By Doug Davala - Web Hosting Magazine


The company in question, an outsourced private-label hosting services provider, had already undergone extensive analysis. It had cleared a rigorous screening process, and had been given high marks on a scorecard-like rating system that would help determine its future. If it was to be funded, it had to fall in line strategically with the firm holding the money it needed to survive.

The technology itself had been tested thoroughly - the hosting company had made good on its claims. Now, as the final stage of a due diligence process, its funding rested before the four-man review committee at the head of the investment arm of a large telecommunications company. Those four men would decide whether to pump much-needed capital into a hosting provider looking for a final push toward profitability.

If it came through, the funding would be no small vote of confidence from TELUS Ventures, the potential investors. In a little more than a year since it established a venture fund, it had sifted through more than 400 applications. Four would eventually receive funding. On Jan. 31, a press release would hit the business wire announcing that the private-label host was one of those four.

Hostopia, based in Ft. Lauderdale, Fla., and Toronto, Canada, received a $2 million investment from TELUS Ventures, part of a $5 million financing package.

Defined by its careful progression, its strict guidelines and its ultimate low yield, the transaction is telling of a new era of venture funding. It is one governed by the prudence, caution and hesitation borne out of a period of excess, a two-year roller coaster ride that burned not only the tech industry, but also those who pumped the money into its arm.

"Venture capitalists are much more conscious of putting money into clear, smaller bundles for which certain milestones must be achieved if subsequent rounds are to be even considered," said Kirk Walden, national director of venture capital research for PricewaterhouseCoopers. "Two years ago, it was, 'Here's $50 million to hold you for a year, and come see us later.' Now, it's, 'Here's 15 now, see us in six months and if you hit these certain [goals], we'll talk about 15 more.'"

On Feb. 4, Pricewaterhouse, along with the National Venture Capital Association and Venture Economics, released its latest MoneyTree survey, which takes the pulse of the venture capital community. The survey showed a spike in the amount of venture capital invested between the third and fourth quarters of 2001, the first such quarterly increase since the tech industry fallout. But while the numbers may bode well for a rebounding economy, analysts say web hosting's black eye may be slower to heal in the minds of investment firms. Hostopia, and the handful of companies like it, may still be the exception to the rule.

TELUS is a Canadian telecommunications company that, after a year of corporate reinventing, is focused primarily on the wireless and IP market segments. One of the largest telco players in Canada, its stated revenue in 2001 was approximately $7.2 billion, and it is targeting $7.5 billion in 2002. Mark Schnarr, executive vice president of TELUS ventures and one of the four-man investment review committee, explained the give-and-take relationship between the parent company and the companies it funds.

"We have a mandate within TELUS to focus on investments that are consistent with our strategic intent," he said. "We're honing in on investments in the IP and wireless space where we know that we can fill a capability gap within TELUS, and where we can add value to the investment.

"We had one of our business units here targeted at the [small and medium enterprise] marketplace in Canada, and they were looking for a web hosting solution that would fit, was simple and automated, and allowed us to make some money. At the end of the day, [Hostopia] fit all the criteria. It lined up with our capability gap, and we could add value with our significant distribution channel."

At Hostopia, the money couldn't have come at a better time. The company, which claims more than 200 web hosts as customers, announced it will eliminate its debts, achieve positive cash flow from operations in FY 2002 and continue its growth. And, of no less importance, Hostopia gets a solid public vote of confidence at a time when the web hosting industry has been severely burned.

"In this climate of restricted access to capital for most of the technology sector," said Hostopia president Franc Nemanic, "this funding - and especially the significant participation by TELUS - validates our performance to date.

"The extensive due diligence carried out by TELUS Ventures ... lends credence to our business plan that calls for significant growth in the coming years."

The Beginning of the End?

Many within the venture capital market are cautiously optimistic about the findings of the most recent MoneyTree survey. In the fourth quarter of 2001, according to the survey, VCs closed 856 deals for $7.1 billion, up from 810 deals for $7.0 billion during the third quarter of that year. Though an increase of just 2 percent, the upswing broke a string of five quarters of decline, beginning after VC funding peaked during the second quarter of 2000. That quarter, companies swallowed up an astounding $26.3 billion in VC funding.

Pricewaterhouse, Venture Economics and the NVCA don't track web hosting as a separate industry in their survey. Instead, the ISP sector stretches across the figures for both the telecommunications and e-commerce divisions, which in the eyes of VCs are hardly at the top of the list for funding.

"This segment has gotten punished," said Walden. "We had a significant decrease from the year 2000 to 2001. Now we've seen investments stabilize, but the drop between 2000 and 2001 for this segment was much more severe [than others]. It fell off a cliff."

The residual skepticism of hosting-related offerings among venture capitalists, said Walden, means the industry is likely to continue to suffer despite the overall pickup in funding.

"Part of it is a misconception, to be fair," he said. "When you say the word 'Web,' you just say that and the media picture that is conjured up is of the e-tailer. That's not what the Web is all about, but it's painted with that brush, so anybody with a startup dependent upon the Web automatically has a hurdle twice as high as anyone else."

