E.B. Writers of Dallas

From the burnt wasteland of the dot-com boom, a fresh, new venture capital market is emerging.

Esther M. Bauer correspondent | HostingTech Magazine, November 2001

Technology businesses wishing to attract investors should be overjoyed to learn that plenty of money is available. There is just one small problem: the cash is only available to companies that already have it. Today's investors only have an ear for businesses that are already at or near profitability.

To put it even more succinctly, unproven startups will find it exceedingly tough to attract investor interest. The private equity community has gotten finicky since the dot-com boom fizzled.

Investors are decidedly more wary, now that fast money from initial public offerings and other early-exit strategies is nothing but a memory. Today's investor community has returned to the traditional strategy of financing less speedy, but more certain, ventures.

Before considering companies for its portfolio of investments, Columbia Capital (www.colcap.com), for example, applies a four-point formula that includes evaluating the experience of the firm's management team, whether the firm has a well established revenue-generating model, and how well the firm utilizes its existing assets, as well as assessing fundamental industry demand. All of those factors have to mesh, or a deal is unlikely.

Hope on the horizon
Approximately 15 to 20 percent of Columbia Capital's portfolio companies target the managed services and managed hosting opportunities - either offering hosted or managed technology solutions themselves, or developing products and technologies to be deployed by managed service providers.

"We continue to believe this is an industry that will experience significant growth from where it is today," says Matt Newton, a partner at Columbia Capital. "We look beyond just website hosting to various information technology services or network hosting. Just the outsourcing of those services to be managed by a third party is something we believe will grow significantly over the years."

Existing firms hoping to inspire investor interest should take heed of Newton's advice:

"Investors now are less interested in a bigger-is-better strategy and more interested in how well you deploy the investment you have. Becoming the next big thing is not as important as getting maximum utilization from every round of financing. People are going to want to understand how much capital is going to go to customer acquisition, revenue generation, and customer support, as opposed to asset deployment and utilization."

Translation: Investors are going to be cautious about dealing unskilled managers who have poor business plans, inefficient management, and profits nowhere in sight.

Demand over supply
Businesses likely to inspire investor interest will be those with a decent customer base and the ability to make a profit. Some existing firms may well have reason to rejoice, compared with bright new businesses that are likely to remain unappealing for the foreseeable future.

Columbia Capital, like most other private equity firms, is not interested in funding any untested start-ups these days - especially in the hosting industry.

The investing frenzy that built the hosting industry was based on an erroneous assumption about industry demand that never materialized, says Newton: "I would say we were extremely thoughtful about [investing], but unfortunately we came to the wrong conclusions."

The evidence is written all over the landscape - many players and under-utilized assets.

Burning away excess
Today's aftermath of fallen companies is as sobering as a wildfire - painful but ultimately necessary to clear the way for healthier growth, says Katherine Jones, an analyst with the Aberdeen Group (www.aberdeen.com).

Excess led to funding even "silly, ill-founded ideas, anything that involved networking or had an 'e' or an 'i' in front of it,'" Jones says. "Now we are seeing what happens when we do that: implosions in great big companies ... small start-ups bombing all over the place. This is why we need forest fires. Everyone and his brother should not get to be a CEO. That is not the inalienable right of citizens," she says.

Nevertheless, Jones predicts the current clobbering of the industry will result in a better future: "The hosting industry will rise again, only under a new guise."

This year is a welcome change from 2001, when most venture capitalists first experienced a state of denial and then a fight for survival, says Chris Shipman, general partner in Catalyst Investors (www.catalystinvestors.com).

"VCs spent most, if not all, of their time working with their existing portfolio companies, figuring out which ones were worth saving and which ones should be let go," Shipman recalls.

Today, investor angst is less about availability of capital and more about the question of where to invest the billions of dollars still available.

A more reflective attitude has replaced the "Big Bang" concept of investing, says Craig Moseley of Daniels & Associates (www.danielsonline.com), a financial advisory firm to the media, Internet, and telecommunications industries.

