eWEEK content and product recommendations are editorially independent. We may make money when you click on links to our partners. Learn More.
A year ago, a fanciful idea, a few employees and a half-baked business plan could qualify a professional-services company for a multimillion-dollar investment from a venture capital fund or angel investor.
The lucky recipient could burn through that cash to develop its offerings and grow revenue as fast as possible to outrun its competition. The boldest, most arrogant of these companies actually figured out how to dominate the market.
When the initial money was nearly gone, the company could simply go back for another private round or go public—at many times its original valuation. In other words, in less than two years, a novice entrepreneur could go from pauper to prince without seeing a profit.
Well, its no secret that those days are gone—if not for good, at least for a good long time.
Todays funding environment has replaced speed to market with speed to profitability. Valuations are down 50 percent to 90 percent from their highs, and both IPOs and acquisitions—the leading exit strategies for VCs—have declined sharply. Indeed, only 21 IPOs, valued at a total of $3.8 billion, came to market in the first 10 weeks of this year, versus 83 IPOs worth $11.3 billion last year, according to Securities Data Co. Such a paucity of deals dries up the flow of funds.
“When valuations decline, all types of financing slows down,” says Phil Canfield, a partner at GTCR Golder Rauner, a venture capital firm.
Still, billions of dollars remain in VC coffers—a record $50 billion or so, according to Floyd Kvamme, a partner at Kleiner Perkins Caufield & Byers. Funds have to invest some of this money to satisfy their limited partners. And private placements, in the form of strategic partnerships, are on the rise, as VCs seek other ways to earn money and finance their holdings while the IPO window is shut tight.
Success Stories Recent recipients of venture largesse include Zefer, an Internet consulting company that canceled its IPO three times last year. The company nabbed $20 million from GTCR—its largest shareholder—in November, and just announced another $48 million capital infusion from a group led by NEC. GTCR also contributed to that round. Under the latest deal, NEC becomes Zefers strategic partner and will share research and development and sales/marketing programs with the consulting firm. (Of course, its important to note that Zefer is cutting costs and has quietly dismissed scores of employees during the recent economic slowdown.)
Other winners in the new VC sweepstakes are PayPal, an Internet-based payment service that garnered $90 million from a group of a strategic partners, including some European and Japanese banks; and Avasta, an Internet infrastructure company that scored $50 million from a group of new and old sponsors, primarily venture capitalists.
“The spigot has not been not turned off,” insists Al Wasserberger, president and CEO of Spirian Technologies, a managed services firm that recently got $7 million in third-round funding. “Theres a lot of money that needs to be put to work, but less places are getting it.”
In the fourth quarter of 2000, VC funding fell 31 percent to $19.6 billion, as compared with the third quarter, according to Venture Economics, which projects a further drop-off in the first quarter of 2001. Some of the newer deals are initial placements, but most are follow-on rounds to earlier funding, say VC sources. An example of the former is Salion, an e-solutions company founded by McKinsey & Co. and AV Labs. Salion just secured $7 million in first-round funding led by Austin Ventures.
“We are looking at new deals,” confirms Bob Greene of Flatiron Partners, a New York venture capital firm. “But, we will not add as many new [portfolio companies] as last year.”
Like most venture capital firms, Flatiron is fixated on servicing its existing portfolio companies, while its traditional IPO and acquisition entrance ramps remain blocked.
As a result, Flatiron has less energy, time and money to invest in new companies, which are the VCs primary means of attracting new investors and boosting the value of existing holdings. Because all VC firms are caught in the same bind, the effect on the overall venture capital market is magnified many times.
The focus now is on grooming portfolio companies to achieve certain performance milestones so that they eventually can qualify for more funding from other sources. Portfolio investments that are deemed dead weight are getting cut loose.
“We have to make triage decisions to see which companies deserve money and which dont,” says Green at Flatiron Partners.
Howard Anderson, senior managing director at YankeeTek Ventures, calls it “the end of amateur night.”
Look Smart To get in a VCs door during the bear market of 2001, youve got to look and act professional. To get that VC to actually part with money, youll need a lot more.
Youll have to show a profit, or at least a path to profitability on a cash-flow basis, within six to 18 months. This is what qualified Zefer, which became profitable in the fourth quarter, to secure its latest funding. Avasta, too, expects to break even by year-end, which was a critical factor in its recent fund-raising effort.
“We want to see profits in 2001 or 2002, rather than three to four years down the road,” says John Hoctor, of StartingPoint Venture Partners. “And we are watching every dollar that a company spends.”
Being profitable means the company can sustain itself without difficult-to-obtain external financing. Moreover, profits increase your chances of launching a successful IPO or getting acquired if and when those opportunities arise.
“Because the path to liquidity is a lot longer now, we have to be more concerned with whom gets the money and how its managed,” says Russ Irwin, a partner at Convergence Partners.
