coping with the new climate in early-stage investing
i’m OK, you’re OK, but we’re not investing

It has become conventional wisdom by now that investors are tightening their wallets and riding out the market downturn since the dot.com bubble burst. Everyone says that it’s harder to get deals done and, when they do, valuations are down. While entrepreneurs acknowledge this fact intellectually, it doesn’t seem to be affecting their behavior according to many investors. At this Netpreneur Coffee & DoughNets event held March 22, 2001, a panel of experts discussed how the early-stage funding environment has changed and offered specific suggestions for what entrepreneurs must do in response if they expect to get funding in the post-bubble world.  

Statements made at Netpreneur events and recorded here reflect solely the views of the speakers and have not been reviewed or researched for accuracy or truthfulness. These statements in no way reflect the opinions or beliefs of the Morino Institute, Netpreneur.org or any of their affiliates, agents, officers or directors. The archive pages are provided "as is" and your use is at your own risk.

Copyright 2002 Morino Institute. All rights reserved. Edited for length and clarity.

mary macpherson: welcome

Good morning.  I'm Mary MacPherson with the Morino Institute's Netpreneur Program.  On behalf of the team, I'd like to welcome you this morning to “I'm OK, You're OK, But We're Not Investing.”

          Let me tell you how that topic came about. A few weeks ago our teammate, Fran Witzel, met with a group of early-stage investors, many of whom are here today.  They wanted to talk about what has changed in the investing community and what they might do about it.  One of the things that came through loud and clear was their sense that entrepreneurs knew, intellectually, that things had changed, but they seemed to be doing the same things they were doing a year ago and getting different results, i.e., no money.  They suggested that it might be a good idea if we had a little fireside chat where they would be willing to talk about early-stage investing in today's climate.  That's why we're here today.

          This morning we have a panel of early-stage investors and an extraordinary moderator, Esther Smith, who was seen yesterday on “Talk The Talk,” our email discussion group for entrepreneurs, commenting on what she called “gut-bucket funders.”  Maybe she'll elaborate on that because it's something she seemed to feel pretty strongly about.  Let me introduce Esther Smith.

esther smith: introduction

Thank you.  It's always great to be with Netpreneur.  I think I came to the very first meeting and have since been a huge fan and supporter as much as I can.

          I was in a hurry yesterday on Talk The Talk, but I didn't want anybody to think that the OTC:BB was the right path to take.  I'm glad I got the point across.  Somebody else expressed it much better than I did, so I sent a second message that just said, “Yes!”  If you really want to have a more informed discussion, read that note.

          This morning we have a topic that's near and dear to everybody in the room and to the rest of our burgeoning Netpreneur community.  As a general rule, my observation is that the very early stage-funders -- angel, post-angel and seed stage -- have had less money to invest and have had to be extremely careful.  They are showing very good results in many cases.

          It's great to see such a huge turnout and to be on a panel with four tremendously well-informed people who are ready to share what they really think.  I'm not going to introduce everybody in detail because you've got their bios in the links.  They are all wonderful people to work with and people I've enjoyed knowing.  They have a lot of wisdom.

          Each of our panelists will speak for about five minutes, then we'll open it up for the Q&A.  Let’s start with Zim Putney who's the founder of NextGen Capital and a fixture in the tech community, perhaps for longer than I have been.

zim putney: wrestling with greed and fear

Thanks very much, Esther.  Yes, I remember being in that room for the first Netpreneur meeting as well, and I was on the Board of the Northern Virginia Technology Council when you brought out the name “Titans Of Technology” for our breakfast series.  We go back a long way.

          I'll say a few words this morning about what's happening in the investment community.  I think a lot of you understand it, but I'm not sure that any of us understand it completely.

          There's a lot of motivation coming through greed and fear.  A lot of you are motivated that way, and a lot of us on the venture side are motivated that way, too.  A year ago, I would say that we, the capital community, were force-feeding the entrepreneurial system.  We were forcing a lot of money into a system that really couldn't adequately and efficiently use all that money.  It was like a big government program to build a super computer in which you put a lot more money in than could be efficiently spent.  That's what happened, and a lot of companies have fallen by the wayside.  It's happened in both the public and nonpublic companies.  We were funding a lot of ideas that were not good ideas as demonstrated in the marketplace.

          As they say, “What's old will be new again,” and now we're back to looking very carefully at deals, and working with companies we've invested in to make sure that they're successful -- the companies that are already out there.

