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Investing in the 'Real" New Economy (Nov 2002)

By Charles O. Heller, General Partner, Gabriel Venture Partners

Every article written today about venture capital must begin with the fact that there has been a radical decrease in investing during the past two years. Some wonder if this fall-off is a result of a drop in demand for private equity or a decrease in interest by VCs to invest – or perhaps a bit of both. In my opinion, it is definitely the latter.

We have seen no drop in the demand by entrepreneurs for funding. In the “post-bubble” period, we have seen a significant improvement in the quality of deal flow, and – at the same time – no decrease in the quantity of potential investments. With respect to quality: the management teams are more experienced and dedicated than during the Internet craze, and most of the companies are built upon foundations of solid business models and real technologies. The fact that the number of deals that we see has not decreased is a surprise, and it proves that real entrepreneurs are not discouraged by a temporary economic downturn.

The bad news for startup companies is the fact that the economic struggles of nearly all technology sectors have caused the majority of venture-funded companies to struggle. Consequently, venture capital firms have been forced to provide additional financial (and management) support to their existing portfolio companies. The VCs’ focus has shifted from looking for the startup home run to protecting existing investments. Those new investments which are being done tend to be later-stage (most often flat or down-rounds), and the terms for all investments are more onerous than in the recent past. The following are the trends that I am seeing in today’s venture capital investing:

Valuations and tranching
Valuations are considerably lower than in the past. For Series B and beyond, more than half of the financings are down-rounds and approximately another quarter are flat rounds (meaning that the pre-money valuation of the new round is less, or equal to, the post-money valuation of the last round, respectively). Moreover, the majority of financings are staged such that each tranche is paid out only if the company meets predetermined milestones. In down-rounds, valuation ratchets – conversion rate adjustments when operational milestones are missed or if a liquidity event is at a lower value than that agreed upon – are not uncommon.

Enterprise hurdles
During the bubble, it was common to fund “two guys with MBAs and an idea.” Now, we are back to traditional hurdles for institutional private equity financing: a revenue stream which demonstrates market acceptance; entrepreneurs with successful track records, reducing execution risk; and no more than 12-18 months to cash flow break-even, minimizing the risk of requiring another round of financing during which the existing VCs would be crammed down by new investors.

Liquidation preference
Most investments are being structured such that they include liquidation preferences, giving the VC a preferred position in a liquidation of the company, including an IPO, a sale of the company or change of control. Liquidation preferences of 2-3X, and even as high as 5X in some rare cases, are common, and they give the VC a multiple of his original investment in case of a liquidity event.

Antidilution protection
In flat and down-rounds, VCs protect themselves against the effects of future down-rounds through a device called “full-ratchet” antidilution protection. Such a clause guarantees that, in case of a lower valuation in a follow-on round, the price of the VC’s entire original investment will be reset at the new low price. In Series A (first institutional) rounds, the less onerous weighted-average antidilution protection is generally used.

VC participation in company operations
In a Series A round, the Board of Directors make-up tends to be the traditional: two management/two VCs/one independent outsider. However, today’s down-rounds sometimes result in the investors having majority control of the Board. Moreover, there tends to be more operational involvement by VCs, particularly in approval and tracking of budgets, after all levels of investment.

This provision, common in today’s investments, attempts to force all existing investors to participate in future financings or suffer greatly. Typically, in such a future round, the VC holder of preferred stock who fails to participate in that round is subject to a conversion of his preferred to common stock. This is a particular problem for VCs who do not have sufficiently deep pockets to hold their pro rata in future financings.

What is an entrepreneur to do?
The foregoing describes a climate which is extremely unfavorable to the entrepreneurial venture. But, the entrepreneur must appreciate the VC’s position. Venture capital funds are limited partnerships, where the LPs provide the capital for investment. The general partners’ first duty is to maximize the return on the LPs’ dollars. In a market with nearly nonexistent exits, and an uncertain future, the GPs must be extremely selective when looking for ways to deploy funds and, when they find them, to structure deals in ways that will give the highest probability of returns which are expected by their LPs.

The management team lucky enough to be extended a term sheet in today’s climate cannot afford to lament over the severity of the terms. Instead, it needs to “keep its eye on the ball,” and keep in mind the fact that its, and the investors’, interests and goals, are aligned: to build a great, profitable, company which will provide a successful exit for the investors and personal, professional, and financial success for those entrepreneurs who made it happen.

Dr. Charles Heller contributes a wide array of expertise, including 18 years as founder/CEO of two software companies, international advisor to newly-privatized companies in his native Czech Republic, builder of one of the foremost entrepreneurship centers in the U.S., and years of instructing in leading academic institutions. Further, his experience in mentoring hundreds of young entrepreneurial companies makes a breadth of skills and resources available to Gabriel’s portfolio companies.


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