CAPITAL LOSSES

Sunday, January 19, 2003
By Jim Bodor
Telegram & Gazette Staff

Since 1998, $965.6 million in venture capital was invested in Central Massachusetts companies, stimulating an economic boom unlike any before.

The return on that investment, however, has been less than stellar. Of nearly $1 billion invested, $480.75 million went to companies that ended up in bankruptcy or ceased operations, according to a Telegram & Gazette analysis.

The newspaper examined every known venture capital investment in Central Massachusetts since the beginning of 1998, using information from the companies themselves, venture capital surveys such as those by PricewaterhouseCoopers and VentureOne, and bankruptcy court records.

Venture capital is money investors give new companies to hire employees and begin development of a product in exchange for a share of future profits.

The two largest casualties were Celox Networks Inc. of Southboro, the recipient of $155 million in venture capital, which closed in December, and Cereva Networks Inc., which attracted $106.4 million in venture capital and closed in June. Both created new technologies that, ultimately, companies did not want or need.

But the list also includes dot-coms such as Furniture.com, founded in Worcester; software companies such as LifeTecNet of Westboro, and even a furniture-delivery company, NationStreet Inc. of Westboro.

Five years after the venture capital boom began, hundreds of Central Massachusetts residents have seen high-paying dream jobs slip through their hands; investors are absorbing losses that far outpace those on less risky investments, and the entrepreneurs who started the companies are wondering how so much cash was spent so quickly.

At the same time, savvy business people are scouring bankruptcy courts for the kernels of innovation, hopeful that a patent snagged at a huge discount may spark the next big thing.

Economist Joseph A. Schumpeter coined a phrase to describe such a cycle: creative destruction. Progress in capitalism occurs, he believed, only through failure and change.

“That's what we're living through right now, and it's not very comfortable,” said Michael D. Granoff, a Worcester native and founder of Pomona Capital of New York, a private-equity fund. “From the ashes, though, I expect to see a whole new set of pretty interesting companies.”

What follows is a look at how the largest investment of venture capital in history -- both nationally and in Central Massachusetts -- has affected those directly involved in the great venture boom at the turn of the century.

It is an accepted principle of the venture capital industry that, out of every 10 companies financed, one or two will succeed, three or four may be sold at a modest profit and the rest will fail.

A study by VentureOne found that 20 percent of the companies that received venture financing during 1999 and 2000 are out of business. That percentage will likely surpass 50 percent by the end of year, according to VentureOne.

Few venture investors like to own up to their failures, however. “It's always been a public secret that the VCs have a lot of money in troubled companies, but they don't want anybody to know about it, because then they can't raise any more money,” said A. Larry Lindsey, managing director of SageGroup Strategies of Northboro, which helps troubled companies find financing and manage turnarounds.

Peter S. Cohan of Marlboro ran a venture capital investment company from 1996 to 2001. Today, he has opted for the more tranquil career of writing and lecturing about investing and technology trends. Like every other venture investor, he has experienced huge successes -- and some failures he'd rather not discuss.

One of his investments, Suppliermarket.com of Waltham, was sold to Ariba Inc. in 2000 for $930 million in stock. Another, Andromedia, an Internet software company, was acquired in December 1999 for $440 million in stock.

“What it boils down to is venture capital investing is very risky, which was something you could forget between 1998 and 2000,” he said. “Now, there is tons of capital down the tubes.”

Such cycles are a necessary evil of capitalism, he said. “If you want nice, steady growth, you can go to Soviet-style, five-year planning,” he said.

Still, Mr. Cohan worries about all the people who lost jobs at venture-funded companies, including some he financed. He also worries about the state's stagnant economy. The current downturn, fueled in part by failed startup technology companies, seems to have no end in sight, he said.

“When you think about the last 20 years in Massachusetts technology, there was always another big thing,” he said. “Now, for the last three years we've been waiting for another big thing, but the latest surveys show that tech spending will be down again this year.”

He is hesitant to assign blame for the fallout from the most recent venture-driven boom.

“Failure still happens even if people are smart and they tried hard,” he said. “Sometimes, they just don't make it. Even if everyone's intentions are pure, you still lose your money. I knew I was taking a risk. That's how our system works. People take risks.”

Mr. Granoff, president and chief executive of Pomona Capital, takes risks every day and has registered returns of more than 20 percent each year since 1994 because of it.