          Basically, money is pulled upstream.  If you don't have an IPO market, the Series C investors are reluctant to invest because there's no place to exit.  The same thing goes for the Series B and Series A investors.  All of us are a lot more cautious without the ultimate exits that were tremendously stronger a year ago --the IPOs as well as the technology companies that had tremendous capitalization and could spend their stock as cash to acquire companies.  All of us in the investment community are a lot more cautious about putting out money.  We need to make sure that yours is not only a good idea, but a great idea.  We have to make sure that it’s got some staying power, that it's really going to work and that we will be able to find future rounds of financing -- but there is money out there.

          Some have stepped away from some of the seed stage, pre-revenue deals.  We've done a number of deals.  Some of them worked out and some of them haven't.  It's a lot higher risk.  It's probably a lot harder to find seed money than it was a year ago.  You probably have to go to angel investors, but there still is early-stage money.  Our fund is still doing investments in early-stage companies that have modest amounts of revenue, and others are doing them as well.

          There is still money out there, but people are going to look a lot more carefully at your idea than they would have a year ago to make sure it's something that has uniqueness, that you've got the right team and that you're going to have the market potential over the long-term to make the venture successful.

          Most of us are looking at longer horizons.  A year or two ago there was this incredible gold rush mentality-- we have to get out there; we've got to get the money out there, we have to get the companies turned around.  We've always looked at something like a five-year horizon, now we're looking at a five-year horizon again.  From our point of view, at least, the money is more patient now.  A year or two years ago it was impatient money.  It was, “Get it out there and get us a return quickly.”

          With that, I'll turn it back over to Esther.

Ms. Smith:  Thanks, Zim.  Next we're going to hear from Joan Winston of Steve Walker & Associates.  I have had a lot of fun as an observer of the Steve Walker & Associates technique because of their relationship with WOMENAngels.net, in which I'm involved. They have a couple of partners in it as well, and have contributed very strongly on the due diligence side.

joan winston: space matters

Thank you.  I certainly agree with everything Zim said.

          Currently, we have about $50 million under management.  We consider ourselves seed and early-stage investors, somewhat in the angel range, although we are investing other people's money so some of our metrics are a little bit different.  Typically, now, as before, our first investment will be anywhere on the order of $100,000 to above $1 million.  We typically like to keep our pro rata share for the next couple of rounds, so our reserve analyses are very carefully done, especially now, as the steady movement upstream has slowed a bit.

          One of the things we've always done is that we don't really look at our investments as just a money placement.  We are looking for a partnership, and we tend to work very closely with our portfolio companies.  We have a lot of companies in our portfolio, and you might ask how we can do that.  The answer is there are a lot of us.  We have about 12 people in the investment team.

          The other thing we think is a strength for us as a partner with a new company is that most of us have had a lot of operational experience in the software industry -- in sales, marketing, technology, human resources -- so we can bring that operational experience to bear to help our companies succeed.

          In addition to the analysis that Zim gave you, some of the themes we're seeing now include a lot of companies that are resurfacing, still looking for that first round.  That's sad because you know that a lot of them aren't going to get that first round ever.  On the brighter side, a lot of the "me-too" ideas that were trying to get big fast and get sold back during the craze are going away.  The noise to signal ratio is getting better.  Maybe a lot of people are registering for spring semester instead of starting a dot.com, and that's probably a good thing.

          On the other side, for companies that are seriously going for it, the bootstrapping phase is more important, and it's going to be longer.  A lot of the sources of that quick, easy, first $1 million based on the back of a napkin -- if it ever happened -- it's certainly not going to happen anymore.

          At least for the non-individual angels, there’s another theme that we're seeing.  Instead of getting $100,000 then another $100,000 a month or two later, companies are now trying to pull together a syndicate's worth of money so that they've got maybe 12 to 18 months, or at least enough to get to reach a major milestone, such as the cash flow break-even point, but at least a milestone that's credible in this environment.  We can't assume it's going to get better, although we hope it does, so you have to reach a milestone that will let you close another round.

