Cleaning Up Investment Messes at the Surviving Dot-Coms

In the movie “Pulp Fiction,” there is a character known as “The Cleaner” who arrives on the scene after an especially grisly murder and, well, cleans up: He supervises scraping the gore off the walls, bleaching the car upholstery, squaring the eyewitnesses and so forth.

Barry Kramer’s job is something like that. The gore he’s been scrubbing away is the mess left over from the dot-com and telecommunications busts, carnage that he witnessed as a partner at Silicon Valley law firm Fenwick & West.

Today, a fair amount of Kramer’s practice involves restructuring technology start-ups hobbled by the financing frenzy of the late ‘90s. This is accomplished largely by finding a way to sweep aside or subordinate the original investors so there will be room for those with new money.

It’s a difficult process, complicated by pride, grief, conflicts of interest and the residual delusions of entrepreneurs and financiers alike.

“It’s never fun,” Kramer, a transplanted Baltimorean who looks and sounds like movie director Barry Levinson, told me recently at his firm’s offices in Mountain View.

But it’s a crucial step in repairing what went wrong with high tech in the boom years.

“The big picture is that there was a party during the Internet boom, and companies raised money at valuations that weren’t sustainable. Those that survive will have to bring their capital structure to present-day realities,” he added, in the voice of a doctor telling a patient to swear off Luckys, or else.

The decor of the conference room at Fenwick & West features a sort of gleaming panorama of the high-tech dream world of the late 20th century. Its shelves groan under the weight of those Plexiglas objets d’art distributed to investment bankers and law firms involved in initial public offerings and other big financings. Miniature copies of the offering circulars are encased inside -- or perhaps the right word is “entombed,” for some of these deals eventually got consigned to the churchyard. (The Internet broadband company Excite @Home, for example: IPO 1997, RIP 2001.)

Others whose names are etched in these clear plastic cubes are still hanging on, if profoundly chastened in price and outlook.

In some cases, their only sin was to attract frenzied investors at unrealistic prices. Indeed, many start-ups are struggling today because they were fed too richly from the venture trough in past years -- not because their underlying technologies or strategies are unsound.

It may help here to recap how companies typically got financed in the heady old days. A start-up seeking to raise, say, $20 million in venture capital might claim it already was worth $30 million, even though it had a farcical business plan and no revenue.

That meant the venture investors ended up with preferred stock worth 40% of the company, having put $20 million into a company now valued at $50 million. A few months later there would be another round of fund-raising; this time the company might seek $30 million while claiming to be worth $120 million. The new investors, who normally included some of the old investors ponying up more cash, got preferred shares worth 20% of the start-up.

There might be four or five such rounds, until the company was ready to sell stock to a ravenous public, at which point all the preferred holders cashed in their shares, presumably at a huge profit. (Executives and founders, who were holding options on common stock rather than preferred, also got to cash in at this point, though they received their money only after the preferred holders were paid off.)

As long as prices kept rising, and talk of the “new economy” persuaded people that heaven was the limit and venture funds lined up to invest more money on such terms, everybody was happy.

Then came the crash, which exposed the folly of this Silicon Valley calculus. Companies whose initial public offerings soared from $8 to $87 on the first day of trading and reached $200 six weeks later were cut to $2. Start-ups that had raised $100 million in four venture rounds were now understood to be worth $20 million or less.

The only course for some of these companies was to go under, leaving their computers and fancy Aeron office chairs as the only assets to pick over. Meanwhile, those trying to press on face a quandary: If new investors in a $20-million company can’t make a dime of profit until it pays off $100 million owed to old investors, there won’t be any new investors.

That’s the time to call in the Cleaner.

Kramer says companies in this fix don’t have a lot of choices. The most dramatic step is to entirely wipe out the old investors -- convert their preferred stock to common, which in all probability will never be worth anything, and start over from square one. This is the neutron bomb option, certain to generate the maximum ill will, not to mention litigation.

It’s preferable, if more complicated, to work out a program by which earlier investors take a haircut and allow the new investors to take a preferred position on any profits. Sometimes the previous investors are also required to pony up money for the new round of investment to avoid being wiped out, which is known as “pay to play.”

There has been plenty of grousing among entrepreneurs about the draconian terms being demanded by venture firms these days. Carping the loudest are those who see their stakes in their own companies getting hugely diluted. For a while it seemed that the pendulum had swung all the way from ridiculously high valuations to dishonestly low ones.

A year ago, venture capitalists “were trying to get not only a deal but a steal,” says Santosh Alexander, the CEO of ISpheres Corp., an Oakland network management company that has gone through two rounds of venture funding since 2000.

More recently, that ruthlessness has ebbed. The reason may be that the low-hanging fruit has been picked, but venture investors also may have come to recognize that keeping a fledgling company going for the year or two that may pass before the IPO market gets hot again means reducing resentment to a minimum.

“If the new investors’ attitude is, ‘We’re going to screw the other guys,’ nothing is going to work,” Alexander says. “The company will end up spending a lot of time trying to pacify people who just don’t like each other.”

In any event, it’s clear that this painful shakeout is necessary. Kramer’s viewpoint is a variation of the old saw about how whatever doesn’t kill you makes you stronger.

“If you’ve gone through this, it’s a sign your company’s got some value,” he says. “In this environment it’s almost a badge of being successful.”

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Michael Hiltzik can be reached at golden.state@latimes.com.