ABA Section of Business Law
July/August 2001 (Volume 10, Number 6)
Dot-coms hold out hope
Yes, the rush has slowed, but venture capitalists still have money to invest.
By Eran Kahana
Unless you've been living on Neptune for the past year, you've probably heard that the NASDAQ has lost nearly 60 percent of its value since March of 2000, and that the promise of the "new economy," e-commerce, has taken a severe beating.
Every major business publication these days appears to take a certain morbid joy with splashy, tabloid-style headlines that unleash spine-chilling detail of diseased and dying dot-coms, layoffs and losses in the many billions of dollars. Mob violence reminiscent of the famous stoning scene in Monty Python's "Life of Brian" may become a reality where the "criminals" being stoned by angry investors are the CEOs of failed dot-coms.
But this entire bad rap seems a bit unfair when considering the fact that most new businesses, with some figures pointing at 70 percent, fail within the first year of their existence. For some unexplainable momentary lapse of reason, dot-coms were thought to be exempt from this rule of thumb, and to make matters worse, the nearly ridiculous level of expectations pinned on them was the final nail in their not-so-virtual coffins. Tom Weber of the Wall Street Journal recently wrote that "[D]ot-coms weren't just expected to run before they could walk - they were supposed to fly to the moon."
But don't write off e-commerce and dot-coms or look for stones to throw. There are still plenty of folks, that is, venture capitalists (VCs), out there willing to invest big dollars. Business Week recently quoted a Venture Economics research indicating that money is being poured in at an annual rate of $80 billion.
Sure, the hysteria levels of 1998, 1999 and first three quarters of 2000 are nothing more than faint echoes of the past. And no one in their right mind will argue that VCs should or are going to write a $10-million check after a 20-minute pitch.
But the potential for making enormous profits is still alive and well and the VCs know this. Consider, for example, the fact that this "new economy" right now has a potential user pool population of "only," according to Fortune Magazine, 180 million users. This is a relatively insignificant number when compared with the 6 billion people on this planet. Even if just half of all of these people become users in the next 10 years, e-commerce has enormous potential. Another important characteristic that VCs will focus on is the phenomenal gross margins, 90 percent or more, that e-commerce has to offer.
Additional favorable predictions come from the VCs themselves. For example, according to John Doerr of the top-ranking venture capital firm Kleiner Perkins Caulfield & Byers, there will be just as much innovation in the next 10 years as in the past few. Vinod Khosla, another Kleiner Perkins "superstar," and a business publication "darling," predicts that we will see as much innovation in the next 25 years as we have seen in the past 100.
These optimistic accounts are not merely interesting but also critical to the success of e-commerce, especially when one considers the fact that VC funding is the single most important capital source for dot-coms for many reasons. For example, Business Week recently quoted Harvard Business School professor Joshua Lerner, saying, "The impact of venture capital on innovation is four to five times greater than corporate research and development."
From a numbers game perspective, it is apparent that the Internet in general and e-commerce in particular are VC favorites even though there are clear declines in funding. According to Venture Economics (VE) and the National Venture Capital Association (NVCA), Internet-specific companies saw a decline in the total amount invested, 44.55 percent in Q3 2000 vs. 50.12 percent in Q2 2000. However, the Q3 2000 figure is close to the 45.18 percent invested in Q3 1999, so it's not such a gloomy picture. Quite expectedly, within the e-commerce and content category, there was a decrease in the sum of investment and in percentage of total amount invested. This quarter, $7.7 billion was invested in e-commerce and content companies, compared to $10.3 billion in Q2 2000.
So aside from occasionally shelling out nauseating amounts of money, what do VCs do and what's changing? Perhaps the most significant change is that there is a growing emphasis (from the VCs themselves) these days on going back to the business of building companies and staying away from running around looking to flush out the next billion-dollar deal.
The business of building companies, which is what VCs do best, means among other things that VCs do not merely provide critical early-stage funding, but also act as surrogate management. This function is as critical as it is unique because most e-commerce entrepreneurs that approach VCs have an idea, but all too frequently lack certain important management functions, resources and skills.
For example, one of the primary goals for VCs is to help the start-up achieve sufficient diversity so as to realize both the technology and execution. Without both of these elements properly in place, the start-up has no chance of success. So VCs participate in the general management of the company, offer advice, seek out additional funding, help forge alliances with suppliers and customers (that is, distribution channels) and find the right people for the job: If the start-up is a pure technology company, the VCs will look at the caliber of Ph.D.s in the company. If the start-up contains a mix of technology and service, they will examine the marketing experience in the company. They do not, however, typically get involved with running the business on a day-by-day basis.
