Venture Capital: The Lifeblood Behind Security Innovation

This is the first of two articles.

David Cowan, who was one of the first venture funding executives to specialize in the cyber security industry -- and now is among its most prominent investment experts -- remembers the day that encryption vendor Codex was sold to Motorola in 1992.

"The CEO of Codex, Per Suneby, put his arm around me," Cowan recalls. "He said, 'Son, don’t ever invest in security.' "

Fortunately for the industry, Cowan -- and a rapidly-growing number of investment executives who followed -- didn’t listen to this advice. In fact, according to data collected by Thomson Reuters, venture investors put nearly $3 billion into cyber security companies between 2011 and 2013, resulting in new funding for some 300 firms. And this year, the investment rate could be even higher.

In the first quarter alone, more than 20 security startups have launched or announced significant funding, and the wave shows no signs of cresting. "I don’t expect the pace of cyberattacks to slow down, and I don’t expect the flow of venture capital to slow down," says Cowan, whose firm, Bessemer Venture Partners, has funded some 32 cyber security companies -- including VeriSign, Qualys, and Mojave Networks -- since that day in 1992. "If you’re an information security professional today, you’ve got to embrace the reality that you’re at war, and you’re not going to succeed without an active defense."

Funding from investment companies like Accel Partners, AGC Partners, Bessemer, Sequoia Capital, and many others is now becoming the currency on which tomorrow’s security innovators build. Today’s "hot" security companies -- names like Palo Alto Networks, FireEye, and CrowdStrike -- all grew from seeds planted, at least in part, by venture firms that recognized their potential and helped put them on the map. Without such funding, those firms, like many others that start and subsequently disappear, might never have found their way into today’s enterprise security strategies.

"A few years ago, security was stuck in a non-competitive market that was dominated by three large companies who had very little incentive to innovate because there was very little competitive pressure," says Rick Gordon, CEO of MACH37, a "cyber accelerator" organization that funds and trains entrepreneurs and young security companies on how to develop their ideas and bring them to market.

"Today, that environment has been turned on its ear because enterprises are so desperate for real solutions and they are willing to take a chance on a startup to do it," Gordon says. "There is a real opportunity for a new company not only to get started and make a graceful exit, but to become disruptive and change the whole platform that enterprises are using today."

Indeed, more than a dozen security startups have made their initial public offerings since 2011, including hot new firms like FireEye, Palo Alto Networks, Splunk, LifeLock, and Barracuda Networks. In addition, according to figures from AGC Partners, some 115 security companies were involved in mergers or acquisitions last year.

Why is cyber security becoming such a hot market for investors? Because the technology enterprises are using today is not working, and because there is no clear solution or next-generation leader yet.

"The security industry is in for a paradigm shift, a platform shift that will pave the way for a whole new generation of companies," says Sameer Gandhi, a partner at Accel Partners, which has funded emerging security companies such as AirWatch, CrowdStrike, Lookout, and Tenable.

Like many investors, Gandhi is recognizing game-changing trends in security, including the introduction of mobile and BYOD technologies, the broad implementation of cloud services, and an increasingly sophisticated base of attacks that defy current defenses. "We want to be involved in areas where there is real change going on. Not just areas where companies are building a nice business that they can sell to someone else, but areas where there is a chance for a company to be number one in the whole market."

Cowan agrees: "I’m not interested in a product that’s a better version of something that already exists. I’m following the hackers to see what they’re doing, what’s motivating them. If you recognize where the threat is going, you can see where the truly disruptive technologies will be."

With tens of millions of investment dollars at their disposal, venture capital firms get dozens of startups reaching out to them every month, asking for meetings and making presentations. Think of the TV show Shark Tank, only with a security spin. How do these investors choose the startups they will back? Technology and market potential are important, but people -- the founders and leaders of a security startup -- are universally cited as the most important factor in backing an emerging firm.

"The first thing we look at is the experience of the team -- what companies have they worked on, what’s their background, what’s their technical level of sophistication," says Gandhi. "A company with founders who have real experience has a much better chance of getting funded."

One of the poster children for this concept is CrowdStrike, whose management team is a virtual who’s who of cyber security. Started by former Foundstone founder and CEO George Kurtz and former McAfee Vice President of Threat Research Dmitri Alperovitch, CrowdStrike quickly added names such as Shawn Henry and Steve Chabinsky, both former cyberleaders at the FBI.

"Venture capital firms are looking to invest in the team itself and its ability to execute its vision," says Kurtz, whose company generated $30 million in funding last September. "There are a lot of good researchers and technologists out there who know security, but they have no idea how to run or sell a company to a bunch of investors. You have to have the right people."

Adam Ghetti, founder of startup Ionic Security, which recently raised $25.5 million, agrees. Ionic, whose distributed data security solution is still in stealth mode, has received backing from Internet Security Systems co-founder Tom Noonan and PGP Corp. co-founder Phil Dunkelberger, among others. "It’s not who you know, it’s how you know who you know," he says. "When we started, we wanted to get the best people we could find behind what we were doing. Then, when you call on a VC firm, they know you’re not wasting their time -- you have credibility."

"If you’re an all-star startup, they will basically fund you with a PowerPoint slide," says Garrett Larsson, founder of mobile security startup Mojave Networks, which collected $5 million in funding in November. "Security is not a place where you’ll find many startups that are two guys in a dorm room. But the difference between the startups that succeed and the ones that don’t is traction in the market. If you don’t have customers, and you’re not getting real implementations, even the best ideas and people won’t succeed."

Venture capitalists and security entrepreneurs agree. One of the hardest problems for any startup, they say, is getting a few large enterprises to trust its technology enough to implement it in a real, operational environment.

"You don’t see a lot of large enterprises working with 20 little startups, especially in an area as critical as security," says Kurtz. "Some [enterprises] are very conservative and don’t want to work with startups at all; others are more liberal and will look at a lot of technologies. But most of them will choose a couple of really innovative startups to work with, and place their bets on those. As a startup, obviously, you want to be one of those bets."

Increasingly, observers say, investment firms are helping to broker those deals between startup firms and large enterprises. "Periodically, we will bring in a team of CIOs and CISOs from enterprises and give them a look at half a dozen startups that they might not know about," says Accel Partners’ Gandhi. "They know what their problems are and what’s coming. They may not want to buy anything yet, but that sort of a meeting keeps the dialogue going and helps both the enterprise and the startup. And six to 12 months later, they may bring those products in."

Next week: How enterprises can use the intelligence collected by venture capital firms to make smart decisions on emerging security technology.