Venture Capital Industry

Beyond the Crash of 2000: The Venture Capital Cycle Repeats Itself

The crash of the NASDAQ began in March 2000, resulting in more than a 60 percent drop in value by late summer 2 001. This major crash in equity values began a shakeout and downturn in the private equity and public stock markets whose repercussions and consequences are still impacting the venture and growth capital marketplace. Typical of the dot-com meltdown, many high-flying companies went public in 1998 and 1999 at high prices, saw their values soar beyond $150 to $200 per share, and then came plummeting to low single-digit prices. Take Sycamore Networks, which went public in October 1999 at $38 per share, rocketed to nearly $200 in the first week, and was trading at under $6 per share through most of 2003. The list of dot-coms that went totally bankrupt (such as webvan.com, the home delivery grocery firm) is significant.

Similarly, beginning in the late summer of 2000, many young telecommunications companies saw their stocks begin to decline rap­idly, losing 90 percent or more of their value in less than a year. These downdrafts swept the entire venture capital and private equity markets. By mid-2 001, the amount of money being invested had dropped by half from the record year of 2000, and valuations plummeted. Down rounds - investing at a lower price than the previous round - were truly the catch of the day. Not since the periods 1969-1974 and 1989-1993 have entrepreneurs experienced such a downturn.

To illustrate the consequences for small business owners and investors alike, in 2001 as companies burned through their invested capital and faced follow-on round of financing, the valuations were sag­ging painfully Even companies performing on plan were seeing share prices 15-30 percent below the previous round a year or eighteen months earlier. Where performance lagged milestones in the business plan, the down round could be 50 percent or more below the previ­ous financing valuation. To make matters worse for entrepreneurs, the investing pace slowed significantly. Due diligence on companies was completed in forty-five days or less during the binge of 1998-1999. By 2002 investors reported a six- to eight-month due diligence phase,

which would be very close to the historical norm experienced prior to the feeding frenzy.

The stark reality of all this, which is summarized in Exhibits 5.4 and 5.5, is that the venture capital cycle - much like real estate - seems to repeat itself. Scarcity of capital leads to high returns that attract an over­abundance of new capital, which drives returns down. The new millen­nium welcomed the real "Y2K problem": the meltdown side of the venture capital and private equity markets repeated the 1969-1974 and 1989-1993 pattern.

The Venture Capital Process

Exhibit 5.7 represents the core activities of the venture capital process. At the heart of this dynamic flow is the collision of entrepreneurs, opportunities, investors, and capital.13 Because the venture capitalist brings, in addition to money, experience, networks, and industry con­tacts, a professional venture capitalist can be very attractive to a new venture. Moreover, a venture capital firm has deep pockets and contacts with other groups that can facilitate the raising of money as the ven­ture develops.

The venture capital process occurs in the context of mostly private, quite imperfect capital markets for new, emerging, and middle-market companies (i.e., those companies with $5 million to $200 million in sales). The availability and cost of this capital depend on a number of factors:

• Perceived risk, in view of the quality of the management team and the opportunity

• Industry, market, attractiveness of the technology, and fit

• Upside potential and downside exposure

• Anticipated growth rate

• Age and stage of development

• Amount of capital required

• Founders' goals for growth, control, liquidity, and harvest

Exhibit 5.7 Flows of Venture Capital

ovide capital

I dent *y and screer oppcrtun'ties

Trarsae: and close deals

IV'onitor and acd value

Ha^esi

Raise add tional'unds

Poftfoiio Compaiiie ' l_.se caoital

Gatekeepe-s 1% annual fee

2-3^tANMJAL y-E

General oartrers

15-26% e-f capital gains

IPOs,'mer^-v'Hiiia:ices

i.rtrep'fern.urs

KetLT: c-prrcipal plis 7=^86%-r capital gar

EQL -Y-

V'aiue-c-eaticr anc harvest

Source: William D. Bygrave and Jeffry A. Timmons, tenture Capita! at the Crossroads (Boston: Harvard Business School Press, 1992), Figure 1-3.

Fit with investors' goals and strategy

Relative bargaining positions of investors and founders given the

capital markets at the time

Further, a small business owner may give up 15-75 percent of his or her equity for seed/start-up financing. Thus, after several rounds of venture financing have been completed, a small business owner entre­preneur may own no more than 10-20 percent of the venture.