Insofar as funding is concerned, VC funding is a method of raising capital during the first stages (rounds) of the start-up's existence and amounts to equity financing. This funding method is different from debt financing, which is obtained by getting a bank loan against assets (receivables, equipment, etc.). While most stock market investors focus on short-term profits, successful VC investments are driven by a long-term focus.
Stock market investors usually consider six months long term and are often driven by quarterly, monthly and even daily performance - and mood swings - VCs generally identify their bad investments within three years, but their winners can often take seven years or more to emerge as proven successes, as shown in their post-IPO performance.
VCs can enter a company at any given phase. At the start-up phase, some VCs will look for e-commerce companies that have a high level of efficiency in their use of capital. That means they are not going to use venture funds to satisfy their "burn rate." In other words, the start-up will not buy equipment, fixtures or pay salaries with these funds. Rather, they will use the venture funds to develop key technology from its embryonic beta (with R&D investment), transform it so it is proprietary by filing for a patent, trademark or service mark, and use their intellectual capital in such methods that make it difficult and preferably impossible for competitors to enter the same market.
During these first steps, the VCs will work closely with the entrepreneur and his or her team to build the company and guide it in the right direction. Hopefully for the entrepreneur, this is a mutually agreeable direction that was carefully reviewed during the initial negotiations, otherwise he or she would be wise to invest in the makers of Pepto-Bismol, and get ready for some nasty turbulence.
During the expansion stage, the VCs will focus on developing and maintaining strong, proven business leadership, revenue momentum and early market leadership. During the buyout, or recapitalization stage, the VCs will help acquire other businesses (or sometimes just parts) that fit the start-up's model. Once the company has been "released" to the public in an initial public offering, the VCs will usually get out of the picture as soon as the lockout period expires.
Since any would-be e-commerce entrepreneur needs VC funding, there are several proven methods of finding them: Networking is the best of all. Networking opportunities sometimes exist right under the entrepreneur's nose in the form of tapping existing customers or beta partners (companies who test the start-ups' product/service, sometimes for a nominal fee). These folks can prove to be a goldmine for referring VCs. The symbiotic nature of the relationship puts them in a strong position to put in a good word (but only of course if it is deserved) since they are also users. Some VCs like this scenario because it indicates the start-up is already generating working capital, which means less of a drain on venture funds and potentially represents a safer investment.
Another related method is through introduction. Because of the large number of opportunities VCs have to sort through, an introduction by someone they respect and trust will generally make it through the lower level review (done by staff) and to the final decision makers if, and only if, the reference has the ear of these decision makers. One way to gain access to this reference is by hiring a well-known business consultant who can gain and then carefully disperse intimate knowledge of the company and the opportunity it presents.
Another proven, but less statistically satisfying method is preparing what Norm Brodsky of vfinance.com calls a "hit list." This approach, which invites rejection as a tool for sharpening the business plan, lends a lot to the credo that says "you'll never meet a successful pessimist." Brodsky suggests that listing only four or five VCs means that the probability they will invest in the company is small. Once rejection occurs, Brodsky suggests that the entrepreneur go back and ask why he or she was rejected and then make course corrections as necessary.
This list can be built from combing through the Internet. Numerous Web sites offer to hook up entrepreneurs with VCs. Type in "venture capital" in Yahoo, for example, and the search will yield numerous options. The negative aspect related to this hit-list approach is that it amounts to cold calling, which requires a lot of time and usually the business plan will not even make it through a low-level review. This needs to be considered in comparison to other, potentially competing entrepreneurs who get in through their network and introduction and get the funds first.
Good solid, logical business plans, not too long ago shunned by VCs, are now a must. Once the VCs have been initially engaged, the next step is to sell them on the business plan. The entrepreneur must invest in writing a business plan that makes sense and showcase the team that is going to execute it all.
The significance of this cannot be overstated since like all good investors, the VCs will look at the start-up's leadership and ask themselves what the entrepreneur should be asking him or herself constantly: Can the team execute the plan? Given the choice, VCs would rather bet on a Class-A team bringing a Class-B product to market then a Class-A product with a Class-B Team trying to make it happen. A Class-A team has a proven track record and will make it happen whereas a Class-B team is a significantly higher risk.
The business plan must also clearly indicate what the VCs should expect to get out of the deal. For example, one proven method is to graphically demonstrate the company's run rate and then show how new projected sales sit on top of this. One thing to avoid like an Egyptian plague is to indicate that the founders plan to use VC funds to reimburse themselves for their initial investment.
Another critical component in the start-up's business plan is to make sure that there is a market for the product or service offered. The Idealabs! Pet.com failure is but one shining example of misunderstanding what the market needs. On the other hand, consider a company like Check Point Software Technologies, Ltd. (CHKP US). The company designs software that protects networks from hackers. Because network security is the lifeblood of all e-commerce companies (and "old economy" companies as well), no one can afford to cut spending on this technology. In fact, demand proliferated in 2000 for Check Point's virtual private networks (VPN), which allow businesses to set up secure computer networks over the Internet without having to set up more expensive private lines.
