With Strong Growth, Web Consultants Find Favor Among Venture Capitalists

About the last thing a venture capital firm expects these days is a request to fund a Web-consulting company. But sure enough, one firm recently received three requests. While this firm passed, others are still open to funding these sorts of ventures.

Why would a venture capital firm put money into a sector that's been battered by warnings of weak financial results? Two answers. First, there's still some belief in the sector's long-term prospects and the current environment makes it cheap to invest. Second, venture capital firms still have money they need to put to work.

"Historically, this has been a good growth sector, generating both revenue growth and cash flow," says Thatcher Thompson, an analyst at Merrill Lynch. "The long-term trends suggest there will be considerable IT [information technology] services spending for a long time to come."

As an example, former highflier Scient(SCNT Quote) grew revenue in excess of 400% in its fiscal first quarter ended June 30, while iXL Enterprises (IIXL Quote) grew revenue more than 100% for the second quarter.

Swooping In

At the same time, venture capitalists see a good chance to swoop in and invest when valuations are low, in hopes that the company will go public or be acquired when valuations are much higher. "Private equity takes an interest in sectors when they get hit," Thompson says.

Of course, all this runs counter to what most people would believe. After all, more than a month ago Web consulting firms began having real problems, which was punctuated by Lante's (LNTE Quote) earnings preannouncement last Tuesday of a third-quarter net loss and lower revenue. Computer Horizons (CHRZ Quote) also preannounced that day, while Breakaway Solutions (BWAY Quote) followed suit last Wednesday.

But money has continued to flow into these businesses.

"There's never been as much liquidity in the history of mankind," says Joseph Bartlett, an attorney with Morrison & Foerster, a law firm that works on deals for venture capital firms, and the author of Fundamentals of Venture Capital. "The money has to find a home. It's use it or lose it."

Hitting It Big

In September, privately held Headstrong, a digital strategy consultant, raised $173 million from Welsh Carson Anderson & Stowe and $18 million from H&Q Asia Pacific, a staggering total of $191 million, the sector's largest investment this year. Also, Wheelhouse, a provider of interactive marketing consulting services, raised $52 million in second-round funding from investors including Kleiner Perkins Caulfield & Byers, Integral Capital Partners and Charles River Ventures, for a total of $66 million.

"E-consulting is a good sector because it's trying to help Old Economy companies transform into New Economy companies. It serves a very useful purpose there," says Ta-lin Hsu, H&Q Asia Pacific's chairman.

Even the companies that hoped to go public but withdrew their plans for initial public offerings after massive losses by tech stocks last April and the events of the last month will likely get money, should they need it. Those companies include Zefer (which filed and withdrew twice), Infinite Technology Group, Nexgenix, Fort Point Partners and Inventa Technologies.

Merrill's Thompson points out, however, that this isn't a business that requires a great deal of capital. And the companies themselves say they can last until the public markets turn.

Bill Seibel, Zefer's chairman, president and chief executive, says his company is financially solid, with more than enough money, from private-equity firm GTCR Golden Rauner's May 1999 investment of $100 million, to last until the next attempt at an IPO. Seibel also points out that the company currently employs over 600 billable people (or consultants who bill clients for revenue) and will reach profitability with 700 billable people in the "very, very near future." It will also open offices soon in Atlanta and Munich.

More Optimism

The same optimism exists at Fort Point Partners. "It was our intention from day one to grow a great long-term company, and an IPO is a byproduct of that," says James Roche, co-president and co-chief executive. He adds: "We've grown very rapidly, with 80% sequential growth in the second and third quarters. We did a $30 million mezzanine round in May. We feel pretty good about our financial position right now." He also notes that the company has moved to focus more on long-term clients and global players in its customer base, and that it has put none of its expansion plans on hold. (Fort Point opened offices in Chicago and Munich earlier this year.)

Infinite Technology Group pulled its IPO early last month but also says it's fine without the public money, though it may decide to raise more private money or use a bank loan, says Stanley Wunderlich, chairman of Consulting for Strategic Growth, which advises Infinite on its corporate development. Infinite Technology will test the waters of the public market again sometime around March, after integrating an acquisition and replacing underwriter Auerbach Pollak & Richardson.

Needless to say, the sector's strengths are certainly obscured at the moment, with Scient stock down 90% from its 52-week high, iXL Enterprises down 95%, Viant (VIAN Quote) off 91% and Razorfish (RAZF Quote) off 92%. As of last Wednesday, a dozen companies in the sector had preannounced earnings and/or revenue shortfalls for the third quarter.

Though funding is readily available, companies should be forewarned that some venture capitalists are still exercising discipline. Hsu of H&Q Asia Pacific emphasizes that he invested in Headstrong not only because of the business model but also because he has known its CEO for more than a decade and he was able to invest when valuations were lower. "Relatively speaking, we didn't invest at the peak. We don't buy into hyped valuations," he says.