Feature: Layoffs, Restructurings Help Win Mid-Stage Rounds –

Before heading back to the market for a second round of venture financing, DealerSource.com announced that it would streamline its costs by eliminating 30% of its staff.

DealerSource, an online business-to-business exchange for off-lease and used office equipment, is one of the latest venture-backed companies to discover what appears to be the magic formula for getting a second or third round: drastic layoffs and restructuring.

While each case is unique, in recent months a stream of private companies have simultaneously announced major layoffs, revamped business models and a new round of venture financing. Like DealerSource.com, many companies – especially Internet-related startups – are in a do-or-die situation, trying to accelerate their path to profitability by cutting costs and altering their strategies. With a round or two of venture funding already behind them, and enough time to bring their products to market, companies are determining what works and what doesn’t. More importantly, they’re looking at which revenue streams can bring the company beyond a break-even point.

“We’re planning to offer a new product line – a software line that differs from our previous marketplace model,” says Misha Reznikas, vice president of business development at DealerSource.com. “There’s a bigger opportunity in software infrastructure. Cash was tight and we didn’t feel we could do both. Now we’re prioritizing a value-add revenue stream.”

Once its planned software package moves through the development and beta stages, DealerSource.com will be back in the VC market this summer, and expects to close a series B deal upwards of $8 million.

DealerSource.com raised its first round of venture financing last May. Apex Venture Partners, Lunn Partners and Trident Capital came in with a $8.6 million equity commitment that allowed the company to build its infrastructure and develop a Web presence while also expanding its sales and marketing teams.

During its brief two-year existence, DealerSource has received an endorsement from the Business Technology Association, and created a captive audience with 1,800 users registered to its site, which was launched in October. But despite its accomplishments, the company’s business model wasn’t producing the revenue its founders and investors had predicted. Banking on the possibility of transforming its user base into a market for its other offerings, DealerSource.com shifted its attention to a more profitable side of the business – software development.

While the company met all its initial projections for registered users and completed online transactions, company management acknowledged the upside potential for a b-to-b exchange was limited. “Pressure came from cash management,” Reznikas says. “We had to reach profitability by a certain point and really manage cash flow.”

No One’s Immune

Amid the worsening macroeconomic conditions, it seems no company has been spared from painful layoffs or restructuring, from online marketplaces to software developers to online media.

Just a week after firing 25 of its 150 employees in order to realign strategy with market demands, Redwood, Calif.-based online photo service Shutterfly announced the close of a $23 million series C funding from Epoch Partners, Granite Ventures, Mitsubishi Corp. and Texas Instruments Ventures. Its existing investors, Adobe Ventures, Jim Clark and Mohr Davidow Ventures, also participated in the round.

Soliloquy, a provider of search technology connecting users with online information, services and products, laid off half its 40-person staff just weeks after securing a $4.5 million bridge financing from Genesys Angelbridge and Overbrook Management. After announcing the cutbacks, the New York-based company confirmed it was in the market for another $3 million to $5 million of venture funding.

Some companies have had to streamline costs as a condition of their venture financing. To be sure, there are some exceptions to the order in which the events happen. San Francisco-based online private equity marketplace OffRoad Capital eliminated one-third of its staff or 41 employees, soon after announcing a $6 million equity infusion led by Mayfield Fund, an existing backer of the company.

But there’s no question the pairing of layoffs with injections of venture capital has become increasingly popular. Christopher Kidd, managing director of Korn/Ferry International’s global private equity practice, attributes the trend to two problems: companies scaled-up too fast without identifying a large-enough market and investors took too many risks with early-stage companies.

Excited by new technologies and the perceived need to bring them to market quickly, investors poured money into young companies brimming with ideas, but lacking both experienced management teams and the proven ability to execute according to plan. Companies that doubled their R&D efforts and added a sales and marketing infrastructure soon flooded the market with technology. A glut of over capacity soon came to dominate certain markets, driving prices so low that few investors were able to recoup the billions they spent in scaling these new technologies.

“The market for technology is not materializing,” Kidd says. “It’s not to say that any of these products are bad, it’s just that they came in at a sufficient volume that they failed.”

The Next Example

UNext.com Inc.’s online learning platform for M.B.A. candidates, for example, never found a large enough market to realize a steady revenue stream. Founded in 1998 by junk bond king Michael Milken’s educational initiative, Knowledge Universe, and spun out soon after as its own entity, UNext.com hoped to leverage the prestige and intellectual property assets of its partners to develop an online marketplace for learning. (Although the company has never disclosed the names of its venture backers, one company source said it closed a $110 million series C deal last year. Milken’s Knowledge Universe maintains a 20% ownership stake in the company.)

With partnership agreements in place with business schools at Carnegie Mellon University, Columbia University, London School of Economics, Stanford University and the University of Chicago, Unext.com succeeded in lining up some of the biggest names in higher education. In exchange for developing Internet-based courses and learning materials, the schools would receive royalties based on their sales. And in some cases, those royalties could be converted into equity. Columbia Business School said UNext.com had guaranteed the school a minimum of $20 million over the next five years. UNext.com marketed its online course catalog – and the prestige of is partners – directly to multinational corporations like IBM Corp., which was the first to sign up. Eventually, UNext.com hoped to secure the accreditation needed to deliver an online M.B.A. degree.