According to Ilana Treston, director of Technical Research at Merrill Lynch in Israel, "VPNs are mission critical for most large organizations and are a tool that enhances the efficiency and return on investment of existing networks." Check Point, therefore, is expected to continue its impressive growth patterns and beat analysts' projections. This type of story is a powerful way to persuade VCs to invest.
During the recent "Lemming Era," VCs abandoned traditional methods of evaluating business plans, if they even existed or were required. The sobering reality is that a large number of dot-coms approached VCs without a business model and the VCs had no problem with that. They were blinded by the near-hysteria surrounding dot-coms and when everything looked like a winner, they were more eager to fund.
Business models sank to the lowest common denominator, and in some instances were totally ignored. With this disfavor comes some maneuvering and some dot-coms shift their business models to adjust to what seems like an unaccounted-for life raft after the sinking of the Titanic: The ASP (application service provider) model. So now we are bombarded by ASPs out there.
But many VCs have wised up to this incessant barrage of neo Internet-terminology and fancy maneuvering and are waking up from their inexplicable bout of hyper sleep and hyper investing. Now they're saying "OK, so you're an ASP, but show me the money!" In other words, who is buying your services? And when the dot-comers now turned ASPers say, "well, we've got projections
" that is as far as they get.
But now that the Lemming Era is over, there is a dawning trend among VCs not to give away money but to move more money into current portfolio companies. If a VC typically took a 20 percent equity stake in a portfolio company, now they will take a 35 percent stake and devote more time to that company.
OK. Now the start-up has the VC funding in the bank. Now what? Perhaps the singular most important thing to keep in mind is that equity funding is an expensive asset. That is because ownership stake in the company has to be given up in relatively big chunks during the early phases of the company, when it usually is not worth as much. Generally, as the company matures, it is worth more and less equity can be surrendered for funding. With that in mind, venture funding should be channeled to fund the growth of the start-up. For example, allocate funds to the development of the beta and set up distribution channels.
A common mistake is using venture funds to satisfy working capital needs. Working capital is used to pay salaries and other overhead such as rent and utilities, and in every company cash flow is king (or queen, if you prefer, but you get the point). However, using venture funding to pay for this will not be seen positively by the current and future VCs since it is taking away from funding the growth of the company and consequently risking their investment.
VCs generally expect the entrepreneur to focus on ensuring that customers are paying on time so the start-up is not funding them through payables (getting loans, credit lines against payables or other assets). A startup may be able to secure customer funding through advance payments, or progress payments, which some ASPs routinely require in every contract and which is an important function for legal counsel to focus and negotiate on. Ensuring that this provision is in place provides a significant advantage to the entrepreneur since it does not require giving up additional, even excessive, equity.
Another important concept for an e-commerce startup is to carefully measure out the venture funding. Some e-commerce companies, particularly ASPs, took the proper approach and did not play the game of gaining advantages over competitors by amassing enormous amounts of capital. As was mentioned earlier, one of the rationales is that the earlier equity capital is brought into the organization, the more equity will need to be given up in order to secure the funding.
You don't need to be a Harvard Business School MBA to know that in every company there is a limited amount of equity. Therefore, to maximize the amount of funding for a given amount of equity, the funding must be properly staged. In other words, the start-up should be careful that a sufficient amount of funding is secured to be sure what it is proposing can actually be accomplished, with some room for error. Funding in stages is also very much in the interest of the VC because, in part, it mitigates risk.
E-commerce and venture capital are a marriage made in heaven. Despite the constant barrage of gloomy predictions offered by the media, most insiders are purposefully refraining from joining the gloom parade. While this does not mean that everything is hunky dory, it does provide a useful lesson in understanding the difference between Wall Street and the VCs. As Vinod Khosla put it, "Wall Street isn't concerned with reality, it is concerned with people's perception of reality."
Most successful VCs put Wall Street where it belongs and focus their efforts on finding great opportunities for long-term investors. To be sure, there are technology developments in the works that promise to make their job successful. For example, the European DataGrid project currently under construction at the European Laboratory for Particle Physics in Switzerland (CERN), promises to yield computer power that is nearly seven times more powerful than today's fastest super computer. This technology will not be stashed away in some secret cavern in the Swiss Alps; it will be made available to the public and promises to dramatically change the Internet as we know it.
So while it is true that the market environment has changed, a bear market has been certified, investments will slow down and the number of VC firms and money raised will drop, the Internet and e-commerce still offer enormous profit potentials for long-term investors.
Strap yourselves down. It's going to be a wild ride.
Kahana is a sole practitioner in Minneapolis. His e-mail is eran@mchsi.com.
