Venture Capital Journal invited business leaders and entrepreneurs to discuss the current state of private equity fund raising in this difficult environment. The panel included freshly minted entrepreneurs and savvy veterans.
The panel featured:
Carolyn Chin, CEO of Cebiz!, a consulting firm specializing in the development and deployment of leading edge e-business and e-commerce strategies;
Halim Habiby, president and founder; and Bill Hurley, CEO, of Specdex, which provides software that lowers the cost of sale and boosts bottom-line profits for distribution;
Damir Perge, CEO of Futuredex and a serial entrepreneur;
Kenneth Bob, CEO of Safewww Inc., an international company that provides identity protection products and services, using patent pending third party user authentication and content encryption technology, for business and personal Internet transactions;
Bob Hornsby, co-founder/president of Slingshot Solutions, a business service provider, that has developed a patent-pending inventory disposition technology for large multi-channel retailers and asset recovery specialists;
Joseph Dooley, president, Dooley Associates, a consulting firm that helps entrepreneurs obtain financing and provides consulting work;
Bill Nesmith, director and national sales manager of Chapman, Spira & Carson, LLC, investment bank consultants that work with companies on financing, issues.
Ken Ryan, editor-in-chief of Venture Economics, moderated the roundtable, which took place Dec. 11. Following is an edited transcript.
VCJ: How does today’s difficult fund-raising climate compare with previous downturns in the market?
Carolyn Chin: I think [today] is a really very bad period. I was embarking on raising funds for two companies and it was June 2001. We had just gone through the tech wreck. So, the traditional VCs were either in shock, crying or running away or just figuring out what to do with their portfolio. The angel investors had gotten their portfolios clobbered, and then it was summer and people were looking to go on vacation as fast as possible. So, it was a very hard time to raise money. Just as we thought it was safe to get back into the water again, and the VC was thinking about coming back, we had September 11th. In fact, in one case we had a wonderful deal ? it took us a long time to do it ? we had gone through 200 hundred prospects before getting the deal and the accountants and the lawyers were in the World Trade Center. The world stopped for a while. You just couldn’t get a deal going. So, I think this has been the worst environment I’ve ever seen to get funding.
VCJ: Do you see any signs of the situation improving?
Chin: Yes, I do see things improving because life does go on. I was one of the ones that was buying in the market meltdown 1987 and knew that those were some of the best investments I made then. I think there’s an analogous situation now in terms of firms.
Damir Perge: The funding climate is going to be tight next year. The VCs have been hammered; they’re cleaning up their portfolios. And the angels have been hammered due to their investments. Right now there’s this huge gap between angel investing and VC investing. It’s like the value chain for investing has been broken. And it’s going to take time for it to repair. And so, you’ve got very few people right now that are actually interested in their early stage investing and some of the deals that we’ve seen would blow you away. You go, huh? I can’t believe these companies cannot get funded. It’s mind-boggling.
Halim Habiby: Can you give an example?
Perge: Quantum Vision, for example, has very solid technology. It’s a cathode tube where it goes into large projection televisions. So, it can create HDTV-type of technology at a much lower cost. Mitsubishi is knocking on their door, they’ve got everybody lined up, and they’ve got patents out the kazoo. I mean, like a gazillion of them; right? They were funded for about $5 million, $6 million, something like that, and they couldn’t get that next round. And so, what they needed was a million dollars to get to the production level. And by getting to the production level the customers would finance the next stage. This is a no-brainer, but they could not get it because the market’s contracted.
Besides all these different issues is that the B-to-B sector, is not sexy anymore. Well, guess what? B-to-B is not going away. Hello. I mean, we’re all going to live on the Internet still. But once you get tarnished in a certain sector, what happens is the investor community goes away. And then you’ve got to struggle and you’ve got to turn every corner to get the money.
Joseph Dooley: I’ve also noticed that a lot of the clients that come to me have not adjusted to the reality; where they’re still thinking in a 1999 mode and they don’t understand that just because they have a good idea doesn’t mean that they’re going to get funded. So, a lot of them approach investors with the attitude where all you need to do is see my product or listen to my idea and, of course, I’ll be funded. And that’s not the case. So, a lot of them, I find, really need to approach investors as though it’s a marketing campaign for a new product and really have to think in that perspective; that I have to sell this investor on the idea. I can no longer just present a business plan and it will be funded.