However, in early February, the Deerfield, Ill.-based company said it was realigning its strategy to reflect the demands of the market. The reason: the company could not attract enough participants to justify the expense of developing online learning programs and shifted efforts away from degree-driven coursework to shorter, executive-level classes.

Even with a list of corporate clients like IBM, UNext.com’s catalog of offerings – priced between $380 and $500 – did not generate enough revenue to justify the $1 million it cost to develop a single online course.

“We determined that market demands were greater for [the shorter courses], so we shifted resources to concentrate activities to assist us in building the shorter courses,” says one company source.

At the same time, UNext.com announced a strategic partnership with The Thomson Corp., an information and electronic solutions provider to the financial, legal and medical communities based in Toronto. (Thomson Corp. is the ultimate parent of Venture Economics, publisher of Venture Capital Journal.) Through its strategic investment in UNext.com, the plan is for Thomson to bring significant new distribution and marketing channels to UNext.com’s professional development courses, and to license UNext.com’s learning administration systems and technology platform. Thomson will likely develop new content for UNext.com, and the two are expected to pursue joint ventures and strategic alliances.

But UNext’s retooling didn’t come without a cost. Along its restructuring path, UNext.com eliminated 52 of its 390 employees with layoffs across the board.

“For the first three years, we were just thinking about how to do this – educational research and infrastructure and how to deliver,” says the company source. “When that infrastructure was in place, we didn’t require that number of individuals to build out that infrastructure. We’re developing in other areas to build and support courses for our core audience.”

Market players note that a lot of these cases point back to the same fundamental problems. “The environment is not as fruitful as we thought it would be,” Korn/Ferry’s Kidd says. “We went through a period where we believed our own bullshit.”

Funding Frenzies

Over inflating the technology marketplace, however, is not the only factor driving the recent spate of realignments and layoffs. Venture capitalists may have taken too many risks by investing in early-stage companies. While the amount of venture capital available to start-ups has exploded in recent years, the number of VCs in the market hasn’t jumped accordingly. Thus, young companies eager to raise funds found a receptive audience, but VCs, arguably, spread themselves thin by taking on too many board seats and too many investments across too many industries. And in many cases, VCs didn’t take enough time to complete thorough due diligence before placing large equity bets on companies that had not developed mature business plans.

Caught in the fever of its own hype, The Motley Fool became almost schizophrenic in its pursuit of market share and distribution channels. Founded in 1993 as a monthly newsletter, the personal finance media network took hold on the Internet in 1994. After securing a partnership with America Online Inc. in 1996, the company began a period of rapid growth. By 2000, the company had already published four books, nationally syndicated both a radio show and a weekly newspaper column, spun off an online store as a wholly owned subsidiary and launched an international expansion into the U.K. Taken together, The Motley Fool’s content is estimated to reach 30 million people, said one source familiar with the situation.

But, like most media companies with a significant Web presence, revenue models were difficult to sustain. Consumers were unwilling to pay for content, while advertisers proved fickle. Two weeks after closing a $30 million series B round in January with investors Softbank Finance Group, AOL Time Warner Ventures, Maveron and Mayfield Fund, the company eliminated one-third of its staff, or 115 employees. Layoffs, said one source familiar with the situation, hit all staffers not contributing directly to the bottom line.

“[The company] was making record traffic numbers, but what the traffic numbers don’t show is that [the company] is not making what it used to make. You have to have profits,” the source explains.

Both the company’s focus and management team had become diluted. Since the appointment of Pat Garner as chief executive last May, the company had been looking for ways to streamline its operations and turn money-losing business initiatives around. It shut down a German unit and concentrated energies in its profit-making online seminars and personal finance decision centers. Although it will continue to build its brand across mediums, The Motley Fool will center its energies over the next several months toward creating profitable distribution channels that mimic the partnerships it currently maintains with Ameritrade Holding Corp. and Fidelity Investments.

Lessons Learned

After the roller coaster ride of the past year, VCs and their portfolio companies are working hard to ensure they do not get burned again. VCs are making safer investments, or later-stage investments completed after a long cycle of due diligence, while their portfolio companies are getting themselves in top shape before seeking more venture backing.

“Venture capitalists will be taking the time to do things they should have done over the last four years – spending more time with companies, being more engaged at the board level, ” Kidd says.

Despite the stream of layoffs and the pressure to reach profitability, young companies have not abandoned their search for venture funding. After fine-tuning their business plans and avoiding the pitfalls of their predecessors, private companies may be able to find some more equity – albeit at lower valuations.

“There’s still a lot of money in the venture capital marketplace,” Kidd says. “Venture capitalists have to be investing that money. They just can’t sit on it.”

But going forward, the question remains whether cost-cutting and retooling are enough to get some of these companies over the profitability hump.