Stage fright- Wary of back-of-napkin pitches, VC firms demand sophistication from early-stage prospects

When WaveSmith Networks, a telecom-switch company in Acton bought by Ciena Corp. for $158 million in April, first went looking for venture capital in June 2000, founder Bob Dalias was armed with 22 slides explaining his idea — but no business plan — and raised $11.5 million.

By:
Tom Witkowski
Boston Business Journal

Three years later, a startup looking for a first round of capital needs more than slides and an idea. Early-stage companies raising so-called A rounds are much further along today than were their counterparts of a few years ago. The metamorphosis comes amid changing fortunes in the venture capital arena: The economic climate has turned chilly, venture capital trends have shifted and entrepreneurs have learned that bootstrapping a company into product development or customer and partner acquisition can attract venture capital more effectively than a knockout PowerPoint presentation.

Recently funded early-stage companies have all had some research or technology development under their belts before the venture capital term sheets were set, experts said. "Given the difficult funding environment, the cream rises to the top and people are looking to give themselves any edge they can," said Robert Fleming, a general partner with Prism Venture Partners of Westwood. "They’re finding ways to do it with minimal capital,"

Prism invested in three recent A rounds: Ammasso Inc. of Boston, Peptimmune Inc. of Cambridge and iScience Surgical Inc. of San Francisco. Founders at Ammasso, which is working on application networking technology, have been speaking with customers. Peptimmune’s founders had already completed some of the science and can present evidence their idea would work. Likewise, iScience’s founders have collected data that shows their device would help in glaucoma treatment, Fleming said.

Even before knocking on a venture firm’s door, a smart entrepreneur has made customer contacts and found partners or original-equipment manufacturers with which they will work, Fleming said.

"They realize venture capitalists are pickier and busier and not feeling pressure to make an immediate decision," Fleming said.

Partners at Advanced Technology Ventures Inc. of Waltham prefer to see teams fund their companies longer with angel money or the management’s own dollars, said Bob Hower, a partner with ATV. "People are taking their ideas farther. They have more to show before the A round," he said.

Compared to 2000 and earlier, another ace an entrepreneur is more likely to have up his sleeve when seeking funding now is a very experienced team, given the plethora of talent in the market today, said Hower.

"You can really assemble a team of folks who have really specific experience. When you see a team come in now, a lot of people aren’t going to waste their time unless they have that bench. That goes more than anything for the quality of the CEO," said Hower.

In contrast to the overheated VC climate that ended three years ago, entrepreneurs now are much more hesitant to dip their toes into the venture capital waters until they are sure they are ready, said Bryan Pearce, a partner in Ernst & Young LLP’s Boston office.

"They’ll go back and really do a bootstrap operation and get much further along with the company," Pearce said. But the entrepreneurs also feel a squeeze. They must build that business with fewer active angel investors, either because stock market losses have slowed those angel investors, or because the angels are still nursing along their previous investments, he said.

In a Catch-22 for entrepreneurs, venture capitalists want all the intellectual property rights sewed up before they’ll consider committing any money, yet startups have trouble affording the legal costs of doing that without the VC money, Pearce said.

"The VCs want to know there are barriers to entry (for competitors), and one of the best barriers to entry is legal protection for intellectual property," Pearce said.

Still, venture firms that hold the bar too high are not really making many early-stage investments anymore, some experts said. An important part of the early-stage recipe is two people with expertise and an idea, not a complete management team with products already emerging from field testing.

"Early-stage investing is you’re pre-product in most cases. We’re there to help build the team and help fund the product," said Jo Tango, a general partner at Highland Capital Partners in Lexington.

In 2000, Savantis Systems Inc. of Lexington had no product or customers, but its founders did have an idea about database server networking. Highland took them under its wing, helping them raise $5 million and develop the technology and business plan, as well as giving them office space. When the time came for Savantis to raise a second round of capital, the company was able to bring in $12 million more because it had customers, said Tango.

"For me, that’s where the most economic upside is, and the most fun is," Tango said.

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Scouting Out the Hidden Jewels

By:
Daniel Rosenberg
Wall Street Journal

When venture capital investors learn the trade, they’re taught several guiding principles.