Kenneth Bob: I would add two things, actually. One is, one type of investment that hasn’t been touched upon is corporate investment, which became extremely popular, especially when the technology company has their own funds. And even though we were successful in getting strategic money, the fact is that I went to a number of those groups where we had great synergy. And one that will remain nameless, the head of corporate development said to me, “we’re not smart enough to invest in early-stage companies.”
Perge: Let me second that.
Bob: So, we have a situation where these companies are scaling back their investments because they’re not adding to their bottom line. And so, the publicly traded companies, their investors are anxious about their trip into the dotcom world itself. So, I think that’s a problem; you know, that the whole set of money is no longer on the table.
Chin: A lot of the problem is that there’s a lemming effect. But the truth is that investors have tended to go in crowds. A lot of them got burnt, but this is a time for some leadership and there are great opportunities for those that are willing to show some leadership.
Perge: You asked me, what sector do I focus on and I said I focus only on one sector, the ROI sector. Because I realize all my life I was going the opposite direction. So, I don’t like the herd effect I’ve seen. The bottom line is that even in B-to-B space, whatever the sector, there are still attractive companies but people leave those sectors because they are not sexy enough.
VCJ: For those who have received funding, can you explain the pressure to be profitable or launching a product?
Bob: I was never part of one of those companies that didn’t have to make money or didn’t have to be profitable. I missed those couple of years somehow. I don’t know what happened.
Perge: We all missed it.
Bob: Some people were there, guys. Some people have some incredible wealth out of it.
In all seriousness I think there’s enormous pressure on revenue and on profitability because it used to be when you go to a round the investors would say, ‘And when do you expect to raise money again? When are you going to need money again?’ And now with the same type of investors they all said, ‘why don’t we be a clash flow positive?’ And the right answer was to say a certain date; not, well, ‘we’re going to raise money again in 18 months.’ Absolutely, there is enormous pressure to get to cash flow positive and then raise money because you want to expand, not because you need it for cash flow.
Chin: Almost everybody wants to know when will you get to cash flow positive now. That’s true. On the other hand, one of the things I ran across, is a really strange dichotomy. We had some [investors] that only wanted to put in a few million dollars and then they would want us to get to cash flow positive and they wanted you to focus, focus, focus, and slim down. Then you have the other grand play ones that want to give you $25 million. If it’s too focused, it’s not a big enough play. So, you’re standing there trying to explain to employees while you’re trying to straddle all this because you don’t know which one’s going to give you money.
Bob: Right. And you want to make sure you e-mail the right business plan to the right one.
Perge: Two different versions.
Chin: Right. All things being equal ? and I always believe in substance ? is the right spin will win. And I’m always amazed at how many people that are seeking money really cannot explain what their business is, what is the value proposition, what is the competitive advantage and what are they going to do with the money. So, I mean, it doesn’t have to be a long story, just a good story. And it has to be something very, very crisp. And the marketing sales element is really, really crucial.
Perge: In the old days you could go in as a 25-year-old kid and you could get funded five million bucks or more. Not anymore. The gray hairs are definitely back. You definitely need gray hairs. You’re not going to get funded unless you have gray hairs, and that’s a cold, hard fact. The old days of funding a web savvy dude and not even talking to the gray hairs are over. The role reversed overnight. [Investors] don’t even want to talk to you now if you don’t have a gray hair on your team, which is the way it should be.
Bill Nesmith: The days of sandals and Bermuda shorts are over. Put on a suit, boys. I mean, you’re going to come into our office and ask for $5 million, $20 million and you have a pair of shorts on and a pair of sandals? When I first started in the industry 20 years ago it was “buy the jockey.” It sounds a little contrite but, you know, buy the jockey before you buy the horse. And we are seeing a lot of companies right now with seasoned management and these guys are getting the most attention. They’ve got the track record. They go in and they say, ‘yeah, I was from Iomega. I created Iomega, I did this for the company, I brought it from zero to $500 million in sales.’ You see management that doesn’t know how to approach Wall Street and doesn’t know how to approach the VCs. They’re all wrapped up in their own little world, which we found in biotechnology and scientists and scientific advisory boards. They walk into our office with all these great ideas and inventions and the first thing we say is: ‘Where’s your intellectual property? You want to be unique in this marketplace? You know, go into the B-to-B marketplace, which is overcrowded, tipping over, top heavy, what’s makes you unique? Well, intellectual property. We can bet on that. We can finance intellectual property.