          Last week, I was at the Virginia Venture Conference and heard a comment that I thought was great.  I wish I could remember who to attribute it to, but it's not mine.  This person said that one of the things that you have to look at when you're investing is whether a company is going to run out of money before they reach a milestone or before they start getting revenues.  When that comes up, there's the concept that you can bridge them, but this person said, “You want to make sure that you're building a bridge, not a pier.”  That was great.  Bridging happens, and it's not always a bad thing or sign of mismanagement, but, now, more than ever, investors are going to have to try to decide  right up front how big a bridge they're going to build.  As we tended to do all along, investors want to be looked upon as long-term partners.  If we intend to participate in initial rounds, we have to ask how much construction equipment and materials we’re going to need for you over the long-term to make sure that we can actually help the company grow.

          That comes to another thing, which is: space matters.  I feel badly about it, but a lot of companies come to us and we have to say “no” because they're in a space we don't know enough about to invest in, or at least we don't know enough about it to lead.  Those are not necessarily the same thing.  One of the lessons, especially in this environment, is that entrepreneurs are going to have to do more homework about investors and make sure that there's a plausible fit before they invest a lot of emotional energy or time, or before they use up all their referral chips from trusted sources.  You have to find an investor who can plausibly invest in your space, who knows enough about it to be able to do that mental and paper calculation to see what your requirements are likely to be and how much value they can add in addition to the money.

          When you get told, “Sorry, we're not in that space,” there are two positive takeaways you can have.  One is that you have to find someone who invests in your space.  There's a story, about going door to door selling cookies.  Somebody says, “Oh, no, I'm on a diet.  I don't eat cookies.”  You can either try to persuade them that they don't need to be on a diet -- which might work, but probably not -- or you can tell them that your cookies have no calories, or you can ask, “Do you have anybody at home or in the office that might like cookies?”  It's good to ask, “Who else might be interested in my space?  Who else do you know who is knowledgeable?”  Another thing you can ask is, “If we got a lead investor who is knowledgeable, can we come back to you?  Would you be interested in talking then?”  Often, you'll find that the answer is yes.

          For us, we're also looking at the management team, the opportunity/technology and whether or not the company will be able to have a protectable advantage in either its productivity gain or its competitive advantage.  If we can't really feel comfortable about our role in all three of those areas, it's not something that we're likely to lead. However, if we can partner with somebody who knows the customer space better than we do or who knows the technology better than we do, then there's a synergy for early-stage investors, and you might get a round done.

          Instead of continuing to butt your head in a corner, try to find a way out where you can get people to pool their intellectual resources as well as their money.

Ms. Smith:  Thanks so much, Joan.  Now next we're going to hear from Jeff Weiss who, in addition to being the Managing Director of ASAP Ventures, is also a serial entrepreneur from the tech environment here in Greater Washington.

jeff weiss: customers give the party

Thank you and good morning.  I thought I'd start by spending a minute or two talking about ASAP Ventures since we're very new on the scene and not as well-known, then make a couple of broader comments.

          It's interesting to have us here today because we are not a venture capital firm.  We are a services firm, an Internet business accelerator. It's a group that Cal Simmons and I founded last summer, together with a group of investors including a lot of venture capital partners, such as Russ Ramsey, Rick Rickertsen, Harry Hopper, Will Dunbar and a dozen others.  We are both an incubator and advisory services company, and what that really means is that we help in two ways -- strategy and capital formation.  In both cases we execute; we're a group that actually joins the team and helps do these things.  Whether it's marketing, branding, business development or operations or helping discover the value proposition and how viable it is.  It's our feeling that with market conditions tougher than they've ever been, what we want to do is help raise the momentum and the value of the company.

          Now, following up on something that Joan said, and something that I have felt very passionately about for a long time, we can't lose sight of the fact that customers give the party.  If you think about what you're doing in starting a business, from many points of view it's really all about making customers happy.

          There are some old financial metrics which say that there are only four things that matter in a company, and they're very simple: profits, growth, interest rates and risk.  If you know the financial equations and go back to how companies are valued, that's what matters.

          Borrowing from Zim, if you start with the idea that companies, at some point, have market values in the public market, then you know that there’s a Series C round before that, and maybe a Series B, a Series A or an angel round.  From an investment point of view, everyone is playing into that food chain.  Ultimately, it's based on profits and growth since you can't control interest rates and you can only control volatility to some extent.  You can control your profits and your growth, however, and that's really all about customers, so customers give the party.

