Cover Story: No More Easy Street as VCs Tighten the Purse Strings –

The seeds of doubt, fear and retrenchment that began to bud among Wall Street investors last fall are now in full bloom on Sand Hill Road. Start-ups are shutting down or filing for Chapter 11, stock portfolios are plummeting and the rules of the venture capital game are changing – and venture capitalists are getting the upper hand.

For start-ups, capital is a lifeline. But in today’s VC market, that lifeline now comes with a hefty price tag. Cash-strapped young companies currently raising capital are not only being forced to cede control of their enterprise, but they are also under pressure to agree to lower valuations and stringent terms – including higher liquidation preferences, full-ratchet anti-dilution rights and participating convertible preferred stock – previously abandoned by VCs.

“Nothing’s normal today, but there was nothing normal about what was going on two or three years ago,” says Stephan Mallenbaum, a partner in the New York law offices of Jones, Day, Reavis & Pogue. “People were writing checks because a company was in the right space or because everyone else was. Term sheets were easy – they were basically form sheets. Now they’re intricate and tough deals.”

New investors structuring protective measures and lower valuations into the term sheet are pushing existing venture backers into defensive positions, forcing some to dig in their heels, survey their portfolio and make strategic moves out of companies lacking either revenue or a clear exit strategy.

“There’s increasing tensions between people participating in later stages and those that are backing out, getting cold feet and not willing to refinance and re-up for otherwise healthy companies,” says Josh Lerner, professor of business administration at Harvard Business School.

“We’re seeing down rounds and inside-level rounds where venture capitalists are protecting their investment,” Mallenbaum says. “Either they cut it loose in a polite way and say, We’re not investing anymore so go find another investor,’ or, they say, We want to support the company, why find an outside investor if we’re not going to find one’.”

In down rounds, investors are demanding a liquidation preference at a multiple of up to three or four times the original investment. In the event of a sale or liquidation of the company, preferred stock – the most common financing instrument of the VC – has a liquidation preference over common stock. When the liquidation preference is dictated by the term sheet at such a high multiple, the feature “… is really harsh and compounds the decrease in valuation,” says Mallenbaum.

At the same time, VCs are securing full-ratchet anti-dilution rights rather than the weighted-average anti-dilution rights prevalent during the Nasdaq’s peak. When an underperforming company sells stock in a round of venture financing at a price lower than in previous rounds, the convertible preferred stock retains its value through anti-dilution provisions. While the adjustment level is a negotiated term it will either take the form of a complete adjustment – a full ratchet – or it will be based on the size of the round and the size of the price decrease – a weighted average formula. By having an automatic adjustment, says Harvard Business School’s Lerner, an investor is less likely to oppose a much-needed capital infusion for a cash-strapped company in a difficult private equity market when the issue dilutes an investor’s percentage ownership. According to one Silicon Valley VC, full-ratchet anti-dilution provisions are appearing on 5% to 10% of term sheets for early-stage companies and on 60% to 70% of later-stage deals. Compared with two years ago, he estimates that only 10% of later-stage deals had full-ratchet provisions and virtually no West Coast VC had them on early-stage deals.

Meanwhile, VCs taking new positions in de-valued companies are protecting their investment from further losses through the issuance of participating convertible preferred stock. The feature made its first reappearance since the 1960s about a year ago, just as the public markets began their roller-coaster slide.

“I saw it even in the midst of the bubble, but it was a grab,” Mallenbaum says. “If [the investor would] reach for it, you’d slap their hand back. It was in the background lurking and became popular last fall.”

In the event of a sale or liquidation of a private company, holders of participating convertible preferred stock have the right to receive the face value of the investment plus the equity participation – as if the stock were converted, Lerner says. Thus, the investor guarantees a larger share of the upside, if the company is sold.

Knowing Your Value

Tough terms, however, have not spurred a drought in the VC market. Although the pace of venture investment has slowed considerably since last year, the pool of venture capital has not dried up. The number of billion-dollar funds has more than doubled in the last year – and the money must be put into play. According to preliminary data from VentureXpert, the first quarter saw $11.7 billion worth of investments into 1,072 companies. That’s a far cry from the previous quarter’s tally of $20.2 billion, but still on par with historical numbers.

Early-stage companies with a core management team of three executives and a string of beta customers once valued at $15 million are now looking at a $12 million pre-money valuation, says Ken Elefant, senior associate at Battery Ventures. And the early-stage companies valued between $10 million and $12 million a year ago are now being valued between $3 million and $4 million.

“As the public markets move, so do valuations, but where do valuations in private companies come from?” asks Harvard’s Lerner. “The right answer should be cash flow: where they are and what do we discount them on? What are comparable public companies being valued at? Investors are looking at what those companies are worth and stepping back out – there’s the inferred valuation.”

However, more often than not, a company’s valuation is based on less tangible metrics that reflect the whims and tastes of the investor.

“Is there one A-plus member on the management team, someone with direct domain knowledge? Are there three marquis beta customers? If a CTO comes in and says I built a similar router and this is just faster,’ we know the guy can build it and it brings them a higher valuation,” Battery’s Elefant says. “The most important thing is the exit opportunity. If they’re attacking a niche market and the exit is limited, then there’s no financials to work with.”

The inferred value, for example, of UGO Networks Inc., whose site fills an entertainment niche for 18 to 34-year-old males with music, technology and wrestling channels, has moved in sync with other content-driven portals.

“We’ve experienced the whole spectrum in terms of leverage,” says Michael McCracken UGO Networks’ chief financial officer. “In five rounds of financing, we’ve seen great markets, okay markets, and now, which is a very tight market.”

