SOMETHING VENTURED: Tough Contracts Turn Off Startups

PALO ALTO, Calif. — Times are tough for entrepreneurs, but Chief Executive Kris Canekeratne counts himself among the lucky ones.

His six-year-old software company, eRunway, raised $36 million in 2000, turned profitable in the fourth quarter of 2001 and doesn’t need to raise
venture-capital money to keep going.

By MARK BOSLET

Of DOW JONES NEWSWIRES

Good thing. The collective view of venture capitalists is, "When it comes to investing, they basically skin you alive," he said of the deals being
forced on many startups. "I think term sheets are extremely onerous."

Canekeratne isn’t the only one with such impassioned views. Venture investors have been driving hard bargains over the past year, taking
advantage of the uncertain fund-raising market and flexing the power their checkbooks. The question is, will they regret the strong-arm tactics?

Entrepreneurs say tough terms and meager funding agreements are making many think twice before proposing new business plans or company
expansions. This pause is coming at a time when the industry is trying to regain its footing after a deep downturn. Some fear it is already
leading to a slowdown in the new ideas and innovation that fuel Silicon Valley and the high-tech industry.

"That’s very difficult to confirm," said Mike Mitchell, senior client partner at recruitment firm Korn/Ferry International. "But I think it is happening.
There are a lot of people on the sidelines."

It is easy to see why. Any entrepreneur faced with today’s draconian terms "feels a little like they’ve got a gun to their heads," said Randal
Buness, chief financial officer at startup Primarion Inc., which developing technology for the computer-chip industry. Founders end up with little
ownership of the companies they nurtured. Some lose their jobs altogether or cede crucial authority to VC-appointed board members.

In one deal in January, a Silicon Valley optics company raised $12 million in a second financing round, but its founders were forced to cut their
stake in half to 8%. The latest funding round valued the company at $24 million, far below the $60 million valuation it had when it first raised
money.

"If you are an investor, you’ve got to be wondering do the key people have enough stock to keep them here," said Ron Nelson, president of the
startup Agility, an optical-laser company. "I think in a lot of companies, that will not be the case."

The tough term sheets are a reaction to the Internet bubble, when too many companies with flimsy business plans were given large sums of
money. A necessary weeding out is taking place. VCs have to guard against a repeat of the losses they have experienced in the past 12
months, and adding terms to protect new investments they make is a natural reflex.

"It may feel like tough medicine, but it is aligning the risk-reward profile of today," said Karen Griffith Gryga, principal at Liberty Venture
Partners. "It’s a tough, analytical environment, (and) it’s not a dream and a team getting funded anymore."

Among the terms most commonly tacked onto contracts are liquidation preferences that guarantee VCs up to five times their money if a
company is sold. Protections also compensate VCs with more preferred stock if a company’s value drops over time. Venture firms also are
insisting on vetoes over operational decisions, such as adopting a budget or a management structure. In some cases, founders seeking seed
money turn over 60% of the company.

Some Moderation Seen

There is some evidence the most dire term sheets are moderating, at least for very early stage companies. Facing difficulties are companies
that raised money during the boom times and now need to find later-stage financing. "That is the category of company really going through the
ringer," said Santosh Alexander, chief executive of software maker iSpheres Corp.

"In the short term, it will discourage entrepreneurs," Alexander said. But a benefit will come, too, in "winnowing the real entrepreneurs from the
ones who thought they were entrepreneurs."

Nevertheless, Alexander admitted he ran up against deals he described as overly demanding. Last summer two venture firms approached him
with offers for funding. Alexander declined to identify them, but said he rejected the proposals.

One called for mandatory dividends of up to 10% annually that were to be paid to the VC in preferred stock. Dividend provisions often are
included in early stage deals, but rarely is payment required. The new stock was to come at the expense of other investors and employees.
"You are getting diluted by the hour," Santosh said of his position in the company.

Another term called for the "full ratchet" protection of the VC in the event of a down round, where the value of the company would fall. The VC
would be issued more stock to compensate for the lowered value. Management and employees would not.

ERunway’s Canekeratne, too, said he was offered deals he would never have seen a few years ago. An average of two VCs come calling each
month. But so far none has persuaded him. In September, he was presented with a term sheet that valued his company at between $80 million
and $100 million. When he last raised money in November 2000, his pre-money valuation was $250 million. "These guys are really avaricious
right now," he said.

The September proposal also had clauses that made him recoil. One promised the VC firm a liquidation preference of 2-1/2 times its money
should the company be sold.

Many entrepreneurs clearly are waiting out the difficult market. But venture capitalists as a whole aren’t worried about a dearth of new company
ideas. "The whole game has got much tougher," said Lise Buyer, a partner at VC firm Technology Partners. But "the entrepreneurial spirit runs
deep. By definition, entrepreneurs are optimistic and idealistic" and they will come forward.

"I don’t see that this environment is discouraging," said Liberty Ventures’s Griffith Gryga. Companies with solid business plans and strong
management will get funded, he said.

Still, discussions at partnership meetings are more likely than before to examine whether portfolio companies have enough stock options to
keep employees on board. And some VCs complain privately they can’t find attractive companies in which to invest.

"The structure of the deals are a sign of the times," said Tom Bain, an associate at Columbia Capital. "You are taking on tremendous exit risk
right now."

With the likelihood that the difficult money-raising environment won’t disappear quickly, some startups are looking hard for alternatives to
venture funding. One such alternative is selling out. "We get a lot of phone calls" from companies interested in being acquired, said Agility’s
Nelson.

Other entrepreneurs are trying to scout out money from wealthy individuals or angels. Jim Moran, executive vice president at online billing
company edocs Inc., said he knows of several founders who have used their own money and taken on this added risk.

"I’d open my checkbook first," he advises entrepreneurs, before turning to a VC.

-By Mark Boslet, Dow Jones Newswires; 650-496-1366; [email protected]

http://online.wsj.com/article/0,4286,BT_CO_20020306_004722-markboslet,00.html?collection=&vql-string=%28Mark+Boslet%29%3Cin%3E%28article%2Dbody%29