          Last year's business plans were somewhat typified by something that was in the New York Times 13 months ago.  There was a business plan for a company which amused me at the time.  The man said that he had the perfect business plan for that market.  The plan said he was going to sell $100 dollar bills for $95.  It was a limited offer, only one per customer.  As a result he was going to have all the best metrics of any site on the Internet -- more hits,  more traffic and, because it was only one per customer, he would have lots of repeat customers.  VC's would love the metrics.  He would raise his A round, he would raise his B round and then he would surprise everyone.  He would dramatically improve his financial metrics by raising his prices.  He was starting out with a pretty good set of financial metrics -- only a 5% negative gross margin.  After all, Amazon had a 35% negative gross margin and look at their market cap.  He would only have 5%, then he would raise his price to $97 for a $100 dollar bill.  All his financial metrics would look so much improved that Wall Street would take him public and the rest would be history.

          That was last year's business plan.  Last year, as you all know, was the year of the first mover.

          So what is this “the year of?”  What are we thinking about?

          This is the year of the smart mover.  That's something I'd like to talk about which we should have been thinking about all along.

          As Joan was really saying, what venture firms have traditionally invested in is disruptive change.  Just having something which is incremental is not good enough.  There certainly were many companies and investments in the momentum market of last year which were just incremental.  They were features; they weren't companies.

          Disruptive change means creating new markets.  It means doubling productivity.  It means slashing costs or doing better than that.  It means something we knew about five, 10, even 20 years ago called the “killer app.”  Imagine life without email.  Imagine creating financials without the spreadsheet.  Imagine life with only three television stations or research without the Internet.  Twenty percent improvements just don't cut it.  There were a lot of ideas in the last year that got funded, but that arguably weren't great ideas.  How many people have rushed to the Internet to buy a 50 pound bag of dog food and have it delivered?  It just wasn't a radical change.

          Here are some quick stories about this with things to think about from the smart mover point of view.  They're stories from specific companies that I won’t talk about in great detail.  Here are some of the issues that arose.

          One is about ego.  The story about ego is that you really need the right “whole team.”  It's not just about having the good idea and coming up with the theoretical disruptive change.  It turns out that the team is absolutely essential to making the market because, remember, the customers give the party.  Quite often, the team needs domain knowledge which, when you're very, very early, actually means going in and among and becoming almost organically part of the customer base.  In this particular company that was raising money, a lawyer had an idea and he hired a software developer.  They were both very bright and very passionate, and they had a lot of charisma and desire to do what they were doing.  Neither of them, however, and it wasn't their fault, but neither of them had any prior experience in the area that they were serving.

          The ego part is that they realized it, so they hired somebody.  But from a team point of view, they didn't bring him in and really make him part of their team.  They made him an employee, but he was never integrated.  He was never part of that passion or charisma; he was the tag-along.  Building teams is very important, and, even though they had an industry specialist, they were never able to get the traction.  When the due diligence came around it was sad, in some way.  The due diligence verified that it was a very good idea and a very good market.  Because of the way the team worked, however, which was, to a large extent dysfunctional, it wasn't a company that the investor thought could be built with that team.

          Now, greed is point number two. We're all hearing about lots of deals.  Esther and I were talking about the concept of one earlier.  Everyone wants the best financing and the best valuation, and you want to have ever-increasing numbers.  The truth is that, since customers give the party, getting the market is what's really important.  Even if you get this round of financing or the next round of financing, ultimately what's going to matter are your profits and your growth.  Profits and growth happen when you have a dominant market position and you're in front of customers.  Don't be greedy.  Do the best deals that you can.  Having money is better than not, and being positioned is better than not.  In one particular case, at the height of last year's market, this company was doing the right thing.  They got what was an awesome term sheet, then one of the members of the team got greedy.  As a result of his personal comportment, they scared away a major investor at the last minute.

          The final comment I'll make is about discipline.

          Branding is very important to any business, but doing it in the relevant range is important.  Netscape started a trend which was something of the cornerstone for a lot of what happened in the last five years in the financing market.  The trend was that going public was a branding event.  When Netscape went public, no one had heard of them.  Arguably, they went public dramatically earlier than any company had, from a metrics point of view.  They were pre-revenue.  All the things we think about happening ordinarily during the last five years, hadn't happened ordinarily before that point in time.