It is the venture capitalists' stringent criteria for their investments that limit the number of companies receiving venture capital money. Venture capital investors look for ventures with very high growth potential where they can quintuple their investment in five years; they place a very high premium on the quality of management in a venture; and they like to see a management team with complementary business skills headed by someone who has previous entrepreneurial or profit -and-loss (P&L) management experience. In fact, these investors are searching for the "superdeal." Superdeals meet the investment criteria outlined in Exhibit 5.8.

Identifying Venture Capital Investors

Venture capital firms have an established capital base and professional management. Their investment policies cover a range of preferences in investment size and the maturity, location, and industry of a venture. Capital for these investments can be provided by one or more wealthy families, one or more financial institutions (e.g., insurance companies or pension funds), and wealthy individuals. Most are organized as lim­ited partnerships, in which the fund managers are the general partners and the investors are the limited partners. Today, most of these funds prefer to invest from $2 million to $5 million or more per round, although some of the smaller funds will invest less. Some of the so-called megafunds (comprising more than $500 million) do not consider investments of less than $5 million to $10 million. The investigation and evaluation of potential investments by venture capital corporations and partnerships are thorough and professional. Most of their invest­ments are in high-technology businesses, but a good number will con­sider investments in other areas.

Sources and Guides. If you are searching for a venture capital investor, a good place to start is Pratt's Guide to Venture Capital Sources (published by Venture Economics), the VentureOne website (venture-one.com), and the directory published at the PricewaterhouseCoopers MoneyTree Survey website (pwcmoneytree.com).

Because venture capital firms receive thousands of proposals every year, their first screen as to whether they will pay any attention to the business plan is whether it comes from a "warm" referral. If you mail your plans unsolicited to a number of firms, you will be very lucky if one even acknowledges that you sent them a plan, let alone reads it and considers it as a deal worth investigating further. Therefore, you need to find a "warm" referral to each venture capital firm you plan to con­tact. Small business owners can seek referrals from accountants, law yers, investment and commercial bankers, business school professors, and businesspeople who are knowledgeable about professional investors.

Exhibit 5.8 Characteristics of the Classic Superdeal from the Investor's Perspective

Mission

• Bring scale to a highly profitable company that can become the industry-dominant, market-leading company

• Go public or merge within four to seven years at a high price/earnings (P/E) multiple or sell to a larger company at a high P/E

• Complete management team

• Led by industry "superstar"

• Possess proven entrepreneurial, general management, and P&L experience in the business

• Have leading innovator or technologies/marketing head

• Possess complementary and compatible skills

• Have unusual tenacity, imagination, and commitment

• Possess reputation for high integrity

Proprietary Product or Service

• Has significant competitive lead and "unfair" and sustainable or defensible advantages

• Has product or service with high value-added properties resulting in early payback to user

• Has or can gain exclusive contractual or legal rights

• Large, robust, and sustainable business model

• Will accommodate a $100 million entrant in five years

• Has sales currently at $200 million, or more, and growing at more than 25 percent per year

• Has no dominant competitor now

• Has clearly identified customers and distribution channels

• Possesses forgiving and rewarding economics, such as:

- gross margins of 40-50 percent, or more

- 10 percent or more profit after tax

- early positive cash flow and break-even sales

Deal Valuation and ROR

• Has "digestible" first-round capital requirements (i.e., greater than $1 million and less than $1 0 million)

• Able to return ten times original investment in five years at P/E of fifteen times or more

• Has possibility of additional rounds of financing at substantial markup

• Has antidilution and IPO subscription rights and other identifiable harvest/liquidity options

What to Look For. You are well advised to screen prospective investors to determine their appetites for the growth stage, industry, technology, and capital requirements proposed. The Pricewaterhouse-Coopers MoneyTree Survey is particularly useful in that it allows you to sort venture capital funds by region and industry focus, with links to the funds' home pages. Most of the firms give explicit definitions of what types of deals they are interested in, as well as an overview of other companies in which they have invested. Thus, you can identify venture capital firms that might provide value-added benefits (e.g., the fund may have invested in some potential suppliers or customers, meaning they can network you to these important firms).

Studying the venture capital firm's website can help you answer a number of questions - for example, do they have money to invest, are they actively seeking deals, and do they have the time and people to inves­tigate new deals? Depending on its size and investment strategy, a fund that is a year or two old will generally be in an active investing mode.