Since its launch three years ago, has counted 6.5 million unique users and secured $80 million in five rounds of venture financing from an investor list that includes Donaldson, Lufkin & Jenrette’s Global Retail Partners LP, Gryphon Holdings II LP, J.P. Morgan Partners, J.W. Seligman & Co., Liberty Digital, Soros Fund Management and Vivendi Ventures. The company completed its most recent financing, a $23 million series E round, in March.

Although New York-based UGO Networks reports overall annual revenue of $15 million, most of it is driven by advertising, which is expected to drop this year due to a slowing economy. While the company has assured its investors that its roster of blue-chip advertisers will not abandon the site, proceeds from the latest equity offering will largely be directed toward the development of UGO Technology Solutions, a project that includes Web hosting, network services, streaming media applications and application development. UGO Network Technology Solutions is expected to bring in 30% to 35% of the company’s revenue during the next year, McCracken says.

While the company’s strategic realignment may save it from the fate of many content-driven plays, UGO Networks’ venture backers aren’t taking any chances, securing their own downside protection through term sheets heavy with stringent protective provisions, such as liquidation preferences, anti-dilution rights and participating convertible preferred stock.

“In past markets, venture capitalists were somewhat protected for dilution,” says McCracken of UGO Networks. But companies will continue to raise much-needed capital even when valuations fall. As the number of down-financings rise, McCracken predicts, so will the use of full ratchets as a protective measure.

Being in Control

Even those companies able to withstand the swings of the market and hold onto the optimistic pre-crash valuations are having to cede control of their operations to venture investors.

Wall Street Rarities, a purveyor of rare coins both online and off, first attracted the attention of VCs more than a year ago, when it secured a $4.5 million series A financing led by St. Louis-based Gryphon Holdings. By its next round of venture financing, a $3.5 million deal that included Gryphon and Scient Corp. alongside a number of individual investors, Wall Street Rarities President and Chief Executive William Anton had secured a $45 million valuation for his New York-based company. After the company closed its second round in May, Anton had already begun pitching a $10 million future round to new investors. However, by July, the board decided to abandon plans for outside financing, and instead, voted to self-finance the next round of venture capital. The company’s existing backers pumped an additional $6.75 million into the company, but kept its $45 million valuation.

Wall Street Rarities is a retailing play with four active sales channels – direct marketing, telemarketing, an e-commerce platform and a shop on Manhattan’s Wall Street. Even today, with a fully developed Web presence, less than 25% of the company’s revenue comes from Internet sales. Still, the company went back to the venture market last summer, it was spending heavily on technology and Web site developers. And with Internet retailers already taking a beating in the public markets, no investor was willing to value a still-unproven Internet retailer at $45 million.

“An insider won’t push you back in valuation, but to keep that valuation, there’s a report every week to see what you’re spending, how you settle with creditors, monthly expense budgets and converting vendors to equity,” Anton says. “They really want to see where the money is going, but they have a knowledge base in the company that a new investor wouldn’t have.”

For Wall Street Rarities, the new money came in two tranches, thus cutting into Anton’s projections for working capital and day-to-day operations. At the same time, the company’s existing backers demanded that Anton make control of the company more transparent.

After making an acquisition in Louisiana, Wall Street Rarities shifted its marketing operations to New Orleans. It also slashed its technology group from eight employees to two. The decision to reduce head count, Anton said, was ultimately the right one, especially on the technology side.

“The site is built, and the pace of site improvement is not a priority in this market,” he says.

Priorities instead shifted to driving revenue across its most profitable sales channels. The company spent heavily on inventory, thus driving sales. Now, with another $2 million of insider venture financing behind it, the company is two to three months from hitting the cash-flow positive mark.

“Investors are looking for clear management and a clear case as to when it’s going to be a stand-alone and how much it’s going to take to get it there,” Anton says. “First, it was about first-movers and time-to-market share. Then, it was about cool technology. Now, it’s still about cool technology, but it can be incubated around a more traditional business model. It’s about technology leadership, a path to profitability and what’s going to support the Web model that’s a cash-flow business.”

Still, as alternative sources of finance – angels or debt investors – seek cover in their existing portfolio and all but abandon the technology-driven industries, and VCs see fewer exit opportunities in the near-term, a company must cross murky waters to find a clear path to profitability.

“In such a VC-favored market, investors can call their own shots,” says Gabor Garai, a partner in the New York office of Epstein, Becker & Green. “It’s very unusual that companies can negotiate and look at alternative financing sources, such as bridge loans or equipment finance. For these types of companies, with high-risk financials, there’s no real alternative.”

Instead, VCs have adjusted their forecasts. Not only do they expect a longer runway toward profitability for start-ups, but also are forcing valuations down to reflect the market’s tightening liquidity.

“Funds are viewing this environment as a tremendous opportunity,” says Jay Hachigian, a partner in the Boston law offices of Gunderson Dettmer. “With lower valuations, funds can increase the returns they generate.”

Start-ups faced with onerous provisions, on the other hand, may seek internal financing rather than risk losing control of the company’s day-to-day operations and hitting lower valuations and dilutive investment terms. Ultimately, however, a company’s growth will be limited without expansion capital. And in this market environment, start-ups may just have to play the hand they’re dealt.

“If you’re launching a business, it’s because innovation does not stop and the desire to transform the world does not stop,” Mallenbaum says. “There’s still a lot of opportunity to do pretty well. The only standard you’re not doing well by is the bubble.”

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