Shaking the money tree

Shaking The Money Tree

Startups having trouble securing venture capital - and some don't even want it

By Erika Stutzman, Camera Business Writer
April 28, 2003

The basic plot behind the flameout of Boulder's Network Photonics — funded with a spectacular $139 million — is unfortunately not unique.

The story sounds something like this: Promising company wins over investors, raises tens of millions in venture capital, hires dozens or even hundreds of smart people, makes a great product, wins customers or accolades or both.

And then, after a few short years, something happens. The market doesn't look as large as it once did. Investors don't see the returns they had banked on. There may be a sale in bankruptcy court — like with Boulder's netLibrary or DataPlay — and the assets sell for pennies on the dollar. Or the company could just shut down forever, such as with Boulder's SmartPoint or Broomfield's GlobalCommerce.

In either case, most of the money and most if not all of the jobs disappear.

As venture capital investments have dwindled — down from 2000's $4.34 billion to 2002's $547.3 million in Colorado — so have the opportunities for investors to make a return on their investments. Which means that many young firms, no matter how promising, don't stand a chance.

And making those returns is critical, as investors continue to struggle with their own funds and portfolios. Venture capital funds lost an average of 23.3 percent in 2002, according to Thomson Venture Economics for the National Venture Capital Association. That follows a 27.8 percent loss in 2001.

On April 22, a year after it started selling its product, Network Photonics announced it was shutting down. The company, which made optical switches for telecommunications traffic, was founded in 1999 and employed 140 people in 2002. About 15 people are working on the shutdown now.

President and chief executive Steve Georgis blames the telecom slump.

He said the market for Network Photonics' product — the super high-speed Internet explosion — is years away. And when it comes, Georgis said last week, "it will be a lot smaller than anyone anticipated."

And size matters.

Local VCs said the criteria for funding new startups includes the need for its future market to be many-times-over tens of millions of dollars.

They stress that startups that don't meet their criteria can still become very successful companies — but they might be better off in the long run seeking less money from other types of investors, like angels or friends and family, or banks.

"A lot of businesses we talk to, they want to grow organically with a little bit of money, and steadily increase year over year," said Craig Hanson, a principal with Vista Ventures in Broomfield. "That represents a great business strategy, but not one that is going to make a great VC investment."

A multibillion-dollar market — like the one that had been anticipated by investors and Internet experts for Network Photonics back in 2000 — sounds more like it.

"They need to be preparing to ramp up to a large amount of sales," Hanson said. "If they plan on making $10 (million) to $20 million a year, it will not reach the level that venture capitalists need to make a return."

The reason: Only about 10 percent of a portfolio will be a "home run," Hanson said.

"So out of 20 companies, only two will go big, and that will carry a large part of the rest of the portfolio," he said. So a $10 million return on a $1 million investment, while not bad for the portfolio, doesn't make the investor's goal of a good home run.

"That's not a big impact on a $65 million fund," Hanson said.

Another qualification companies seeking venture capital must meet: an exit strategy.

"You need a liquidity event at some point. Within a 10-year period, there's got to be a way to get the money out," Hanson said.

Chris Wand, a principal at Mobius Venture Capital in Superior, said another issue is the relationship the entrepreneur wants to have with the investors.

"We you start selling your equity you give up some control. The venture capitalist will seek some amount of control," Wand said. "There are horror stories about how much control some take, but there is a healthy balance that can be struck. Quite honestly, you have to figure that out at the beginning."

And the downturn, with fewer deals, hasn't made that process easier.

"There's been a real cycle on how companies think about the role of the investor. In the mid- to late-'90s, you could raise money from everyone, and people had the luxury of where they took their money from.

"Then the process became much more difficult, and CEOs were thinking, 'First and foremost, we need money and we'll think about the relationship later.' That's not necessarily a good thing," Wand said. "You have to make sure that the investor and the entrepreneur see eye-to-eye."

For some businesses, that means seeking a funding source that's not a venture capitalist firm.

Boulder's Energy Velocity, a new startup that will provide information products to the energy industry, is one of those firms.

The company, which wants to hire 45 people to start, is under the umbrella of Global Energy Decisions — which itself is funded by Quadrangle, a large private equity firm in New York.

Global Energy's chief executive, Ron McMahan, said that funding arrangement is a good one for a firm that can take its time ramping up — without the pressure to make enormous revenues and go public or get bought out anytime soon.

"They are fully funded to do what they need to do," McMahan said. "This is in it for the long haul."

But there are some for whom venture capital may be the only option.

LeftHand Networks, a Boulder-based data storage firm, has raised $39 million in two successful, oversubscribed rounds. The firm employs more than 50 people.

Bill Chambers, the president and chief executive of LeftHand, said the firm had already developed its technology by the time it approached the firms, including Vista, that invested in it.

But with the size of the market, and the size and number of successful data storage competitors, the firm needed the millions to get off the ground quickly.

"I don't think it could have been done with less money than that," Chambers said.

One thing that is being stressed in this economy, by both investors and the entrepreneurs, is that they thoroughly research each other to find the right match.

"Starting and building a business in this environment is not for the faint of heart," Chambers said. "One of the things we were really lucky to have is a great investment team. We did due diligence on them just like they did on us. We were committed to them, and they were committed to us for the long haul."

The current state of the industry is smaller deals by private investors like angel investors or companies bootstrapping or borrowing from banks, said Dale Oesterle, professor of law at the University of Colorado. In addition, a few, very select big venture capital deals will continue.

He said that state will stick around for a while.

"Until the IPO market or the mergers and acquisitions market comes back, the VCs are not going to invest," Oesterle said.

But the future could be bright — just not as blinding as during the tech bubble.

"There are VCs with money to invest. They have the money, they just don't have opportunities with the rates of return that they need right now," Oesterle said.

Contact Erika Stutzman at stutzmane@dailycamera.com or (303) 473-1354.