InformationWeek

August 14, 2000

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Vendors As VCs: Money And Influence

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More on venture capital:

sidebar: Vendors Partner With Venture Capitalists To Fund Startups

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Computer Reseller News Catching The VC Wave (6/26/00)

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Often, investments are tied to a startup's use of a vendor's products, in hopes that a series of orchestrated investments can capture a share of an emerging market. For example, Microsoft in February invested $12 million in FirstWorld Communications Inc.; in return, the data-center operator is developing a platform for hosted application services based on Microsoft server software. Sun Microsystems' $20 million investment in Digital Island Inc. last year included an agreement that the Web-hosting company purchase as many as 5,000 of Sun's servers and other products worth $150 million. "We're interested in fueling innovation and winning platform affinity," says Jonathan Schwartz, VP for corporate strategy at Sun, which claims about 30 companies in its portfolio and this spring doubled the capital it has earmarked for investments to $400 million.

Hewlett-Packard in the last year has invested about $1 billion in more than 50 companies through a "venture debt" program--HP loans companies equipment with the option of converting the loan into equity at a relatively low set price. "We want to get people started on HP equipment up front," VP of finance Craig White says. The company this year also unveiled its Garage program, providing equity investments averaging about $750,000 to very young startups. IBM appears largely absent from the venture-capital scene. But IBM Global Financing VP Bill Doscas says the company is taking small stakes of $1.5 million to $5 million in technology startups, often tied to leasing IBM equipment and software.

Some analysts question the value of those technology trade-off deals, or whether venture-capital investments can really influence technology. "I'm a real skeptic that putting $5 million into a bunch of companies can shape the direction of an industry," says Dintersmith of Charles River Ventures. In fact, he says, some of the most successful startups, including Akamai Technologies, Ariba, Bowstreet, and Vignette, have sought to protect themselves from undue influence by resisting corporate venture capital until after the first round of financing, when products have matured, management teams have gelled, and business plans have been clarified.

Jeffrey Nolan, a partner at SAP Ventures, which holds stakes in companies such as Extricity, Neoforma, and Red Hat, as well as other smaller companies, says he "sets expectations pretty low" for portfolio companies hoping for a technology deal with SAP. Oracle this year experimented with "software-for-equity" arrangements in which the vendor exchanged its products for a stake in small companies. "It's not a program we're going to push," says Mosman, who declined to name the companies involved. "It's something we're going to do less of, not more."

Microsoft, which during its last fiscal year completed 95 investments or acquisitions totalling $5.37 billion, says its investment strategy aims to achieve business goals first, financial returns second. "If an investment in a company can support and benefit our customers and partners as well as provide market traction for Microsoft's products, we consider it a successful venture," says Amar Nehru, VP of corporate development. In other words, the company won't let pure return on investment get in the way of entering new markets and spreading Windows.

Microsoft's investments fall into four categories, according to Nehru: generating demand for Windows 2000, enterprise servers, streaming-media technology, and development tools; supporting systems integrators and E-services companies; delivering software through electronic distribution channels; and funding emerging technologies, such as PC and console games. While Microsoft occasionally acquires companies to supplement its product line or gain development talent, most of the time it's using the $23.79 billion in cash it reported on hand June 30 to buy stakes in networking, cable, telecommunications, and application services companies, and to build its service-delivery capability.

"These deals aren't revenue generators," says Aaron Scott, an analyst who covers Microsoft at investment bank Advest Inc. "They help Microsoft get its products to the next level" by adding wireless and broadband capabilities to its platform. "As PC growth slows, you need something to generate Microsoft revenue growth down the road," Scott says.

In a presentation to financial analysts last month, Microsoft CFO John Connors said 42% of the company's investment transactions fall into the category of enterprise software and services. For instance, Microsoft this spring kicked $385 million into its $1 billion Avanade joint venture with Andersen Consulting to deliver systems integration services to large companies, though the venture is expected to lose money for at least the next year.

A $300 million investment in Qwest Communications International Inc. in late 1998 helped Microsoft begin to craft a licensing and pricing strategy for the application service provider market. On Aug. 1 Microsoft rolled out new licensing terms that let service providers pay for Microsoft apps and platform software based on the number of users who log on each month. Investments in ASP Corio Inc. and data-center host Digex Inc. are yielding software development work aimed at incorporating IP billing services into future versions of Windows, Microsoft said earlier this year.

"For us, the key to the future is our work with the communications industry," says Jonathan Usher, a group manager of service-provider marketing at Microsoft. "One of the key evolutions that's happening at Microsoft is when products are created, the question that's asked is, 'How is this relevant to the service providers we work with?'"

It's an important question, as virtually every effort at the company converges around its Microsoft.Net initiatives for supporting software delivered as an online service and coded with the increasingly popular XML. In November, Microsoft took a $5 million stake in Data Return Corp., a Dallas company that manages servers, networking equipment, and platform software for customers such as RadioShack.com, Texas Instruments, and Intimate Brands' Victoria's Secret. Microsoft has rights to invest an additional $3.7 million in Data Return, which is also backed by Compaq and Level 3 Communications.

David George, Data Return's director of business development, says his company's experience deploying Web apps on Windows and BackOffice helps Microsoft understand how to adjust its products for the ASP market. "Our engineers see things hundreds of times a week that IT departments might see only a few times," says George, a former Internet business development manager at Microsoft. In return, Microsoft's field sales force names Data Return, along with competitors Digex and Exodus Communications Inc., as options for customers. And Data Return gets early access to upcoming Microsoft products.

One dot-com operating on Microsoft Windows that's hired Data Return to manage its infrastructure says the company can act as a conduit to Microsoft. "It's really hard for a company of our size to keep on top of all the changes" in Microsoft's products, says John Basso, chief technology officer at PlanetOutdoors.com, a 70-person online retailer of outdoor gear in Boulder, Colo.

The corporate venture market shows few signs of slowing. A downturn in tech stocks this spring put a damper on initial public offerings, but investment dollars continue to pile up. "The only thing likely to slow is the rate of growth," says Kirk Walden, national director of venture-capital research at PricewaterhouseCoopers. As the pool of venture capital increases, it may be hard for venture capitalists to sustain the 35% to 45% rates of return they've delivered during the past three years, he says.

That may be why vendors warn of putting too much store in their investment portfolios. "We'll forever deliver better returns to investors with our stock than with the fund," says Sun's Schwartz. Still, done right, the venture-capital business promises tech vendors access to new development work, new customers for their products, and an attractive boost to profits. An investment, says SAP's Nolan, is "a bet on what's going to happen, but one we're going to make happen as much as watch happen."