Find the right company with the right product and the right management team – and get the right deal.

"That’s high-level apple pie and American flag," said Marty Mannion, managing director of Summit Partners, a venture capital company that manages over $5 billion and invests in a variety of industries.

But there’s more to it than that, Mannion and others in the industry say. Sometimes finding the right company means digging a little deeper and isolating characteristics that make one firm stand out from a crowd of competitors.

For Mannion, the make-or-break factor can be a company’s balance sheet.

"A company that has a good balance sheet typically is better than you think, and one without a good balance sheet is usually worse," Mannion said.

In the go-go 1990s, investors were less likely to closely examine the nitty-gritty financial details. But in today’s more conservative environment, such focus can pay off.

When surveying a possible investment, Mannion said, he looks at the company’s days-receivable record. If a company can’t get the money it’s owed within 45 days, that raises a red flag. Maybe it’s offering its product on some sort of trial basis and customers don’t feel the need to pay back right away, or ever. Or perhaps the company just isn’t paying enough attention to detail.

When Summit invested in Lincare Holdings (LNCR), a health-care company, one asset that attracted the firm was Lincare’s ability to collect from customers.

"Lincare had an incredible system allowing it to collect in just 45 days," Mannion said. "Everyone else (in the industry) was at 80. It was an incredibly well-run business by every metric. They turned over their inventory 14 times a year and everyone else was six. They had a high cash flow. It allowed them to buy competitors that were less well-run."

A few years ago, venture firms looked first at a company’s product, hoping it could make a big splash in an existing market. But now, with the economy weaker and customers less willing to shift vendors on a dime, a good product or a good market isn’t necessarily enough. Sometimes investors have to find something unique.

"There’s so much investor money out there going after the ‘hot spaces’ that it’s easy to fall into a herd mentality," said Eric Gonzales, partner with DCM-Doll Capital Management, an early-stage firm in California focusing on communication, networking, software and Internet service companies that manages more than $1 billion. "Every four or five investments, we try to look for something that’s out of the box. That’s the expression we constantly use."

DCM isn’t the only firm taking the "out of the box" approach.

When Focus Ventures, a Palo Alto, Calif., firm that manages just under $600 million, was looking for a new software and services company to invest in, it eventually put money into Wily Technology, a company that makes Java application management software.

"It’s a new playing field without a lot of close competitors," said Steve Bird, a general partner at Focus.

George Bischof, another general partner at Focus, noted that Wily has demonstrated the ability to sell to over 100 different customers, which speaks to its ability to successfully execute on sales. "Some of Wily’s products have helped save companies $1 million," Bischof said.

At Itochu Technology Corp., the business development and venture arm of Japanese conglomerate ITOCHU Corp., venture capitalists seek U.S. companies with the ability to make technology products that fit into the Japanese market.

Itochu is eyeing a small northern California company that makes wireless technology for cell phones. In the U.S., cell phones are common, but not cell phones with advanced functions. Those are more popular in Japan, and Itochu thinks this company has a product that, if properly molded, could be a hit with distributors across the Pacific.

"The product isn’t quite right, but they’re very in tune with adjusting for the Japanese market," said Frank Thibodeau, director of venture investment at Itochu. In this case, the company’s willingness to change its product for a different market makes it attractive.

When Thibodeau learned the venture business, a mentor told him a company’s management and its market were the top two priorities, he said. That hasn’t changed.

"You have to have someone to sell to and have an advantage over competitors," Thibodeau said. "Product is probably less important than before, because the belief is that a great team with a great market will eventually find the right product."

Almost everyone these days talks about capital efficiency. If a company doesn’t have a realistic plan to get to a break-even cash flow within two financing rounds, Gonzales of DCM usually isn’t interested.

"You don’t want to have to raise large amounts of money down the road in this environment," Gonzales said.

Successful venture firms also scout a market carefully before choosing a company.

Mannion, of Summit Partners, says his firm spends a lot of time "cold calling" companies to ask about their history, current market environment and competitors.

"You’d be surprised," he said. "Most will tell you a lot on the phone. When you talk to each company, they’ll name three or four competitors, and dominating players get mentioned often. You can say, ‘Ahh, that’s the top player.’ You want to invest in the top company."