The single largest concern of the investment community is whether investors "can really put all this money to productive use," Moseley says.

Consolidation games
Plenty of deals abound, as the hosting industry consolidates amid a conflagration of mergers, acquisitions, and bankruptcies, which are proving to be rich fodder for companies that have the wherewithal to take advantage of pennies-on-the-dollar acquisitions.

The frenetic pace of turnovers is only partially reflected in this recent selection of headlines:

Global Crossing Files for Bankruptcy
USi files Bankruptcy, but Gets Cash Pledge
Cybergate, Inc. and Affinity Internet, Inc., Merge
Digital River Picks Up Beyond.com Assets
Interland Acquires AT&T Small Business Web Hosting
The significance of some of these transactions still remains open to interpretation.

The U.S. Securities and Exchange Commission is examining the practices of Global Crossing (www.globalcrossing.com), a Bermuda-based fiber optics telecommunications and hosting company with offices in New Jersey and California.

Analysts predict a merger between application service providers Interpath, (www.interpath.com) and USinternetworking (www.usi.net). Interpath is already a portfolio company of Bain Capital, which announced plans to infuse $106 million into USi.

"Bain is going to have to merge Interpath and USi and take the best nuggets out of both. Then that will probably be one of the strongest enterprise-class ASPs around," says one analyst.

The Exodus acquisition is perhaps the most significant, because it exemplifies both the scope of the hosting industry's consolidation and its excess capacity. The balance sheet of Exodus, with its 44 datacenters, listed assets in billions of dollars, while the British company Cable & Wireless (www.cw.com) purchased the company for mere millions. Many of the exquisitely expensive datacenters were considered worthless and not included in the acquisition.

Such bargains make growth by acquisition more efficient than doing it organically, Shipman says.

"Good assets were picked up at great prices - well below replacement costs - which, if nothing else, will pretty much preclude any new competitors from entering the space for years to come. It is definitely a very attractive asset for the right buyer at the right price."

Shipman and Moseley predict industry consolidation will continue for at least a year, creating a lucrative environment for investors with the capability and nerve to restructure floundering companies into profitable enterprises.

Harder than it looks
Although acquiring assets at fire-sale prices may conjure up the unflattering image of a vulture replacing the "V" in venture capitalism, such transactions take skill as well as financing, Moseley says.

"These are pretty nerve-wracking situations for anybody to step into. A lot of times you have no idea what type of assets you are truly getting - you can bet the customer base is fairly unstable. These companies are typically a mess. They have been operating at huge losses. Their operation systems are generally pretty poor. The organization is demoralized. It's a nightmare," Moseley says.

Still, a good return on investment awaits those with "the guts" and know-how to maneuver such deals into revenue-producing, viable businesses, he says.

Divine (www.divine.com) apparently has both the courage and the knowledge. Since late 2000, divine has acquired a total of 31 companies, including Data Return (see p. 52).

Analyst Ted Chamberlin of Gartner (www.gartner.com) says divine is one of the best examples of companies making opportunistic purchases.

"Traditionally, divine has software development capabilities. They are starting to piece together more of a full-service hosted offering, and they have done it. Trying to grow that internally would take a lot of time and money ... you buy it cheap, and your overhead is going to be cheap, but trying to integrate all those companies is tough," Chamberlin says.

Because the industry is so overbuilt with datacenters, the most valuable asset divine and other hosting companies can hope to acquire is customers, says analyst Carrie Lewis of the Yankee Group (www.yankeegroup.com).

"The real draw, the real benefit companies are looking for in acquisitions, is customers," Lewis says. "They already have the infrastructure, and lots of it is sitting empty. Before they build more or spend more, they need to fill up what they already have with paying customers. It's a race to profitability."

Parker Brophy, a principal at Meritage Private Equity Funds (www.meritagefunds.com), says customers hold the key to profitability, while good management teams with sound business plans carry them to that goal as well as warrant interest from "investors with the ability to employ inexpensive assets to create valuable companies that will do very well in this market."