Dooley: As a corollary to that, since I deal mostly with IT and biotech companies, I found the same thing where a lot of the people starting these companies are so enamored with the technology that they lose sight and can’t articulate it to the common man. I find a lot of entrepreneurs now ? and it goes back to what I was saying before with some of them being stuck in ’99 ? where they can just throw the idea on the table and they’re going to get funded. They really have to work harder in getting that structure, that message, in a way that resonates clearly. A lot of investing is emotional. And any good marketer knows that you play on emotion.
Nesmith: That’s all we’re turning into is a marketing team. We’re branding. We’re doing everything.
Perge: The thing is, I get hit up all day long. I mean, literally all day long now because the word’s out that there’s a crazy entrepreneur funding entrepreneurs, because I’m not a VC. But the one thing I have is what I call the dot-bubble index. Is that person living in a dot bubble? I’m amazed that even today, it’s just mind-boggling how many entrepreneurs still live in 1999.
VCJ: Do you still see that?
Perge: Absolutely. Despite all the conditions, the recession in Japan, Germany, United States, the world economy, the September 11th tragedy and so on, it’s still mind-boggling to me. People with salaries like $200,000 and they’re in Series A. It’s really hard to talk to me like this because the first 20 months I never got paid. My recommendation to entrepreneurs who want to get funded? It’s really simple. You have to think in terms of the investor. So, don’t come to him with a $15 million, $20 million pre-valuation right now. Because you know what? Those billion-dollar-plays, they’re not going to happen. Put yourself in the investor’s shoes. I know that’s such a simple basic statement, but I can tell you, 95% of the entrepreneurs don’t do it. Even today, despite the hard conditions.
Chin: People are so insular that they haven’t realized that this is different than 1999 and you wonder how they can be successful. If you don’t have enough common sense to figure out how to ask for money, then how are they going to succeed?
Dooley: I meet entrepreneurs and they come to me saying they’re looking for investors. I ask them, what problem are you solving? I met a VC the other day that had a great line. He says when he talks to entrepreneurs, he says don’t come to me with vitamins, come to me with aspirin. Identify a problem and provide the solution. And I love that line because I think it just encapsulates everything investors are looking for. And a lot of entrepreneurs, again, are so enamored with the technology whether it is delivering video or 3G networks to a handset, my question is; why do we need that? Why do I need video on my telephone? What’s the value proposition? What problem are you solving?
Perge: Well, investors are very skeptical. You come to them with these five-year hundred-million-dollar projections, please. Advice to entrepreneurs: Don’t put down $100 million revenue projections in five years. You will be laughed out of the office. And this thing about having beta customers. Guess what? They’re not interested. They want paying customers. Anybody can get beta. How do you convert a beta into a paying customer? If you can’t convert that, you don’t have business.
Chin: I would say certainly for KindMark things looked up a lot when we started getting customers like AT&T, Clorox. It helps a lot to have paying customers and it gives you enormous credibility.
VCJ: When approaching VCs, what do the entrepreneurs have to sacrifice in terms of, say, ownership in order to get funded? What are some of the things you’ve seen out there?
Bob: I think this is a big issue and I’m sure this is what the other entrepreneurs have to say who are at the table here. This is always one of the big topics, even years ago, that entrepreneurs have to be prepared to give up ownership of their baby if they want to bring in partners, i.e. financial investors. I think what’s happening now because of what was said earlier about down-rounds or, you know, minimal evaluations for start-ups is that it’s a real shock. And again, going back to the 1999 metaphor that was mentioned earlier: I know personally I had to work with our founders. As I said earlier, I’m not actually a founder of the company and I had to walk them through the funding process and explain that the dilution was going to be pretty significant. So, I think this is something that entrepreneurs have to
face that this is the situation of today. And unfortunately they read too many books about the dotcom start-ups and how much percentage people held when they got the IPO. Those days are simply gone, I think ? because in the earlier rounds of funding they’re asking for much more to get going.