Mr. Granoff's fund, named after the street in the Tatnuck section of Worcester where he grew up, buys stakes in other venture capital funds. When investors in those funds want to liquidate their position -- in other words, pull their money out early -- he buys their stakes at a discount. The investors get an immediate infusion of cash. Pomona gets positions in the venture-funded companies at reduced prices.

“What does it mean when a bubble bursts? Unfortunately, we live in a Darwinian world,” Mr. Granoff said. “The companies that make it have made it through tough times, though, and are likely to become larger, more dominant entities.”

It is a good time to be investing venture capital, Mr. Granoff said. Mindful of the excesses of the past few years, investors are demanding and are receiving better accounting of how venture money is used, and business plans are more detailed. The days of wasting venture money on exorbitant executive salaries and extravagant employee parties are over, he said.

Despite the losses of the past few years, venture capital will never disappear, he said.

“The great part of our system is that people are willing to take a chance on a new idea,” he said. “That's not going to go away.” The investors in such funds appear to support that view. Michael J. Donoghue, chief executive officer of the Worcester Regional Retirement System, said his agency has historically invested between 5 percent and 7 percent of its $270 million in assets in venture funds, and will continue to do so.

“It's been a very good investment in the past,” he said. “Now these are tough times, and those types of funds have gotten hit very hard. It's a high-risk investment; we all know that, but that's also where you create jobs. And, with good managers, the possibilities for a great return are there.”

Clark University invests about 4 percent of its $145 million in assets in venture funds, said James E. Collins, executive vice president and treasurer. One of those funds has registered a 49 percent return over the past decade, he said. Others are too new to begin registering consistent returns, he said.

“We look at these funds as adding further diversity to our base, and we continue to believe that, over a long time period, they should produce better returns than the public markets,” he said.

There is no failure in modern American business. That is the lesson many of the founders of defunct startup companies have learned.

“We do not look at the failed businessman and castrate him and throw him out the door,” said Mr. Lindsey.

“Instead, we say, 'Well, he'll never make that mistake again.' A lot of entrepreneurs make good on the second, third or fourth try.”

M. Vaman Rao hopes that adage is true. As an executive with experience working for pharmaceutical companies in the United States, Britain and India, Mr. Rao saw a need for software to simplify the process of winning federal approval for new drugs.

He launched LifeTecNet of Westboro in 1999 to fill that need, and accepted $20 million from venture investors to support the company. By May 2001, however, Mr. Rao said, companies had stopped investing in new technology.

“It's like Christmas lighting,” he said. “If you don't put it up, you're an odd guy. It was the same way with software -- at first. Everybody wanted it. Then nobody wanted it.”

Fearful of losing all of his investors' money and unable to negotiate an acquisition, Mr. Rao closed the company in late 2001, and sold its technology and patents. The company recouped less than 25 percent of the money invested in it, Mr. Rao said, but “if we had dragged on, it would have been worse.”

Now Mr. Rao is making a second try. Last week, he launched a new company, indiGene Pharmaceuticals Inc. of Westboro. The company is trying to develop drugs from a catalog of Southeast Asian plants Mr. Rao acquired in India.

He has hired some former LifeTecNet employees, and this time, he said, he will accept venture capital only after the company has reached certain milestones.

“I know now, having gone through this, that this is not the right time to talk to venture folks,” he said. “We want to deliver value and grow the company first.”

Steven M. Rothschild of Worcester is also trying to make good on his second try.

Mr. Rothschild was the founder of Furniture.com, one of the first dot-com darlings of the much-heralded New Economy. After receiving more than $50 million in venture capital, the business ran out of cash and ended up in bankruptcy in November 2000.

In April 2002, the Furniture.com domain name was sold to a group of former employees for $1 million. They operate the Web site today as a sales channel for Levitz Furniture Corp. and Seaman Furniture Co. Mr. Rothschild remembered the exhilaration of receiving $3.5 million during Furniture.com's first round of venture funding. “It was exciting,” he said. “If your sport is business, it's like going from the minors to finally hitting the major leagues.”

But he soon discovered, he said, that the “VCs were drinking their own Kool-Aid.” They pushed the company to funnel millions into expensive marketing, telling Mr. Rothschild the money was “rocket fuel -- so burn it,” to make the company as large as possible, he said.

Angry about the direction of the company, Mr. Rothschild scaled back his role at Furniture.com and started bulbs.com of Worcester, an online retailer of light bulbs.

