Three Trends in Startup Financing

It’s the best of times for a startup entrepreneur who doesn’t need money or the experience of a seasoned VC. Interest rates are low, cheap space is plentiful and skilled labor is relatively easy to find.

By Robert Dellenbach American Venture Magazine

But it’s mostly the worst of times for companies seeking venture financing: valuations are low, the number of investments and aggregate dollars invested are at 1998 or earlier levels, and financing terms are tough. Investors have less time and resources to focus on seed and early stage startups that feed the venture capital pipeline. What should entrepreneurs expect from VCs in the current climate and what other resources are available to prepare them to compete for venture financing?

VC Terms: A Tale of Two Coasts

Things may be slightly tougher for entrepreneurs seeking venture funding on the East Coast than on the West Coast. We looked at financing terms from investments made in the third quarter of 2002 for 80 companies with headquarters on the East Coast (from Boston to North Carolina) and 94 companies headquartered in the San Francisco Bay Area. In several key respects, the results were consistent across the continent:

• Less than 20% of the investments were Series A rounds, reflecting a shrinking pool of dollars available for startup entrepreneurs—consistent with levels mid-1997;

• more than 30% of the investments were Series D or higher rounds, reflecting continued emphasis on legacy portfolio companies and returns from later-stage investing; and

• 2/3 or more of the financings were down rounds (75% in the East Coast; 67% in the SF Bay Area), further proof that legacy portfolio companies and prior round investors are taking a valuation beating.

However, in the following respects, the terms of venture financings were significantly more favorable to the East Coast investor than the SF Bay Area investor:

• Senior liquidation preferences: ninety-one percent of East Coast post-Series A investors were senior to prior round investors, compared to 60% for SF Bay Area financings

• multiple liquidation preferences: forty-two percent of East Coast preferred stock returned multiples of the original investment before common stock returns were given compared to 32% in the SF Bay Area; and of preferred stock investments with multiple liquidation preferences, only 20% of SF Bay Area investments had preferences more than two times the original investment, compared to 33% of East Coast investments—and of those about half had preferences of three times or more;

• capped liquidation preference participation: most preferred stock reviewed participates with common stock after returning the initial investment; however, in SF Bay Area financings, participation is capped in approximately half of the cases; in East Coast financings, participation is capped in less than a third of the cases;

• cumulative dividends: few SF Bay Area investments require cumulating dividends–only 13% of investments had cumulating dividends compared to 56% in East Coast financings;

• ratchet antidilution; thirty-six percent of East Coast preferred stock had full ratchet antidilution protection, compared to only 15% in the SF Bay Area;

• mandatory redemption: eighty-nine percent of the East Coast financings provided for mandatory redemption or redemption at the option of the venture capitalist (compared to 37% in the SF Bay Area).
Funds that want to be competitive need to know the terms that will be seen as “market”. It is clear that there are different expectations on the East Coast than on the West Coast—at least in the SF Bay Area. The full survey can be found at http://www.fenwick.com/vctrends.htm.

Crossing the Desert

The established venture community continues to focus on later stage investments and portfolio companies. Seed and early stage investments accounted for less than 22% of total dollars and less than a third of the total number of investments for the first three quarters of 2002, compared with an average of approximately 35% of the total dollars and 45% of the total number of investments for the same three quarter periods from 1995 to 1998, according to statistics reported by the PriceWaterhouseCoopers/San Jose Mercury News Money Tree. This reflects lack of bandwidth among established fund managers who are still busy with legacy portfolio companies as well as a very narrow risk tolerance for seed stage investments.

Entrepreneurs with prior successes, great plans and connections in the VC community, are still getting funded. According to the Money Tree, in the first three quarters of 2002, there were 742 seed and early stage investments aggregating more than $3.7 billion. But compared to the 1,237 seed and early stage investments raising $8.7 billion in the same period of 2001 and 2,375 seed and early stage investments raising $23.5 billion in the same period of 2000, there has been a dramatic reduction in capital available for seed and early stage entrepreneurs. And those investments are only being made in companies that have revenues, significant contracts or other validation of their models.

