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Rumors of Benchmark's Demise Greatly Exaggerated

For weeks, rumors have been circulating in the VC community that Benchmark Capital's third fund, Benchmark III, was in trouble, hit hard by losses in e-commerce companies like 1-800-Flowers.com.

Benchmark denies the rumors, and its limited partners say they never received the rumored letter that the fund was in trouble. An analysis of Benchmark's portfolio appears to back up the firm, which despite the rumors, may not just be surviving, but thriving.

Benchmark declined to discuss details, but the firm's holdings as of June 30 were provided by Steve Lisson, the editor of InsiderVC.com, who tracks the performance of leading venture firms for high-paying clients.

At first glance, Benchmark III had its share of overvalued B2C e-commerce firms like 1-800-Flowers.com (Nasdaq:FLWS) and Living.com. 1-800-Flowers.com was the fund's biggest investment, at $18.9 million, and had been marked down to $8.1 million on June 30. The stock price has declined about 30% since then. "There are many private scenarios just like this public one, whereby even if the company can be kept afloat long enough to enjoy some success and eventually make it to a liquidity event, the venture investors will lose money," Lisson said.

But a closer look at Benchmark III reveals a fund with several potential winners, including Internet Data Exchange System company CoreExpress, an intelligent optical networking play. That investment alone could return limited partners' money. Other potential winners include Sigma Networks, Keen.com, Netigy and BridgeSpan.

And Benchmark's newest fund, Benchmark IV, is already showing the markings of a winner, thanks to investments in Loudcloud, Netscape co-founder Marc Andreessen's latest venture, and TellMe Networks, whose valuation no doubt went up in its recent $125 million funding round.

Lisson said the Benchmark rumors reflect a misunderstanding of how venture funds operate. "There's a reason these are 10-year funds," he said. "It's called risk and illiquidity. The one monster hit could happen three, four or five years out. You can be wrong about 39 of 40 companies, and the market uncooperative, as long as one is an Inktomi. That is the history of this industry: one monster hit returning the entire fund. Singles and doubles won't get you there."

At two years of age, Benchmark III still has plenty of time to deliver a big winner. In the meantime, the firm's limited partners can enjoy the returns from Benchmark II, a three-year-old fund that has already distributed five times its partners capital, by Lisson's estimate. Benchmark II boasted big winners like Handspring (Nasdaq:HAND), Critical Path (Nasdaq:CPTH), Red Hat (Nasdaq:RHAT), and Scient (Nasdaq:SCNT). Yes, Scient. Benchmark had the foresight to distribute shares of the Internet consultant to its limited partners at 200-300 times the firm's cost.

Benchmark isn't any different from other venture firms, most of whom "drank the Kool-aid" of seemingly easy dot-com money, hoping the stock market would hold up long enough to vindicate those investments. But Lisson expects that some other firms won't hold up as well. He expects a shakeout in the industry similar to the one that hit the industry from 1987-1991, when venture firms formed during the 1980s averaged single-digit returns, and roughly 20% of new entrants couldn't return their partners' capital. VCs' own fundraising declined from $4.2 billion in 1987 to $1.3 billion in 1991. The $4 billion level of capital coming into the industry wasn't reached again until 1995.

"This is what's supposed to happen in a downturn," Lisson said. "People who shouldn't be in the business, who contributed to the excesses and didn't know what they were doing, will be forced out. It's not like this is the first time we've seen too many new entrants into the industry, or too much money chasing too few deals." And the ones that survive will have a chance to prove themselves in tough times, the ultimate mark of a winner.

Lisson said a few venture firms stand out among their peers. Matrix Partners, Kleiner Perkins Caufield & Byers and Sequoia can normally be found at the top of the charts in each vintage year they raise a fund, he said, proving that "something's in the water" at those firms. And he gives Oak high marks for consistency over a long period of time.

But even top firms have an occasional weak fund, Lisson said. "But by the time you can make that judgment about a fund, you'll have raised another fund and shown some early progress," he said. Meaning that even if Benchmark III was a weak fund, Benchmark IV could keep the firm in its limited partners' good graces for some time to come.

"The moral is consistent performance over time relative to same vintage-year peers," Lisson said. "You're never as good or as bad as your current press clippings might indicate. The real test of Benchmark's mettle will come when we can fairly evaluate whether the firm manages through and makes money, not just with small funds during the best times in the industry's history, but with larger funds in the tough times ahead as well."

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