Chin: It’s always a problem with founders. Founders, particularly with this last bubble, always think they should get more and that they should get a lot. The problem is founders always have to get diluted because you need the money. I think one of the ways we dealt with it is to be pretty simplistic. To say, listen: either we get diluted or we die. It’s just a realty.
Bob: It’s the truth.
VCJ: Bob [Hornsby], as a co-founder, what’s your experience?
Hornsby: After several months of looking for venture capital money in our very early stages about a year ago, we sort of turned our back on venture money and decided that strategic investment, strategic partnership was the way to go. I think our frustration was perhaps driven a little bit by a leftover sense of entitlement from having seen what happened in ’98, ’99. But part of it, too, was due to the fact that we felt like the venture investors, as things got worse and worse in the economy, the target would continue to move as to where you as a start-up company had to be in order to even ? forget about talking about valuation, forget about getting to the point of a term sheet, get in the door and get an audience.
We’re considering going back out and looking for money again. It’s something we haven’t really done in a year. Where we are now had we walked in the door a year ago would have been good enough. Now, you don’t know. You just don’t know. Even though you’ve got traction, even though you’ve got a significant strategic partner, if your sales cycle is longer than you anticipated with some of your clients, there’s tremendous amount of skepticism about your ability to deliver going forward. And so, it’s a difficult path to go down, but a necessary path.
With the exception of a very few industries it’s hard to find institutional money that really understands your business. If they invest in you, they’re going to invest either because they know you or they’ve seen you build a company before or they know about you and they know about you having built Iomega before.
Because we remain a young management team, that’s going to be a big strike against us when we try to get in the door with institutional investors. I don’t like having to give up a piece of the company. We sold a minority share in the company to the strategic partner that were working with, a significant minority stake, and that hurt. And you think about doing it again and losing control at some point. And it’s tough to sort of balance your pride of ownership against the necessary direction for the company. It can be difficult to hear assessments of one’s company and one’s strategic role in an industry from financial players who one might argue have most recently shown a propensity to make a lot of mistakes rather than have a tremendous amount of wisdom about how to invest.
Habiby: We’ve only been through one round of equity financing. So we never had to test whether we’d get an up round or a down round. However, as we spoke to venture capitalists and various investors over the summer, it was fairly clear that it wasn’t going to be an up round and at best, that we might be able to maintain the level we were at prior. And that’s after having achieved multiple milestones. But we never really found out because we never raised that second equity round or we haven’t yet. Now, one of the things we’re doing to raise our valuation and, in fact, to secure bank financing is ? part of it’s the intellectual property. Another part of it is acquiring a company.
Hurley: I have a friend who is a venture capitalist. He had worked for First Chicago, Bridges. He was very instrumental in some start-ups that made lots of money. So, I went to him for some advice before I really got involved with Specdex and his advice to me when approaching venture capitalists is this: VCs are normally very nervous about the deals because even though they may look good on the surface, you have to make sure you understand the management team completely, because that’s really what you’re investing in. And the other thing is that valuations are really what two people agree on. What he told me was having been with a major bank and their investment division for several years is that in these start-ups, about seven out of the 10 deals go bad. So, I’m looking for the one that pays off those seven and hopefully I pick up another one somewhere along the line. But if you have a good idea, if you have a good management team, then valuations can be whatever you agree to.
Dooley: I would be interested in hearing from the entrepreneurs if you knew the rules of the game when you first started. [For instance] like what a full-ratchet anti-dilution clause is and what 5x liquidation preferences mean, and participating preferred stock and the ramifications of a down-round which, in 1999, the term wasn’t used. But now that a down round could lead to quite a dilution, I wonder how many entrepreneurs really understand when they signed that agreement that they have a down-round when they thought they owned 30% percent of the company. After the day is over they might end up owning 5%.
Bob: There are rules of the game and they’re different than in other parts of the business world. People who get involved, even the gray hairs that are involved in the business world, don’t necessarily know the venture-financing world. And so, ratchets and 2x, 3x, preferential dilution, all those things, people are not familiar with it.
