VCs Trapped on Sand Hill Road

SAN FRANCISCO (04/17/2000) - No venture capitalist ever embarks on an investment without planning an exit strategy - a way to cash out with the best possible return. But the Internet stock turmoil, coupled with the growing number of online retailers running low on cash, has blocked the usual exits.

In some cases, the strategy seems to be one hair short of a hasty retreat.

Aside from a few notable exceptions like and Travelocity, consumer Internet stocks are trading in the single digits; many have fallen below their offering prices. Meanwhile, dozens of retail companies sit in VC portfolios while their prospects for initial public offerings dwindle. As the going gets tough, venture capitalists are getting creative. Benchmark Capital, one of Silicon Valley's most powerful and respected venture firms, has held talks with an investment bank about rolling up some of its private e-commerce companies into one big Net retail company, according to two sources familiar with those discussions.

Other options include mergers with the brick-and-mortar companies or smaller mergers of compatible portfolio companies. Benchmark denied talking to bankers. But partner Kevin Harvey concedes that online retailers in its portfolio are rethinking their strategies and that mergers are an option they will need to consider. Still, Benchmark is in a serious quandary - and it's not alone. Two investment bankers who asked to remain anonymous say several VC firms with online-retail investments have knocked on Wall Street's doors seeking advice.

"Every firm that has more than two niche retail plays is considering these moves," says one of the bankers. "We've been in the critical phase in the last three weeks. Things will start to happen in the next month." The pressure to make a deal is growing by the day. Many online retailers that haven't received funding in the past six months are gasping their last breaths. Even retailers that aren't running low on cash are hurting.

EToys - which won praise from the investment community for making many good business moves - fell as low as $5.88 a share last week, down 93 percent from its high of $86. While many online retailers expected some consolidation, few thought it would hit so soon. "The e-retailing shakeout is under way and apt to take place at Internet speed," notes Tom Wyman, an analyst at J.P. Morgan.

Although VCs had hoped their companies would merge after they went public, many now must scramble to merge them at the private stage.

One VC at a national bank says he has money in five dot-com retailers that planned to go public just a few weeks ago; they're now shopping themselves to established retailers. "We're telling them they have no chance of going public, and they are looking for brick-and-mortar partners," he says. And in fact, brick-and-mortar retailers are pressing to merge with Net startups. Last week, Estee Lauder bought, an online cosmetics site that had asked Estee Lauder to be a partner. "They made it clear they didn't want to partner with an independent company, but only wanted to own one," says Joanna Strober, a partner at Bessemer Venture, which invested $4 million in Gloss last year.

"Once they decided that, it made a lot of sense to work with them."

How things have changed since America Online bought Time Warner. "It is very ironic that not long ago people talked about the online companies buying the brick-and-mortar companies," says Brad Garlinghouse, general partner, CMGIAtVentures. "The opposite is now happening." Another big winner in an online-retail fire sale might be Amazon, which can pick and choose from the sectors by making careful acquisitions. "Certainly there's opportunity for Amazon to fill in its product categories," says Henry Blodget, an analyst at Merrill Lynch.

If offline retailers don't come calling, VCs might find it easier to do the consolidating themselves. Sandy Robertson, a veteran investment banker who now manages buyout fund Francisco Partners, says it makes sense that any venture firm pursuing a rollup would first focus on the companies in its own portfolio.

"You take care of your own children first, and then you can always pull others in," says Robertson. It might not be long before the ailing retailers have company. Thanks to Amazon's early entry, retailing was the first big Internet Economy success.

It was also the first to attract a surplus of players - and the first to suffer a shakeout. Other industries soon could follow. Already there are concerns about consolidation in the business-to-business industry. A few weeks ago, the prevailing thinking was that companies would be nurtured this year and merge starting next year. But the recent slaughter of b-to-b stocks has changed that.

"I wouldn't be surprised to see consolidation begin this year," says Harry Wallaesa, president of Safeguard Scientifics, which spawned b-to-b innovator Internet Capital Group. Safeguard last week said that it will no longer invest in b-to-b companies. And if the reckoning in Internet startups worsens, the venture industry could see its own shakeout. "It's been a long time since VCs had a bunch of losers," says Jay Hoag, a partner at Technology Crossover Ventures. "We were batting a thousand. And it couldn't last."

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