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Venture capitalists increase scrutiny on start-up deals amid stock market anxiety

On the fundraising trail this month, entrepreneur Jason Fritton is getting an unusual question from venture capitalists: How soon can you produce profits?

Making money quickly was rarely a demand during a near-record influx of start-up capital, with investment into U.S. start-ups rising to almost $60 billion last year from $30 billion in 2013. Fast-growing companies such as Uber Technologies Inc. and Snapchat Inc. saw their bank accounts generously stocked as they prioritized rapid worldwide expansion over profits.

Desire for fast growth hasn’t fallen. But as mounting concerns about slowing global spending hammer U.S. stocks, investors are demanding lower prices for shares in early-stage companies. And before agreeing to invest, they’re eager to see a start-up’s back-up financial plans, spooked that economic conditions could worsen.

“With all this volatility, you have to be able to assure investors how you’re not only going to show explosive growth, but also be on a predictable and clear path to profitability,” Fritton, 40, said on the eve of investor meetings in New York City. “They want to know you can survive.”

Hundreds of start-ups, from those just founded to more established ones, are feeling the heat. They’re entering an extra-worrisome fundraising period as investors return to a level of scrutiny not seen in at least three years.

Chris Hollod, venture capital partner for billionaire Ron Burkle’s Yucaipa Cos., pointed to a couple of signs that most entrepreneurs are facing colder receptions: Two start-ups nervous about fundraising prospects recently sold to larger companies, where founders got stable gigs, and more entrepreneurs are telling him that share pricing is “negotiable.”

Other entrepreneurs have lengthened negotiating windows. A year ago, founders would demand quick offers, pleading in emails “hurry up, hurry up,” Hollod said. Last month, he told about 10 people that he’d follow up in February. The typical reply back: “Sounds good.”

Fritton, chief executive of alternative lender Patch of Land, remains confident things will work out. He said his investor presentation, which helped him get $25 million over the last two-plus years, needed only minor tweaks to address the recent economic issues.

Patch of Land’s online service allows real estate developers to get cash from thousands of individual investors and big funds. The company had 550% more projects listed in 2015 compared with 2014.

But skepticism has grown about alternative lenders. Shares of similar services Lending Club and OnDeck Capital sank below $10 after debuting on Wall Street at around $25 in December 2014. Another company, LoanDepot, canceled plans to go public in November.

Others have done the same, content for now to wait until things stabilize: January was the first month without an IPO since September 2011, signaling a lack of confidence about the stock market.

When stock market prices drop, start-up investors get cautious about dealmaking because they often rely on big gains in initial public offerings to generate returns, which they then turn around to invest in more start-ups.

That has put pressure on start-up shares. The average price for venture investments hit a two-year low in the December quarter, plummeting 60% from the three months before, according to Dow Jones VentureSource.

“It’s definitely made things harder, but we have an enormous amount of interest from investors,” Fritton said.

There’s hope that stock market turmoil is temporary. So Fritton is emphasizing to venture capitalists and corporate investors that Patch of Land can stay private for a while and do it mostly off profit reinvestment rather than additional outside capital.

“When we first started, ‘profitable’ was a bad thing for a VC because that meant you weren't growing enough,” he said. “We had a couple of months of cash-flow positive, and I couldn’t bring that up. Now, it’s one of the first things I mention.”

A long list of repeat users shows the company can grow substantially simply by deepening existing relationships, he said.

Still, he could use a big cash infusion to bring the company’s services to more states in the U.S. and improve software. Fritton also wants a 10,000-square-foot office, up from 3,500 square feet now in West Los Angeles.

Start-ups still searching for users have returned to more cautious fundraising expectations. Spective Inc. is seeking up to $1 million at a $3.5-million valuation. Co-founders said they purposely set a more reasonable valuation than the recent $7-million norm for start-ups at a similar age.

“We’d rather offer compelling value than going pie in the sky,” said Chief Executive Todd Kurihara, 34.

The downtown Los Angeles company’s online service lets individuals and groups design sunglasses with words or art on them. Spective handles manufacturing, sales, delivery and customer service.

Consumer interest exists. Spective’s three co-founders earlier personalized sunglasses as a side business, taking a cut of proceeds as they helped YouTube stars such as Jimmy Tatro and Vitaly Zdorovetskiy sell thousands of shades to fans.

They launched Spective with $100,000 of their own, supplemented by $200,000 from friends and family. Last month, Spective posted on online investment app FlashFunders to solicit funds for marketing and hiring. The recent stock market volatility came as a shock.

“How could you not have a little bit of anxiety?” said co-founder Tom Larkin, 34. “Waning consumer confidence could become an issue, but our product is priced very reasonably [about $40], and we’re certain it’s going to keep selling.”

Start-ups that haven’t progressed past bullets and sketches face the toughest hurdles. Dave Young, a Santa Monica-based attorney at Cooley who meets with about a dozen start-up entrepreneurs at that stage each week, said he’s now more selective in who he helps because the bar to excite investors has been raised.

Chris Wadden, chairman of investment group Pasadena Angels, said colleagues have adopted tougher stances in negotiations the last two months. Some are splitting payments, offering the full check only when companies meet goals.

The trends haven’t deterred entrepreneurs Anishkumar Raguraman, 28, and Ian McCarthy, 29. Although they didn’t foresee the climate change when they quit good jobs outside of tech a year ago, exhausted their savings and took on credit card debt to develop a dating app, they still see potential.

They say their in-the-works dating app, Curentt, will catch on by providing just-matched pairs with conversation starters based on news topics and interests.

“There’s two critical pieces to dating beside matchmaking: a conversation and going on a date, and you get on a date through a great conversation,” McCarthy said. “No other app is helping you with the conversation.”

An elevator pitch, literally, at a networking event in the fall got Curentt Inc. a $100,000 funding commitment -- enough to hire a designer. But the entrepreneurs are  trying to raise up to $750,000 more to hire a second software developer.

They’re moving in together in Los Angeles with a third business partner to save money. But they’re hoping that their lack of a working app and the market slowdown don’t tarnish Curentt's chances at getting the cash.

“If you have the right team, the right vision, the right passion and think your idea is the next big thing,” McCarthy said, “that comes through to investors.”

Chat with me on Twitter @peard33

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