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Venture capitalists zero in on security

By Anthony Effinger
Bloomberg News

VICTOR FISHER / BLOOMBERG NEWS Entrepreneur Don Massaro evicted three cars from his garage and used the space to launch his latest startup company, Reconnex.

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Massaro's startup, called Reconnex, makes a $40,000 machine that inspects e-mails flowing from corporate computers. It sends an alert when anything secret — from a soft-drink recipe to a Social Security number — leaves.

Massaro, 60, is among hundreds of entrepreneurs chasing profits in this age of hackers, computer viruses, worms, spam and rogue employees e-mailing away company data.

They're reeling in big-name Silicon Valley venture capitalists that survived the Internet bust and are sniffing out the next big thing.

Kleiner Perkins Caufield & Byers, Accel Partners and U.S. Venture Partners all are plowing money into computer security.

The danger is that too many dollars are chasing too few good startups. The same glut of capital turned the Internet boom into a bubble in the late 1990s.

Massaro says it took just 48 hours to clinch funding from Outlook Ventures, a San Francisco-based company that in 1998 invested in Overture Services, the Web search company Yahoo bought for $1.8 billion in October.

Outlook put $2.2 million into Reconnex in September, five months before Massaro shipped his first box.

Twenty-five hundred miles from Massaro's Silicon Valley garage, venture capitalists were clamoring for a piece of Atlanta- based CipherTrust, a startup that makes computers designed to keep out spam, viruses and computer worms.

Chief Executive Steve Raber says 80 firms offered him funding. Twenty turned up in person with hourlong pitches. In March, CipherTrust chose Battery Ventures, Greylock, U.S. Venture Partners, Noro-Moseley Partners and Silicon Valley Bank. They put up a total of $42 million.

In 2003, venture firms invested $630 million in computer security startups, according to PricewaterhouseCoopers MoneyTree Survey.

Security — which accounted for less than 1 percent of all venture capital spending in 1997 — grabbed 3.5 percent last year.

Out of 18 industries, computer security was one of only four in which venture investment was higher in 2003 than in 1999.

That year the Internet boom became a frenzy, sending the Nasdaq composite index up 86 percent.

The other industries were biotechnology, electronics and instruments, and medical devices.

More than three-quarters of the companies born from 1998 to 2000 by using venture capital never sold shares to the public, nor were they purchased, according to San Francisco-based VentureOne, which tracks the industry. It's unlikely that venture capitalists turned those investments back into cash or got a return.

In 1999, 2,107 U.S. companies landed their first round of venture funding. Of those, 50 have gone public, VentureOne says. An additional 425 have been acquired. Most are still private, and 647, or 31 percent, have failed.

Bob Williams, 49, a partner at Bay Partners in Cupertino, Calif., can name nine startups that compete with Massaro's Reconnex.

Vontu, funded by Benchmark Capital, and Tablus, which got $7 million from Menlo Ventures, are two.

Flameouts are sure to follow, Williams says. "There are a dozen or more companies in some segments of security," he says.

What's different from the Internet bubble is that, this time, venture capitalists are careful about who gets money, says Bruce Hendrix, 43, CEO of ServGate Technologies, a startup that makes computers designed to plug into corporate networks and repel viruses, worms and spam.

"Four years ago, venture capitalists were funding ideas and were less concerned about management teams," Hendrix says. "They've stepped back and said hot ideas are a dime a dozen."

Security is more than just a hot idea. In 2005, corporations will spend $17.5 billion to protect their technology, according to the Gartner research company.

They'll buy firewalls that keep out intruders, software that fends off viruses and computers that kill worms, virus-like bugs that spread without the help of other programs.

That's 23 percent more than the $14.2 billion companies will spend this year, Gartner says.

If the projection pans out, investment banks may prosper, too, after a slump in IPOs by technology companies. Investment bankers handled 82 IPOs in 2003, according to data compiled by Bloomberg, down from 507 in 1999.

Like Massaro, Hendrix at ServGate is a veteran who's back in the game.

In 1995, he founded PaymentNet, which processed payments for online purchases. Five years later, he sold it to VeriSign for $1.1 billion.

With his paycheck and time on his hands, Hendrix spent a year wiring his 11,000-square-foot home near San Diego so that a computer could control the alarm system, music, heat and even pool temperature.

His effort was so extensive he had to hire plasterers from Italy to repair the walls he'd opened up. When his friend Lou Pambianco asked him to run ServGate, he mulled it over for three weeks — and then went for it.

Massaro couldn't sit still, either, after an 18-month stint as CEO of Internet equipment maker ArrayNetworks.

"What am I going to do?" Massaro asks. "Go fishing?"

He helped start disk drive maker Shugart Associates in 1971 when he was 27 and holds a patent on the 5 1/4-inch floppy drive. "Work is only work if you'd rather do something else," he says.

If computer security keeps booming, startups and the venture capitalists that back them may strike it rich.

Or if the boom turns into another bubble, they may wind up like most investors and go home with nothing — until the next big thing comes along.

Copyright © 2004 The Seattle Times Company

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