Remember when the entrepreneurs who couldn't get venture
capital funding were the unfortunates, the wallflowers, forced to
sit on the sidelines and envy those with VC partners? Well, if you
were one of those wallflowers, now might be your time to gloat.
Playing with VCs is not the fun it used to be. The once enviable
deals have increasingly devolved into ugly wars over tougher terms
and lower valuations, with entrepreneurs caught between prior
investors and opportunistic new "vulture capital"
partners. On one side are the VCs who have already invested
substantial cash in a given company; they had expected to exit the
deal many months ago, but, because of the nonexistent IPO market
and the sluggish M&A environment, they have no immediate hopes
for liquidity. Now they are either unwilling or unable to sink more
cash into the venture, which likely needs another capital infusion
to survive the dismal economic climate.
Consequently, companies are forced to seek funds from other VCs.
But the new investors are drastically reducing old valuations and
demanding exceedingly harsh terms. "It's a buyer's
market right now," says Dan Primack, editor-at-large for
Venture Economics, a Thompson Financial subsidiary that monitors
the venture capital industry. "The VCs completely control this
thing."
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They're insisting on returns of two to three times the
amount they put in-or more-before management and other shareholders
see a personal return on the investment. "That [puts]
management and common owners down the line," says Scott
Ungerer, founder and managing director of VC firm Enertech Capital
in Wayne, Pennsylvania.
One way to remedy the situation is by arranging "sidebar
agreements" between management and the investors, which say
the management team will start getting bonuses after the first
liquidation preferences are paid out. It's to the VC's
benefit to make sure those running the firm are rewarded. "If
management isn't motivated, who is?" Ungerer says.
But, logic notwithstanding, VCs are adding perks for themselves
that make deals less attractive for founders. One is the
"participating preferred" agreement-previously not
uncommon but fast becoming standard-which gives the VC an ownership
stake in the company, plus priority in recovering their original
investment. In some cases, VCs are also winning more control over
management, capping salaries and predetermining whether the company
can seek additional funding at a later stage.
For small companies, the drop in valuation is the hardest pill
to swallow. Where once upon a time it was only those companies with
no product revenue, little expense history and an incomplete
management team that had to worry about lower valuations, these
days, even companies with established products and revenue are
seeing values drop by 50 to 60 percent. That's bad news for
those who already have a stake in the company.
And not all investors will take that lying down. When online
wine retailer Wine.com (formerly eVineyard Inc.) was facing
bankruptcy and seeking more capital earlier this year, tensions ran
high between Chris Kitze, a serial entrepreneur and major investor
in Wine.com who had begun personally bankrolling the company when
its funds were depleted, and many of the company's 60 or so
investors. The VCs who had plunked down cash in the 2000 round were
furious over the prospect of a new round of funding and a new
valuation of $2 million. But they also refused to cough up more
money to protect their investment and threatened to sue the company
if it didn't go bankrupt. "They were waiting to the last
second to see if we would agree to these ridiculous terms,"
says CEO Peter Ekman, 40. "It was the ultimate vulture
behavior." Eventually, Kitze convinced them that his offer of
5 cents on the dollar was better than the zero they would have
gotten in bankruptcy.
But the experience was grueling-and convinced Kitze the company
was better off without VC involvement. None of the investors in the
July round of financing, which raised $9 million for Wine.com, were
VCs. "If you are an entrepreneur and had the misfortune of
taking their money, you're an expendable piece of
Kleenex," he says.
Avoiding new VC investment may not be a bad idea, at least until
the IPO market returns to full health and offers VCs more
liquidity. For now, in the current harsh environment, entrepreneurs
in search of VCs will still have to do their due diligence whether
the price of capital is worth the sacrifice.
C.J. Prince is executive editor of CEO Magazine. She
can be reached at jprince@chiefexecutive.net.
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