John Barry, managing general partner of Prospect Street Ventures, recently lost a few promising Internet deals just because he couldn’t snag the hot companies quickly enough. Sprout Group’s Patrick Boroian, who reviews information technology companies, occasionally finds himself running into the same problem.
It’s been almost three years since VCs got swept up in the whirlwind of high-tech deals, and amazingly enough the mad rush is still on. Competition to discover and close transactions in this sector – which includes Internet/new media, intranet, IT and wireless telecommunications – remains so intense that venture capitalists must continue to devise aggressive business strategies to stay in the game.
Gone are the days when a venture capitalist focused on IT could leisurely review the pros and cons of prospective business plans, sometimes taking several months to plow through the detailed due diligence process. Now, VCs who cannot wrap up decision-making in a few weeks are almost sure to lose those opportunities to an investor who can.
The pressure is due to numerous success stories generated by the technology sector, and fabulous returns have surrounded these deals with an electric buzz. IT entrepreneurs, in turn, can demand higher valuations and quicker responses to their requests for cash.
Exodus Communications, Inc., eBay Inc. and Inktomi Corp. – last year’s three largest venture-backed IPOs – are all witnesses to the enormous financial gains these businesses can bring. Meanwhile, the Nasdaq composite index, home to the market’s hottest technology stocks, had one of its best years in 1998, thanks in part to the large number of Internet stocks. And the continued market performance of giants such as Yahoo!, Netscape and Amazon.com has only added to the ongoing exuberance.
Life in the Fast Lane
These days, deals must close in as little as several weeks, leaving VCs scrambling to devise comprehensive term sheets and to finalize due diligence in about half the time it previously took.
“Things happen quickly [in] Internet Land,” says Mr. Barry, who invests $3 million to $5 million in seed- to late-stage IT and media companies. “When you invest in a fast moving, dynamic sector like the Internet you will discover that the accelerating pace of change – where an Internet year is one week – is going to require you to move much more quickly in every aspect of your investment process. Whatever it is you were doing, you have a lot less time than you used to … or you’re going to be shut out of that market.”
Mr. Barry’s most recent lesson in being shut out came in the form of an Internet company that his New York-based firm was keen on backing. The business, which he declines to name, had promised to send a placement memorandum, but it never arrived. By the time Prospect, which averages 60 to 90 days to wrap a deal, followed up, it was too late – the transaction had closed without them.
“In a normal marketplace, the [company] would have been all over us,” says Mr. Barry, who closed five Internet transactions in 1998. “But with a good Internet company in this marketplace, you’ll have more investors than you have seats at the table.”
The competition for technology deals is so intense that some venture capitalists on the outside looking in are relieved to be mere spectators rather than participants in what they consider a lion’s den.
“It’s all scary,” says David Coit, president of North Atlantic Capital Corp., a later-stage investor in business-to-business manufacturing, electronic and health-care companies. “I’m glad we’re not in that market because you’re making decisions without having as much time to consider the due diligence, and you may have to pay a higher price than you otherwise might have wanted.”
Most venture capitalists admit the technology frenzy can lead to poor investment practices. Pressure to act quickly can translate into rushing through or even eliminating key steps in the deal process, which involve reviewing intricate details about a company, entering into discussions with its management team, developing a term sheet and conducting extensive due diligence.
“Our friends down in Silicon Valley, when they’re working on Internet deals, they’re kind of crazy,” says Alan Frazier, managing general partner of the Seattle-based Frazier & Co., investors in health-care companies at all stages of development. “There’s a huge pressure to commit early.”
Committing early can mean that some venture capitalists, for example, bypass checking a potential portfolio company’s references – customers, competitors and suppliers – and even short-change a thorough industry analysis, Mr. Barry says. However, VCs say if they can’t adequately fulfill their fiduciary duties to their limited partners, then the deal usually is abandoned.
“It may be the greatest [company] in the world, but if we can’t document and do our homework, we’re just not going to get there,” says Mr. Boroian, whose firm invests $3 million to $50 million in IT and health care companies across the United States at all stages of development. “In the end it takes nine months to make a baby, and it takes two to four months to close a deal.”
Putting It in Writing
At the same time competition is speeding up the deal-closing pace, other necessary considerations, such as term sheet negotiations, are taking longer than they have in the past (VCJ, October, page 38). Some VCs say their terms have remained relatively unchanged, while others say that they have become increasingly complicated, particularly in areas where investors feel a need for more protection.
