CurrentOfferings.com Story:

Venture well: Conspicuous absence

By Brenon Daly, The Deal, April 23, 2004

The Salesforce.com IPO is set to get off the ground in the next few weeks. But don't expect champagne to flow along Sand Hill Road: None of the investors in the hot software company reside on the venture world's Main Street.

In fact, most of the proceeds from the IPO will go to the executives and directors at the company, with chief executive Marc Benioff holding a 32% stake. (Terms haven't been set for the offering, but one source indicated the San Francisco company could be valued at $750 million to $1 billion.)

Salesforce.com isn't as unusual as you might think. The IPO window that has opened up this spring is allowing a number of software companies to go public. But of six in the pipeline now, only half have venture backers.

Instead, there are some rather unexpected names in the "principal stockholders" section in the prospectuses. For instance, San Francisco buyout firm Hellman & Friedman Capital Partners owns almost 70% percent of Blackbaud Inc., which sells software to nonprofit groups and signed its S-1 on Feb. 20.

Similarly, Carlyle Group is a significant owner of Blackboard Inc., an educational software developer that filed to go public in early March. The publicly-traded Internet Capital Group also owns a significant piece of Blackboard.

Of course, it's harder these days to make the transition from a VC portfolio to the public market. Investors are skeptical, and there are additional expenses and scrutiny in a Sarbanes-Oxley era. Startups get gobbled up by an established company more often than they go public. VentureOne reports that 34 venture-backed software companies were acquired in the first quarter alone.

Still, it looks like VCs missed the boat in this sector.

"The funding market dried up," says Tom Taulli, co-founder of CurrentOfferings.com, a Web site covering IPOs. "VCs went into a cave and hunkered down ... so entrepreneurs had to get more creative about funding [and] bootstrap as best they can."

VCs were forced to nurse their existing companies rather than take on new startups. But there was also a shift in the type of software companies that were looking for funding, as more and more of the startups rented their products on a monthly contract instead of selling them outright in a one-off license deal. The companies now in the IPO pipeline live primarily on monthly subscriptions.

"It's not a traditional business for investors to understand," says Dan Starr, head of marketing at Boston-based Salesnet Inc., a rival company to Salesforce.com in renting software that helps manage customer relationships. (Salesnet, which has raised more than $30 million from WestAM, Phoenix Investment Partners and Prism Venture Partners, declines to say if his company has IPO plans, noting only that it is "watching with anticipation" the Salesforce.com IPO.)

And much of the capital invested in such companies goes to selling and marketing the services rather than traditional product development, Starr adds.

But one software industry veteran says the venture community just missed the boat because VCs tend to rush into the same sectors as their competitors.

"There's a herd mentality among VCs," says Dennis Berman, head of corporate development at Kintera, another maker of software for nonprofit organization. "They are comfortable investing in follow-on companies in established categories, rather than innovative companies," says Berman, who has worked with a handful of other startups after spending 13 years as a lawyer at a New York venture firm.

"That may be because of the risk-aversion on the part of the LPs, but may also be because of the modest amount of due diligence" that's required in me-too investing, he says. Kintera was funded inside and went public in mid-December. The stock has more than doubled since the offering, and has the highest return of any IPO in the past 12 months, according to Renaissance Capital's IPOHome.com site.

Down the road, Berman predicts, more entrepreneurs with fat Rolodexes and solid CVs will want to maintain control of their ideas through self-funding. "The venture community may see [riskier] deals with less-seasoned management teams," he says.

There are drawbacks to relying on a close circle of non professional investors, however. In the case of Salesforce.com, the San Francisco Chronicle recently reported that the Securities and Exchange Commission is requiring the company to change its accounting methods before the offering can go ahead. A Salesforce.com representative declines to confirm or deny the report.

"If you fund your own company, there's not the accountability and rigor to the process" that you find where there are more professional backers, says Salesnet's Starr. "We're comfortable with somebody looking over our shoulder."

Still, Salesforce.com is expected to file an amended S-1 shortly with the changes in how it counts sales commissions, get out on its road show and start trading before Wall Street heads off on its summer break. Only at that point will VCs get their chance to invest in the company.