Venture Capital: Cautious VCs again looking at incubation

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Venture Capital: Cautious VCs again looking at incubation

Friday, June 14, 2002

By JOHN COOK
SEATTLE POST-INTELLIGENCER REPORTER

With entrepreneurial activity at a standstill, venture capitalists are falling back on an old practice: incubating companies.

Arch Venture Partners currently has two early-stage biotechnology companies in the oven. Frazier & Co. is putting together the pieces of an early-stage health care concept. Ignition, the Bellevue venture capital firm that raised $285 million in December, is devoting significant resources to early-stage companies that were created, in part, by its directors. And Seattle-based Second Avenue Partners is giving it a whirl, incubating a new concept founded by managing partners Nick Hanauer and Mike Slade called The World's Smallest Software Company.

Incubation -- cultivating companies and entrepreneurs at the earliest stages -- has been an important part of the venture capital process in the past, leading to the formation of powerhouses such as Genentech. But the concept got a bad rap in recent years as high-profile incubators such as CMGi, Idealab and iStart Ventures collapsed.

Now venture capitalists -- flush with money, time and thick Rolodexes -- are once again embracing the incubation model (though most avoid the word like the Black Plague). The do-it-yourself credo has been sparked by a few factors, slacking deal flow, an abundance of talent and gun-shy venture partners who would rather take a risk on something or someone they intimately know.

"We aren't funding as many things that are just coming across the desk," admits Robert Nelsen, managing director at Arch Venture Partners in Seattle. "Of the number of deals we do, a greater percentage of them we are baking ourselves."

In the early days at Arch, about 60 percent to 70 percent of deals fell in the incubation category, Nelsen said.

But during the Internet boom of the late '90s, that percentage decreased as Arch followed the path of other venture capital firms and raced to fund start-ups with built-in management teams and completed business plans. Those companies, in many cases, consumed huge amounts of capital. But they required less work and time than a home-grown idea.

Now, Nelsen said, his firm is hanging out with scientists and researchers in hopes of constructing companies from the ground up.

"This is not easy," said Nelsen, whose firm works closely with research institutions such as the University of Washington. "It is a hell of a lot harder to bake one by yourself than to fund some guy coming in with a business plan."

Ignition says it doesn't incubate companies, although the firm has played such a key role in the early phases of several recent start-ups (sometimes recruiting the entrepreneurs, identifying the market or providing office space) that it's hard to find another term for it.

Four of Ignition's most recent investments, none of which have been publicly announced, were made in teams or individuals before an actual company was formed. At least one of the seedling companies is housed at Ignition.

John Zagula, a principal in the 2-year-old firm, describes the strategy this way:

"We will identify a problem area that is of real interest to us and then match the problem area with an entrepreneur," he said. "The entrepreneurs are still the one who comes up with the idea for a business. That is really our modus operandi."

No matter how it is framed, Zagula admits that the firm is trying to put its stamp on early-stage opportunities by building successful companies through relationships with talented researchers and engineers. It is not a reaction to the down market so much as a strategy the young firm -- heavy with former executives from Microsoft and McCaw Cellular -- has employed since the beginning, he said.

"We invest in all stages," Zagula said. "We invest in fully formed companies, we invest in teams who want to become a company, and we will have entrepreneurs in residence who target a space. And we find that to be an exciting thing. Has that been a major shift? For us, I wouldn't say so."

Alan Frazier has long employed the incubation strategy at his firm, housing companies such as Calypso Medical Technology, XenoPort Inc., Hynomics Corp. and most recently an unnamed health care start-up.

But Frazier, managing director of the Seattle firm, is not entirely convinced that venture capitalists are jumping on incubation because of slower deal flow.

In fact, he argues that because valuations on later stage deals have fallen dramatically in the past 24 months, some investors may not want to bother with the nitty-gritty company-building process.

"Frankly, it is a discussion we often have around here, but we are convinced all the time that you have to create a culture and create deal flow that is based on classic venture capital, which is starting great companies," he said.

Nick Hanauer, who created The World's Smallest Software Company last year and plans to raise about $400,000 this month, does think the changing economic conditions are playing a part in the rebirth of the incubation strategy.

"You couldn't have cooked up something yourself 36 months ago because you couldn't attract people and during the frenzy people didn't have time to think about this stuff," Hanauer said.

In fact, the name of Hanauer's new company flies in the face of the Get Big Fast mentality of three years ago.

"We started this because we believed that we could turn great ideas into great products without creating a massive amount of infrastructure," said Hanauer, whose new start-up employs three contractors and is in the venture firm's downtown office. "We wanted to create a company that was super small and super nimble."

With a 25 percent stake in the new venture, Hanauer also said he stands to make a lot of money if the company is successfully sold.

It is tough to quantify how many venture capital firms are trying to put the incubation strategy into practice. However, venture capitalists -- many of whom are waiting for the initial public offering market to rebound -- did show a greater appetite for early stage investing in the first quarter. Early stage investments accounted for 26 percent of all deals, compared with 23 percent in the prior quarter.

John Taylor, vice president of research at the National Venture Capital Association, doesn't keep track of incubated deals. But he said several large West Coast firms are employing "entrepreneur in residence" programs to attack emerging technology opportunities. Locally, Atlas Venture, Frazier, Mohr Davidow Ventures and Voyager Capital are working with selected entrepreneurs.

"We are trying to identify an entry point into some markets we think are interesting," explains Atlas Ventures' Bill Bryant, whose firm is working with three different teams in Seattle.

Dan Rosen, who oversees technology investments at Frazier, also is talking through ideas with local entrepreneurs. While Rosen said Frazier's approach differs from the failed incubators of the past, he admits the strategy can be full of potholes.

"If you are not set up to do this from the beginning, it is really hard to transition to it," Rosen said. "You need a certain level of people with operational skills and a desire to put your shoulder to the wheel."

P-I reporter John Cook can be reached at 206-448-8075 or johncook@seattlepi.com. For more information on Seattle-area start-ups or venture capital firms, visit www.seattlepi.com/venture.

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