Medical device companies, for example, have a history of poor returns, so VCs are driving harder terms ranging from demands for regulatory approval to stronger liquidation preferences. New technology companies also tend to have more complicated terms because they raise new questions, such as who controls intellectual property rights and licensing agreements.
“That slows things down because every part [of a term sheet] is a moving part, and if you try to insert a new moving part in it, you’ve got to move all the other parts around and make them fit together,” says Geoffrey Etherington, a lawyer in Edwards & Angell’s venture capital and emerging companies group.
Term sheets bind parties to negotiated rules of conduct and specific quid pro quos (VCJ, October 1998, page 38); the more complicated the terms, the longer it takes to close a deal, Mr. Etherington says.
Due to time constraints, a growing number of technology VCs have reversed their normal practice and submit term sheets prior to “having done very little, if any, due diligence,” Mr. Boroian says. Included in the document, however, is a company’s estimated valuation and a 60-to-90 day deadline to close the transaction, provided that the venture firm is satisfied with the outcome of its due diligence. Doing so puts an eager entrepreneur at ease and protects the VC from doing needless work by locking the parties into an exclusive agreement.
In order to move faster, more venture firms are conducting management risk investigations earlier in the due diligence process in the hope of uncovering any criminal records, sexual harassment claims, fiduciary instability or bankruptcy claims that might potentially derail the deal.
Less than 10% of some 200 annual management investigations his firm has conducted have actually killed a deal, says Kenneth Springer, president of Corporate Resolutions Inc., a licensed private investigating firm that conducts background checks. Mr. Springer says venture firms want answers to their questions in two weeks or less, compared to the two-to-six week grace period of the past. There are even firms that ask for updates in a week because of an imminent closing.
Competition Breeds New Business Strategies
Overall, venture capitalists say they are most comfortable receiving business plans from trusted friends or outside associates, who essentially provide an initial screening process. Recommendations are crucial because no matter how detailed the terms, the “biggest part of the equation is investing in a good company,” Mr. Barry says. “The more mature the company, the faster the closing.”
For instance, Prospect set a record for itself when it closed in six weeks on Multex Inc., a provider of securities research on the Internet, based on prior knowledge of the company’s business model and its management team. Multex was introduced to Mr. Barry by long-time friends Milton Pappas of Euclid Partners Corp. and Russell Pyne of Atrium Capital Corp., and Prospect’s investment team felt confident enough to proceed rapidly in wrapping the deal.
Side-by-Side With Angels
With entrepreneurs increasingly looking to angels for seed money, VCs have had to devise innovative ways to live with – and often compete with – the wealthy individual investors. Angels, former entrepreneurs who typically invest a few hundred thousand dollars in a fledging enterprise, use their wealth and advise to help build new companies.
Entrepreneurs are drawn to angels because they make quicker investment decisions than VC firms and often are willing to pay higher valuations. Organized networks of angels can invest as much as several million dollars, putting them in direct competition with traditional venture capitalists.
As a result, a number of VCs, including Russell Planitzer of Lazard Technology Partners, are investing side-by-side with angels, who usually provide a first round of financing and move on to fund another business rather than stick around for the life of a company.
“The combination of angels investing side-by-side with venture capitalists is a great one because they both add a lot of value, and they both get adequate returns for the time they put into a project,” Mr. Planitzer says.
As the former head of ComputerVision Inc., a computer-aided design company, Mr. Planitzer has developed a close working relationship with angels who were once fellow CEOs.
Boston-based MCK Communications Inc. is a recent Lazard success story involving a side-by-side investment with an angel who invested a few hundred thousand dollars, Mr. Planitzer says. The company, which received financing eight months ago, plans to bring in $15 million in revenue this year, he says.
One of the ways Mr. Barry decided to cope with the fast pace of technology transactions was to buy out his seven venture partners at Prospect about a year ago to solely focus on IT investments (VCJ, January, page 5.) The move has eliminated a layer of bureaucracy that, he says, has allowed for rapid decision making.
“As accelerating innovation and technological change transform the industries that we invest in, so changes in those industries are changing the way we invest,” he says.
At the same time, other venture firms have been forced to readjust their business strategies. North Atlantic, for example, a backer of business-to-business and Internet service companies, now prices its deals less aggressively and chases higher-risk deals, Mr. Coit says, because it is faced with severe competition from lending institutions, which are extending more financing to later-stage companies. North Atlantic, created 13 years ago, needs about two to three months to close a deal.