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State-Run Venture Fund Succeeds With Native Firms

By Terence O'Hara
Monday, October 24, 2005

When Sourcefire I nc. , a systems security software company, sold this month for $225 million in cash, some of the biggest names in venture capital chalked up a major payday. Four VC firms, including local shops New Enterprise Associates and Core Capital Partners , collected about six times their $34 million investment in the Columbia-based firm since 2001.

But perhaps the people most responsible for getting Sourcefire off the ground were a few mid-level state employees in Baltimore who run one of the most successful early-stage venture funds in the region, the Maryland Venture Fund . Their investment of $550,000 of public money in Sourcefire in 2001 -- when Sourcefire founder Martin Roesch was developing the software in his Carroll County basement -- netted $3.9 million when the company was sold.

The Maryland Venture Fund was started in 1994 and is a leader among state-run funds. About 35 other states have venture funds of some kind, but none is as large as Maryland's. Most, including funds in the tech centers of California and Massachusetts, offer much smaller equity investments, focusing on technology transfer from research institutions.

MVF is run by six employees of the Maryland Department of Business and Economic Development. It has invested $48 million in more than 100 companies, in traditional venture-equity investments and in seed financing for basement-and-garage technologists with good ideas. It has returned $59 million in cash from more than a dozen exits and has an active portfolio of about 50 venture investments in the biotech and information technology industries. It last reported the market value of its venture investments, in June 2004, at $20.6 million.

In its 10 years, MVF has an annual internal rate of return of close to 30 percent, officials at the fund said. The benchmark annual average for the venture fund industry is 20 to 25 percent.

Like any venture fund, MVF's returns are largely attributable to a relatively few big payoffs. The fund cleared more than $16 million in profit from the sale of Gene Logic Inc . in 2000, and more than $27 million from the initial public offering of Visual Networks Inc . in 1999.

From 2000 to 2004, the fund had no big-money exits. Five exits since 2000 lost money, and two of those were nearly total losses.

But since June 2004, the fund has had four exits that have returned three times each investment or better. In addition to Sourcefire, MVF cleared $2.4 million from a $600,000 investment in Platform Logic Inc. when that company was sold to Symantec in December 2004. It tripled its $500,000 investment in Baltimore's Advertising.com Inc. when it was sold to America Online for $435 million in June 2004. And Panacos Pharmaceuticals Inc. , a Montgomery County developer of antiviral drugs, several months ago returned $1.85 million on a $500,000 investment when it merged with a publicly traded Massachusetts company.

In the past 18 months $11 million has been returned to the fund through "liquidity events," such as a sale of a company or an IPO.

"We're on a path to be self-funding," said Christopher C. Foster , deputy director of the Department of Business and Economic Development, who oversees the fund. MVF gets an annual appropriation from the Maryland General Assembly to cover operating expenses and expected investments, but Foster wants new investments to be funded entirely by returns on old ones. With the returns so far this year and those Foster expects next year, the annual appropriation has dropped significantly. Last year, Foster asked for $7.5 million, and he got it. This year, the fund will get $2 million, and Foster expects to request only $1 million next year.

Foster also has removed the informal (and sometimes exceeded) $500,000 cap on investment in one company. He said the cap limited the fund's ability to participate in later venture funding rounds. Most venture-funding companies go through at least two rounds of funding, and some as many as six. In industry parlance, unless early investors "re-up" and invest in later rounds of funding, their equity stake in the company is diminished, as is any final return.

Elizabeth Good , who became managing director of the fund in 2004, said one of MVF's biggest investments is $775,000 in Frederick-based Qovia Inc. , a company that provides monitoring of networks for Internet phone calls. In addition to lending Qovia its seed money in 2002, MVF has participated in both rounds of Qovia's VC funding, which totaled $16 million.

Foster and Good said that despite MVF's desire to participate in later funding rounds, its primary goal is to be an early-stage investor, in many cases providing the money entrepreneurs need to get off the ground. MVF's investment is always passive. It never takes seats on company boards and its VC investments are always relatively small parts of equity financing deals. For every $1 invested by MVF, the goal is that at least $3 be invested by private VC funds.

"We know the places where we want to play," Foster said. "Our goal is to fill the gap between what an entrepreneur has going early on and when he can get actual VC funding."

"The goal of it is of course economic development," said Donald J. Rainey , a partner at venture firm Intersouth Partners , who sits on MVF's advisory board. "In this case it makes money for the public cash register." Actually, the fund usually reinvests its returns in new companies. Only twice, in the big payouts from Visual Networks and Gene Logic, has the fund returned money to Maryland's general fund.

Like any state-run economic development tool, there's always the potential for political interference, Foster said. Imagine a state legislator or agency head whose cousin or a political supporter is starting a high-tech firm.

"Sure, we get those kinds of calls. Somebody who knows somebody, that sort of thing." Foster said. "But I take them, not my staff, and as a courtesy only. The decent thing is to tell them no and tell them why."

Nor does the fund parcel out its money by region or legislative district, Foster said. "The only way for this thing to work is to do investments based on the technology and the profit potential. . . . I've told the people I've hired that if they ever make an investment based on demographicreasons, they're fired."

Good said that one reason the fund may avoid political interference is its relatively small size. If it had more money to invest it could take bigger stakes in companies. It also could hire more people (who are, by the way, paid state salaries; no VC-style bonuses are handed out). "But, theoretically speaking, if we got more money from Annapolis, they would probably want us to spread the wealth around a little."

Investor Sues Telos

Telos Corp ., an Ashburn-based defense technology contractor, was sued last week by an investor -- a New York hedge fund -- that claims the company's directors are frittering away money on million-dollar-plus executive pay packages and expensive consulting deals.

The plaintiff, Costa Brava Partnership III , is managed by Roark, Rearden & Hamot LLC , which often invests in the debt and equity of companies with troubled capital structures. Telos -- which is operationally profitable and has won some lucrative defense contracts in recent years -- went through a leveraged buyout in 1989 that saddled it with debt and debtlike publicly traded preferred stock.

The dividends on that preferred stock have been deferred since 1995, and now total close to $70 million. Under the terms of the preferred stock, Telos is required to begin redeeming it and paying the deferred dividends late this month. But Telos's charter prohibits it from paying dividends on the preferred stock while it has a negative net worth, and Telos has said its current deficit means it won't be able to begin redeeming the preferred stock.

Costa Brava began buying the preferred stock this year at a steep discount to its face value, and now owns more than 16 percent of it. In its lawsuit, it asked a Baltimore City Circuit Court -- Telos is incorporated in Maryland -- to consider the preferred stock as debt, and to put the company into receivership to protect Costa Brava's claim. Costa Brava claimed that the Telos board pays its executives too much money given its capital problems. Chief executive John B. Wood , for example, was paid $1,056,057 in salary and $1,230,000 in cash bonuses from 2002 to 2004.

A spokesman for Telos declined to comment. A group of independent Telos directors is to present recommendations this month for dealing with the company's capital deficit. The report is expected to address the fate of the public preferred shareholders, several of whom, including Costa Brava, have urged the company to seek a buyer or a public stock offering to raise enough cash to redeem the preferred shares.

"We have no comment in view of the pending litigation against the company and against the members of the board," said Douglas Gleason, in-house legal strategist for Roark, Rearden & Hamot.

Terence O'Hara's e-main addressoharat@washpost.com.

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