Firms Seeking Venture Capital Face New Hurdles These Days
L. Gregory Ballard just spent the better part of six months learning that when it comes to venture capital, things aren’t what they used to be.
In fact, they’re not even close. Venture capitalists no longer salivate over business ideas sketched out on the backs of envelopes or throw money at untested entrepreneurs. They have money to invest, and they still make deals, but--showing a tough new caution born of the recent slaughter of the dot-coms--they drive hard bargains with companies such as Ballard’s San Francisco-based firm, MyFamily.com, which expects to close a seven-digit round of venture financing this week.
“We’re a star in everybody’s portfolio, and we have a sparkling future,” said Ballard, the firm’s chief executive. “But I’ve been working on this round of financing since January.”
Originally a book publisher selling to people researching their ancestries, MyFamily.com made the transition to the Internet age in 1996. But unlike countless other dot-coms, it focused on a simple goal--generating revenue from its online customer subscribers.
That discipline helped Ballard do a big round of venture financing a year ago last March--$30 million from investors such as AT&T;, CBS, Intel, Kodak, Compaq, Softbank, Merrill Lynch and the American Century mutual fund. Many of the same investors wanted in on the current round too, according to Ballard, but they had some concerns that illustrate just how hard it is these days to raise venture capital, even for companies with solid prospects such as MyFamily.com.
The source of their worry was the fact that in the months after last year’s round of financing, MyFamily.com bought three companies, in the process acquiring many new shareholders owning millions of dollars of preferred stock in the target companies. Preferred stock being what it is, in the ordinary course of things any new investors in MyFamily.com would have to subordinate their interests to those of the preferred stockholders--not a pretty prospect for the likes of AT&T; et al.
“They would be the last people to get money out,” Ballard said, “and that was unacceptable to the investors and the management team as well--because we’d have to sell the company for $300 million to $400 million before anybody saw a return.”
The solution? It took months of negotiating, but Ballard persuaded the preferred shareholders that if MyFamily.com was to get more financing, they must give up their preferred status.
“We got all the preferred shareholders to agree and sign waivers to clean out the old preferences,” Ballard said. “The alternative was that no new money would come in.”
Other entrepreneurs face even higher hurdles in raising venture capital these days, according to Charles R. Lax, co-founder and general partner of Softbank Venture Capital and a sibling fund, Softbank Capital Partners, in Newton Center, Mass.
For starters, investors value the companies in which they invest at far lower levels than they did in the past--meaning that they take far bigger pieces of the pie, Lax said. They often also insist on:
* “Full ratchet protection” increasing their stakes in the event that investors in any later round of financing push the value of the company to lower levels;
* “Guaranteed liquidation preferences” assuring investors that in the event of a sale, they will be first in line to get their money back--sometimes a multiple of their capital--plus a share of any proceeds left over;
* “Redeemable preferred stock” carried on the books of the issuing company not as equity capital but as debt and giving investors the right to force a redemption if, for example, the company does not reach a liquidity event within a specific period to cash out the investors;
* “Drag-along” voting rights giving investors the right to force a sale with or without the consent of such other shareholders as the founders and managers.
“At the end of the day, the most important thing is that a dollar today buys what $3 to $5 bought 2 1/2 years ago,” Lax said. “And the only way for entrepreneurs to negotiate on any of these things is to have multiple term sheets in front of them--and in today’s market, they’re not likely to get that.”
Venture capitalists also spend far more time on due diligence, Lax said. Most firms employ teams of back-office analysts to chew the numbers and scrutinize every factor affecting the prospects of the companies coming to them for capital, including the backgrounds and qualifications of the entrepreneurs and managers themselves.
“A year ago, you didn’t need a management team,” Lax said, “and I could have taken my cocker spaniel public. There wasn’t as much scrutiny on business models or ‘comps’--other companies not just on the public side but on the private side. Now there are more bodies and support personnel in the funds to get the work done.”
The aim, according to Rob Steinberg, a partner in the Los Angeles law firm Jeffer Mangels Butler & Marmaro, is to give investors some comfort that they can grow and liquidate their capital.
“This is certainly a buyer’s market for venture capitalists,” Steinberg said. “A lot of businesses that would have been financed a year ago aren’t being financed now because valuations are low and because investors know now that certain business models don’t work. Investors are looking for companies with strong business plans--businesses with real profits or good prospects for real profits.”
Even before the tech-stock crash on Nasdaq, however, not every company with good prospects could dictate terms to venture capitalists, as Ballard discovered in negotiating his $30-million financing round.
“One investor said there was evidence the market was slowing down, and he wanted a ratchet,” Ballard said. “I said no. We had a two-hour negotiating session with the other venture guys, all of whom wanted the same thing once the subject came up.
“I said no and got away with it. We didn’t get a request for ratchets this time around. I can’t tell you why.”
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Juan Hovey can be reached at (818) 709-6420 or by e-mail at jhovey@gte.net.