Perge: I felt the pain of having a down round. I felt the pain of giving too much of a company. Even when you talk about valuations, it’s a very emotional, extremely emotional excruciating process. And so, when I went through these processes I said, okay, I don’t want to give away too much of my company and which even today I try not to do. Then one day this year I got lucky and I raised $32 million and then started thinking about it from the investor’s standpoint. And there’s always going to be this struggle and balance between entrepreneur and investor. If I were your investor, I would look at myself as going on a journey with you. Because at the end of day what happens is there’s too many investors that have weak stomachs, especially in the early stage.
Chin: There are a lot of vultures out there that really are trying to take advantage of the situation as opposed to seeing this as an opportunity. They humble you, and they try to either get the valuations down to a point where it’s, you know, it’s really unfair. Or they try to put all kinds of contracts on you, consulting arrangements, all kinds of things or they put constraints on you that will really render you impossible to succeed. I think that we need to start moving back to a model where you have investors that are really partners, with the entrepreneurs as opposed to thinking they’re on some hill somewhere and they just do proclamations.
VCJ: Are the VCs less accessible than they were a year ago?
Chin: Some of these famous VCs that you normally would not see are starting to get more active and more hands-on again. But I think having an investor that works with you is just really a Godsend.
Perge: Investors want to see Ken succeed, I want to see Bob succeed, I want to see Bill succeed. We want it to succeed. It really still is mind-boggling to me to see the struggle, especially in today’s environment. But you know what? When you start seeing the paycheck come in, you start seeing the marketing budget paid, you start seeing the product development paid, you know what I do? I say thank you, God, for the investors. Especially in today’s environment.
VCJ: In this economy, has your exit strategy changed?
Bob: I believe in liquidity strategy. I believe that the term exit strategy ultimately gives a bad name to what we do. I’m not going anywhere. I accept that investors deserve liquidity. I think companies have to be built to last. And the notion “exit” means that it’s going somewhere. For me personally nothing has changed. The fact that the IPO market is a little bit slower now doesn’t affect me.
Hornsby: Success for me is getting the company to a stage where we are profitable. And we do that by getting more customers to buy into our solution. If you’re successful, your investors are going to find a way to get their return. We have one investor, every time we do business together, they’re getting part of their return. Two years ago I might have thought, ‘Wow, maybe we’ll go public some day.’ And now, the thought is what’s the way to profitability. And it has a lot more to do with spending extra hours talking to customers than investors. That introduces a different kind of exit strategy incentive.
Chin: The goal at one time, not too long ago, was just to go to IPO. The world has changed. Now its back to basics.
Habiby: That’s correct, but the other part is from an investor perspective. As an entrepreneur, how are you going to get funded unless you state [an exit] as your goal? Now, that’s no longer the case today, obviously. I am here today because I have a vision and Bill has a vision and we have a company that’s going to succeed no matter what and that we’re going to stick with it no matter what. And it’s not because of the money and it’s not because of the valuation and it’s not because we’re going to go public or we’re going to get acquired. One of those will happen and we’re going to be with it in the long run. There is also an expectation from the investor standpoint of some sort of liquidity event taking place and maybe Bill Nesmith can elaborate on that. And that some expectations have actually contracted whereas prior, in the last few years, there was an expectation that we’re going to be in this for three, four, five years, and see our company go public. Well, right now, where’s the expectation?
Nesmith: Everybody’s looking for something when you make an investment and it’s not living with a company for 15 years. If you’re running a portfolio, you have to show a gain somewhere and you have to show your investors some kind of return. If you’re running funds and you’re running other people’s money, you’re at the mercy of how you do at year-end. Your P&L is always scrutinized by your performance and people will throw money at you to invest at the end of the year if you’ve done well. So, some people have to cash in on their investment once in a while, which is what makes Wall Street such a wonderful place.
There is so much accumulation of wealth in this country at this time because of that fact. Now, advising companies to find an exit strategy by going public now is totally ludicrous and it’s not going to happen. Companies that have been public are now trading ? one time they had valuations of $500 million and now are trading at $2 million. You can buy public companies for pennies on the dollar if you want a public vehicle, which a lot of people are heading in that direction. The guys who are demanding liquidity now and an exit strategy are guys who should be in public stocks. It’s as simple as that. I don’t trust investors who come to me and say, I want a public company, and I’ll do a pipe. And then they turn around, they short your stock, and wreak havoc. It doesn’t make sense in this day and age.