VCs now expect to stick with companies for three to five years, like they used to do before the Internet gold rush, which saw legions of unprofitable companies enter the public market within 18 months of their founding.
Next, youll need a real, non-vaporware product or service that advances current technology and provides a value that customers will pay for.
“Money has to go to solve big business problems,” said Tony Abate, general partner at Battery Ventures, at a recent Merrill Lynch conference on infrastructure issues.
Examples of products/services that fit that bill are Internet infrastructure applications; managed services (which automate outsourced IT services); and metropolitan area networks that provide high-speed data and voice transmissions in metropolitan areas at less cost than the local phone company. What doesnt fit the bill? Most Internet consultancies, content providers and Internet service providers.
Well Pass Capital-intensive businesses, such as fiber-optic networking that require billions of dollars in financing, are likewise out of favor. Glen Lewy, a partner at Hudson Ventures, notes that “if a company needs $75 million in capital before it can become profitable, thats three rounds of funding and its not likely to happen.”
Moreover, any proprietary product or product-driven service had better be a head above whats currently out there, and as reliable as a dial tone. “Proprietary software cant be just a slight improvement over existing software, but [it must be] a giant leap forward,” says Hoctor.
Companies whose products qualified them for recent financing are Rainfinity, which provides software to improve business transactions over the Internet ($30 million raised); Network Physics, an infrastructure company that focuses on improving Internet performance through “hidden” physics ($25 million); and Yipes, an optical IP provider and competitive local exchange carrier serving metropolitan area networks ($200 million).
Serving a solid, growing niche market is another way to attract funds. A good example is Lumina Americas, a Web site developer and systems integrator specializing in the U.S. Hispanic and Latin American markets, which recently closed a $25 million second-round financing. Lead investor J.P. Morgan Latin America Capital Partners is a strategic partner. The equity firm has merged its technology development firm for Latin America with Lumina Americas, and J.P. Morgan will refer clients to the Web services company.
Another factor to consider is a superior management team, which investors are looking for. VCs have always paid lip service to the importance of good management, but they havent always followed their own advice. Now, they cant afford not to. In fact, VCs have been a major force behind the management reshuffling at many struggling companies, including the publicly held firms on whose boards they sit.
“We want to see adults, not kids; people with experience,” says Jeff Harris, a managing director of E.M. Warburg, Pincus & Co.
More specifically, VCs want to see experienced executives who are familiar with the sectors in which their companies operate, as well as the internals of the companies themselves. VCs, more than ever, are the ones selecting those managers.
“We pick the professional management and work with them, sharing our experience and perspectives,” says Phil Canfield of GTCR, which provides early-stage funding.
“Our company is run by the board, not by me,” adds Ritu Raj, CEO of Avasta. “Im going to operate the company day-to-day, and Ive surrounded myself with strong executives who all had gray hair to start with.”
Rajs advice to other entrepreneurs is to be very careful with your companys cash because its really other peoples money. And dont be greedy about your stake in the company, he says.
Given current valuations, VCs also want to make sure that the executives they work with will have the staying power to remain with their companies even if their stakes arent worth nearly as much as they once were.
In addition, a good business plan that neither contemplates a future, larger institutional round of funding, nor contains any predictions on market share is vital. VCs say they are skeptical about the prospects of future funding and are wary of ambitious market-share claims, which in the past have mainly inhabited the world of fiction.
“Those types of macrocalculations dont work anymore,” says Frank Torpey, executive VP at Zefer. “Your business plan, if youre just starting out or if youre an existing business, has to be defensible in every aspect. You have to define the core market opportunities, and specify the types of clients youll serve and the individual solutions.”
Venture capitalists currently favor companies that service enterprise clients, have customers already signed up and dont go in for lowball pricing.
And finally, VCs want entrepreneurs who are patient and lack of avarice, two hot virtues in the current marketplace.
“Were seeing an awful lot of down rounds or flat rounds in follow-on financing,” says Lewy at Hudson Ventures. “Companies may have progressed, but the market has regressed, which is bringing down valuations.” Get used to lower expectations.
No Fast Cash Be prepared to wait a long time to receive your new funding. VCs are taking their sweet time to do their due diligence and cover every last detail, says Hoctor of StartingPoint Venture Partners.
“If youre trying to get funding for a software firm, we dont just want to know how many engineers you have, but how many sales and marketing people, as well,” says Dave Brown, a managing partner at Oak Hill Venture Partners.
“We want more proof of everything,” seconds Russ Irwin, a partner at Convergence Partners. “We want to know if you can build this thing, if anyone cares, and who are the people who will do it. Were looking hard at each of those answers.”
Avastas Raj says that each funding round now takes at least 90 days—his latest round took 120 days—to complete. “If anyone tells you otherwise,” suggests Raj, “hes lying.”