Growth-minded entrepreneurs need to seek investors who (1) are considering new financing proposals and can provide the required level of capital; (2) are interested in companies at the particular stage of growth; (3) understand and have a preference for investments in the particular industry (i.e., market, product, technology, or service focus); (4) can provide good business advice, moral support, and contacts in the business and financial community; (5) are reputable, fair, and ethical and with whom the small business owner gets along; and (6) have success­ful track records of ten years or more of advising and building smaller companies into larger ones.14

You can expect a number of value-added services from an investor. Ideally, the investor should define his or her role as a coach - thoroughly involved, but not a player. In terms of support, investors should have both patience and bravery. You should be able to go to the investor when you need a sounding board, counseling, or an objective, detached per­spective. Investors should be helpful with future negotiations, financ­ing, and private and public offerings, as well as in relationship building with key contacts.

Warning Signs. There are also some things to be wary of in finding investors. These warning signs are worth avoiding unless an entrepre­neur is so desperate that he or she has no real alternatives:

• Attitude. If you cannot get through to a general partner in an investment firm and keep getting handed off to a junior associate, or if the investor thinks he or she can run the business better than you or your management team, you will probably want to look elsewhere.

• Overcommitment. Lead investors who indicate they will be active directors but who also sit on the boards of six to eight other start-up and early-stage companies, or are in the midst of raising money for a new fund, probably will have less time to devote to your firm.

• Inexperience. You can't necessarily rely on a venture capitalist who has an MBA; is under thirty years of age; has worked only on Wall Street or as a consultant; lacks operating, hands-on experience in new and growing companies; and has a predominantly financial focus.

• Unfavorable reputation. Look out for funds that have a reputa­tion for early and frequent replacement of the founders or those where over one-fourth of the portfolio companies are in trouble or failing to meet projections in their business plans.

• Predatory pricing. During adverse capital markets (e.g., 1969-1974, 1988-1992, 2000-?), investors who unduly exploit these con­ditions by forcing large share price decreases in the new firms and punishing terms on prior investors do not make the best long-term financial partners.

How to Find Out. How do you learn about the reputation of the ven­ture capital firm? Far and away the best source is the CEO or founders of prior investments. Besides the successful deals, ask for the names and phone numbers of CEOs they invested in whose results were only mod­erate to poor, and where they had to cope with significant adversity Talking with these CEOs will reveal their underlying fairness, charac­ter, values, ethics, and potential as a financial partner, as well as how they practice their investing philosophies. It is always interesting to probe regarding the behavior at pricing meetings.

ealing with Venture Capitalists*

It is important to keep in mind that venture capitalists see lots of pro­posals, sometimes one hundred or more a month. Typically, they invest in only one to three of these. The following suggestions may be help­ful in working with them.

If possible, obtain a personal introduction from someone who is well known to the investors (a director or founder of one of their portfolio companies, a limited partner in their fund, a lawyer or accountant who has worked with them on deals) and who knows you well. After identi­fying the best targets, you should create a market for your company by having several prospects. Be vague about who else you are talking with. The problem is, you can end up with a rejection from everyone if the other firms know who was the first firm that turned you down. It is also much harder to get a yes than to get a no. And you can waste an enor­mous amount of time before receiving an answer.

When pushed by the investors to indicate what other firms/angels you are talking to, simply put it this way: "All our advisors believe that information is highly confidential to the company, and our team agrees. We are talking to other high-quality investors like you. The ones with the right chemistry who can make the biggest difference in our com­pany, and are prepared to invest first, will be our partner. Once we have a term sheet and deal on the table, if you also want coinvestors we are more than happy to share these other investors' names." Failing to take such a tack usually puts you in a quite adverse negotiating position.

Most investors who have serious interest will have some clear ideas about how to improve your strategy, product line, positioning, and a variety of other areas. This is one of the ways they can add value - if they are right. Consequently, you need to be prepared for them to take apart your business plan - and to put it back together again. They are likely to have their own format and their own financial models. Work­ing with them on this is a good way to get to know them.

Never lie. As one entrepreneur put it, "You have to market the truth, but do not lie." Do not stop selling until the money is in the bank. Let the facts speak for themselves. Be able to deliver on the claims, state­ments, and promises you make or imply in your business plan and pre­sentations. Tom Huseby adds some final wisdom: "It's much harder than you ever thought it could be. You can last much longer than you ever thought you could. They have to do this for the rest of their lives!" Finally, never say no to an offer price. There is an old saying that your first offer may be your best offer.