a startup by creating conditions that push the company to aim too high from the outset.

Another impact of cloud computing is that many venture capitalists are now wary of companies aiming to build large infrastructure empires themselves. Michael Skok, a general partner at North Bridge Venture Partners, says he wouldn’t touch a business looking to compete with the cloud-computing giants like Amazon and Google. “It’s impossible for a startup,” he says.

What tech startups can do, according to Skok, is fill an important research-and-development role, and he sees opportunities across the industry. For example, Skok says, for every dollar spent to store a piece of data when it’s created, companies typically spend an additional $11 to $15 backing it up and managing it. So he’s interested in startups developing new technologies that address some of the current inefficiencies in enterprise IT infrastructure. “Software is far from dead,” he says. However, Skok notes that new companies also need a big idea that will sustain them through lean times, and they can no longer bank on being acquired.

Larry Cheng, a partner at Fidelity Ventures, echoes Skok’s interest in infrastructure technology. Virtualization, which makes it possible to run different virtual computers on the same physical machine, is widely recognized as an important technological trend, he says. However, much of the technology behind virtualization products is outdated. “The entire infrastructure supporting virtualization is going to have to change,” says Cheng, who also sees opportunities for startups in security.

The mood among software entrepreneurs and investors may be colored by having suffered through the first Web bubble. But Cheng is optimistic about the current environment, partly because it’s now less frenetic. He says that interest in clean-tech startups reminds him of the Internet bubble, and he’s glad to be on the other side of it.

“Enterprises still spend billions on IT, and are always looking for ways to cut costs,” Cheng says. “IT is very steady.”

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