In 2000, the e-commerce segment broken out in the MoneyTree survey - which includes e-commerce content and services - received $6.8 billion. In 2001, that total dropped to $1.7 billion. The telecom sector peaked at $17.9 billion in 2000. That market segment was hit with one the biggest drop-offs, falling 67 percent to $5.9 billion in 2001. Telecommunications fell 76 percent from the fourth quarter of 2000 to the fourth quarter of 2001, from $4.1 billion to $982 million; e-commerce dropped off 90 percent, from $1 billion to $182 million.

The biotechnology and software sectors are the driving force behind the recent upswing in VC funding. During the last three months of 2001, venture capitalists invested $1 billion in biotech firms, bringing the 2001 total to $3 billion. The software sector led the 2001 totals with $6.9 billion invested.

But despite the VC aversion to the Internet, software companies looking for funding had better deal in Web technology.

"Venture capital has always been a big investor in enabling technology," said John Taylor, NVCA vice president of research. "During 1999 and 2000, the industry invested in some of the end users of some of the products [venture capitalists] historically invested in, and this was new territory for the industry. ... Now we're seeing a shift back to traditional enabling technology, software, hardware and enabling services."

"Remember that there's still a lot of money in areas such as communications, but it's in the software that enables those communications," Taylor continued. "It's about better data compression and security ... and not necessarily laying in the networks themselves. ... The software companies offer technologies that can be commercialized and made available to broad markets, or technologies that can be sold to whoever the prevailing provider happens to be, and that's different than betting on one particular provider."

Said Walden: "[Software] is the ideal industry to ramp up once you get it done. Production costs virtually zero. Contrast that to a telecom or networking play where you've got to put a bunch of servers in place and spend a bunch of money [at the outset]."

In 2000, the total amount of VC money invested was $99.6 billion, nearly doubling the dizzying total of 1999, when $52.4 billion was injected into startup firms. But even with the sharp drop-off after the tech sector flameout, the $36.5 billion in VC money invested in 2001 still left it the third busiest year in VC history. That, say analysts, is worth keeping in mind when talking about the shaken VC market.

"You take '99 and 2000 out, and not only is the venture capital industry doing well, but it's doing better than it has ever done," said Walden. "One really good thing came out of the boom-and-bust spike, and that's that venture capital as a financing vehicle is now much more widely understood and respected than it ever was before 1998."

A Painstaking Process

If Hostopia's funding is the exception to the rule, the amount of due diligence that was involved in the funding process is not.

At TELUS Ventures, Schnarr said high growth potential is a must, as is the ability to scale into the North American marketplace. As a general rule, he said, a business must demonstrate the potential to generate $100 million in revenue in three to five years. A strong management team is also a must, he said.

Promod Haque is a general partner at Norwest Venture Partners, which focuses on enterprise software and communication technologies and has several service providers in its portfolio. Norwest has invested in Rackspace and was an early investor in Verio, but those companies are the only two pure-play web hosts to be funded. Current investments include Yipes Communications, Inkra Networks, Zettacom and Winphoria Networks. If a service provider cannot differentiate itself, said Haque, Norwest is not interested. Across multiple funds, the venture firm has total capital in excess of $1.5 billion.

"We're looking at those that are building next-generation services and deploying next-generation networks," said Haque. Providers of innovative data services, gigabit Ethernet, and advanced hosting and VPN services are much more attractive, he said, than service providers offering services easily replicated by telecommunications companies.

"There are tons of people who do simplified web hosting," Haque said.

Taylor points to two indicators that show a company is worthy of receiving funding: actual earnings and potential upside. "The two watch words are 'real profits' and 'dramatic growth,'" he said.

"A company can go public on earnings, but it cannot on market share," said Taylor. "That's one of the strongest lessons learned over the past few quarters. And the upside has to be dramatic. A company that is looking to grow at a 10 to 20 percent rate is probably not a candidate for venture capital. A venture capitalist has to invest knowing that even if most of the companies that the venture fund invests in are not successful, those that are [will be] successful enough to pay an overall good return back to investors."

Walden says investors he deals with use another set of criteria in determining a company's value: percentage of market share and the size of the market. While exceptions to the rule abound, companies generally need to show a 5 percent market share in a market in the half-billion-dollar range.

These sets of guidelines - along with the strategies in use by venture firms such as Norwest Venture Partners - leave SME and other low-margin hosting providers in an unfortunate catch-22. In order to attain the all-important market share, large up-front investments are necessary, and in the wake of high-profile flameouts by the likes of Exodus and PSINet, those aren't likely to take place. Meantime, the mid-size host with a sound business plan and a solid revenue stream doesn't have the potential market share needed to attract venture capital.

"If you're profitable," said Walden, "and in fact, if you have a very solid revenue stream and you're not losing very much money, then is venture capital the best financing available to you? There are other ways, from private equity and placement to partnerships and customer relationships."

He compares the hype of the Internet to that which surrounded the personal computer industry in the mid '90s. Then, the question was whether PC sales could continue at their staggering rate, but the question became irrelevant as the market changed and it became saturated. And certainly, the days of the hot startup PC manufacturer are long gone, and venture capitalists have moved on.

"The same thing will be true for the Web, and therefore web hosting," Walden said. "We will find that as it becomes easier, cheaper and more accessible, the middle market will have it by default, like a Yellow Pages ad. That's a big market.

"The Yellow Pages are not very glamorous, but drilling for oil is not very glamorous, either."