The company has accepted $6 million from venture investors. This time, however, Mr. Rothschild's investors are from Midwestern firms such as Arbor Partners of Ann Arbor, Mich., and are more patient.

“We're funded conservatively and we run judiciously,” he said. “Now we're virtually at break-even, and we're reinvesting in the company. We're doing it the old way, and building a business to make the equity work.” Daniel Bogaty is one of the lost employees. He lost his job as a technical consultant with a venture-funded software company in Framingham in December. Now the 53-year-old Westboro resident finds himself looking for work as his two teenage children begin researching and applying to colleges.

This is not the first time he has worked for a struggling company. Mr. Bogaty worked for Digital Equipment Corp. from 1982 to 1996, leaving as one of 35 former employees who started a digital spin-off at Devens, only to be laid off from that company after 18 months.

Despite that, he remains a supporter of the role of venture capital.

“The idea of venture capital is great,” he said. “That's where ideas are born. Ideally, it allows you to do something free of market pressures. Maybe that's idealistic, but I think it's a valid idea. A lot of good software was bred during the boom.”

He said he is optimistic that he will find another job as good or better than the one he had. He has tried to convey that optimism and resolve to his children, he said.

“Having been through this before and survived it is really important,” he said. “That absolute terror of losing a job isn't there. I've kept my children absolutely in the loop from the beginning, to let them know that we'll get through this and to not make a crisis out of it. I want them to see that this is just another phase of life.”

Mark D. Bermingham joined Celox Networks in October 2000, 10 months after the company's founding. The 35-year-old commuted from his home in Windham, N.H., to Southboro because, he said, “I thought I'd hit gold.” He survived two rounds of layoffs, but could not survive the company's closing in December.

Celox created a telecommunications switch the company claimed was more efficient and less costly than those made by Cisco Systems Inc. and other competitors. But by the time the product was ready for use, telecommunications spending had plummeted.

“Two years earlier, and we would have done very well,” said Mr. Bermingham, who worked in product marketing for Celox. “There was just some very conservative spending and some wariness about dealing with startups. Nobody ever got fired for buying from Cisco.”

He said he would work again for a venture-funded startup company. A former AT&T Corp. employee, Mr. Bermingham said he didn't like the bureaucratic environment of such a large company.

“A lot of the money that came in was irrational exuberance,” he said.

“It's too bad, because now there are some very viable companies that are gone.”

Sharad Joshi is the face of creative destruction.

The Worcester native worked for cancer-treatment firm Alliant Medical Technologies Inc. of Norwood until the company closed in April 2002 after missing a debt payment.

He and a partner acquired the company's technology out of bankruptcy court for $350,000. Today, they are working to restart the company with new financing in Ashland.

“It's probably the fastest way anyone could get in the market,” he said. “The beautiful thing is, all the regulatory approvals and intellectual property became ours, and we're building a whole new company.”

Bankruptcy court has become the place to find new technology, patents and intellectual property at low prices. In 2001, Conversent Communications LLC of Marlboro bought most of the assets of U.S. Data Centers Inc. of Marlboro out of bankruptcy for $400,000. Investors had spent more than $17 million building the company.

The former chief technology officer of cyberMedica Inc., a medical software company in Marlboro, bought its primary product for $15,100 out of bankruptcy court last year. Investors had pumped $12 million into cyberMedica.

EMC Corp. of Hopkinton acquired the storage technology developed by Cereva Networks for $2 million, according to analysts who follow the companies.

More deals are sure to follow. Celox is trying to sell its technology, as is GlobalBA.com, an online chemical sales portal founded by Worcester residents Richard Kennedy and Roger D. Moore. That company, which received $6.75 million from investors, shut down in November 2001 when it could not raise a second round of financing.

“There are definitely technology portfolios out there being peddled, but it's not always easy to realize great value,” said Brian M. Dingman, chairman of the intellectual property group at law firm Mirick O'Connell of Worcester. “It's a lot of work to negotiate a price and identify people who can use it.”

But it is this type of refining of half-developed ideas, the rejuvenation of failed ventures, that pushes the economy forward, said the SageGroup's Mr. Lindsey.

That is the best outcome one can expect from the $500 million spent in Central Massachusetts on companies that no longer exist.

“This type of business cycle has been a basic part of our economy for hundreds of years now,” he said. “It's inevitable that we go through these cycles. And not only is it inevitable, but out of that comes all kinds of good.”