Angels and seed funds that once provided needed capital for the first two years of growth have adopted the same criteria as traditional venture funds, leaving entrepreneurs to fend for themselves until they can demonstrate traction. According to VentureOne, 60 funds made 74 seed investments in the first three quarters of 2002, compared to 100 funds that made 120 seed investments in the same period last year. The funds that made more than one seed investment were primarily small venture funds, corporate funds and local economic development funds. Many established venture firms made one seed investment in this period, reflecting the careful addition of new partners and investment foci, such as life sciences, and showing they are not entirely out of the game, but they are still very selective.

So what’s a startup entrepreneur to do? Scrap, hoard cash and bootstrap.

Post-Bubble startups are operating at least 12 to 24 months before winning their first venture funding. To survive this period, entrepreneurs who do not have VC or angel backing, large money-market accounts, trust funds or rich aunts and uncles, rely on their own bank accounts, credit cards and, subject to applicable minimum wage and employment laws, equity-in-lieu of cash. Software companies are generally easier to bootstrap, as they can often get by without substantial capital investments, than semiconductor, networking and biotech companies. This and the fact that software margins remain high are reasons that software companies remain the most likely to be funded.

While most established venture firms and angel groups have retreated from the seed market, other institutional funding sources are available to startups—although they are limited and may come with strings attached. The Small Business Administration manages approximately $300 million per year in first stage Small Business Investment Research (SBIR) grants from federal agencies to typically more than 3,000 companies and another approximately $24 million per year in first stage Small Business Technology Transfer Research (STTR) grants targeted at funding projects spinning out of federal labs, federally funded university research and public agencies. More than 200 companies received first stage STTR grants last year.

In California, CalPERS, the nation’s largest pension fund and investor in many venture funds, has established a California Initiative to invest in California startups. This year it has invested $10 million in a seed fund to help fill the gap in California startup financing. The University of California’s BioSTAR program offers up to $20 million per year in matching grants for biotechnology startups that do joint research with the university. There are many similar funding sources across the country available to enterprising entrepreneurs.

Many of today’s successful companies were founded in tough times. Entrepreneurs who survive the desert crossing cultivate skills and gain respect that makes them more attractive to institutional funding.

Then: Incubators and Accelerators; Now: Neonatal Units

One of the reasons that early stage venture investing is at record low levels is that established fund managers don’t have the bandwidth for new companies. Higher standards for startups require them to demonstrate traction well before they are able to get institutional financing. Without the guidance of experienced investors, the period between startup and financing can stretch longer than an entrepreneur’s resources may allow.

To address the experience gap for early stage entrepreneurs, a number of successful incubators have been established in several parts of the country. The “incubator” and the successor “accelerator,” as business models—particularly those run for profit—earned a less than stellar reputation by the end of the Bubble. However, a new, not-for-profit model for neonatal care of promising startups has emerged.

In the San Francisco Bay Area, two incubators stand out. The Womens Technology Cluster in San Francisco was formed by an initial grant from the Three Guineas Fund, a nonprofit corporation started by Cate Muther, a former Cisco executive. The WTC currently houses approximately 20 women-founded startups in a Potrero Hill building built specially to foster communication and collaboration among companies housed there. In addition, the WTC serves nonresident portfolio companies that use the facility for meetings and join the other portfolio companies for regular seminars and joint activities. The WTC is very selective and admits only companies that show promise and good management potential.

The WTC is staffed by experienced entrepreneurs who provide advice on issues ranging from market analysis to sales and funding. The WTC also draws upon resources in the local community to provide free legal, accounting, marketing and other advice to portfolio companies. As a result, WTC portfolio companies have raised over $61 million in private equity funding.

Across the San Francisco Bay in Alameda, in a former Naval laboratory, a biotech incubator helps life science companies to germinate. ACET (which stands for Advancing California’s Emerging Technologies and Alameda Center for Environmental Technology) has full wet lab facilities for 10 bioscience companies. It is the only nonprofit incubator of its kind on the West Coast. Over its four year history, the incubator has typically been oversubscribed. Recently, ACET received a $6.4 million grant from the Department of Commerce to build a new facility to house up to 40 bioscience companies. ACET is in the process of securing the land and the building design and hopes to have the new facility operational in two years. ACET’s graduates have raised over $185 million in private equity financing.

Both WTC and ACET charge a market rate fee for rent and services. The services they provide and the environments they foster help prepare their portfolio companies to compete for increasingly elusive venture capital dollars. For investors, companies coming out of these incubators are more prepared to maximize the investors’ time and investment.

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