          If you look at that as the beginning of the spectrum of what happened in branding during the last five years, the end of the spectrum was the idea that a Super Bowl ad could be a branding event.  By a year ago January, and the year before that, there were a large number of ads which in the Super Bowl were viewed as branding events.  The interesting thing, as the research shows, is that the retention of the dot.com ads in that time was extremely low.  The fact remained that one ad in one show, even with the reach of the Super Bowl, wasn't good.  It didn't do it for those companies.  Building enduring brands is critical. People who understand that customers give the party, such as AOL and Dell, didn't get to where they are without doing that.

          Zim said, in essence, that there was way too much investment chasing too few ideas in the bubble.  The interesting thing about our times, right now, is that the range we're all in, and the range that Alan Greenspan deals with, this is an investment-based market collapse.  There were way too many companies funded and there was way too much money put out.  It's not a traditional inventory or production-based market collapse.  As a result, the best opportunities now will be in building real businesses that customers love, offering sustainable advantage from their disruptive changes in the market -- companies that are market-driven and offer solutions to problems that keep CEOs awake at night.  That's really critical.  Companies that are fair will be built to last.  Companies, like the $100 bill company, which were built to flip, will fizzle just like new Coke did a few years ago.

Ms. Smith:  Thanks Jeff.  Our last presenter this morning is Laura Lukaczyk from Avansis Ventures.  Laura's fund illustrates something that, to some degree, the other funds here do also, but it is more explicit with hers.  She has a long-standing relationship with New Enterprise Associates (NEA), the largest venture fund based in our region.  This kind of “food chain effect” is part of the golden handshake that is being developed here in the Greater Washington venture community among the venture capitalists, service providers and so forth.  Now, Laura will tell us about her perspective on things.

laura lukaczyk: rely on your networks

Thank you, Esther, and thank you, Mary, for having me.  This is my first panel within the community and I'm very pleased to be here to share some of the things I know about and have been seeing.

          My fund, Avansis Ventures, is a $25 million early-stage technology fund which acts as a feeder fund of early-stage deals into NEA, Oak Ventures and some other funds as well.  It's because Oak, for example, has such a large fund now that they can't really invest in a company and actively participate in helping it grow unless they put something like $20 million to work.  Well, a lot of the excellent early-stage deals don't need $20 million, and that's where I come in.

          I help companies groom their management teams, vet out the customers, vet out the revenue models, and bring them along with more of a hands-on approach and smaller dollars out the door.  I'll put out between $100,000 and $3 million and be very active on the board, or, if I'm not on a board, I'll be less active, but participate in helping you recruit and do things of that nature.

          I have a very narrow focus because I'm only one person, although I do take advantage of the broad Oak and NEA networks.  My sweet spot is optical components, data communications equipment and storage equipment and software.  I do look at wireless, but when I see a wireless deal I usually team up with one of my colleagues who is great in the space, such as Mark Ein at Venturehouse Group or Scott Schelle who ran American Personal Communications and is now at Sterling Capital.

          One of the reasons we came up with this panel today is that the market has really changed in the public sector.  What happens in the NASDAQ and the Dow eventually funnels down to us at the early stage and to you folks trying to get money.  Many of my colleagues at the bigger funds are only working on their portfolio companies, doing things to cut costs, lay people off and get their cash flow to be positive earlier.  Some have been doing so for the last six months. They're almost consumed by it, and they haven't been putting a whole lot of new money out the door.

          That led us in the Washington area venture funds community to have a meeting to discuss the current climate and see what we can do to work together.  Venture funds are colleagues as well as competitors.  There are areas where we all work together and areas where we're very competitive, but what we're trying to do is help the community here get funded.  That's why we're here today.  There have been some things that we've been seeing that we want to let the community know about because you all have these great businesses that you're trying to get funded, and we would like to help you get them funded as well.  We have to help each other.

          One of the things I've been seeing a lot of is that a deal comes in that has a good technology basis and there's some technology domain experience, but the team has not done a good job of figuring out the competitive environment.  By that, I mean that you have to network into people you know within your various companies who are your potential competitors.  People know each other through their networks, either through technology symposiums, or because they've worked together before or things of that nature.  You have to come in and say, “This is what I'm seeing.  This is the customer set that such-and-such company is going after.  My customer set is a little bit different.  This is why my technology is better or more revolutionary or evolutionary.”  The business plans I'm starting to see, because the funding was easier in the past three years, haven't really drilled down into that.

          The other thing I'm seeing is that knowledge of the customer’s space is not completely there.  For example, when somebody comes in, one of the things that I'm going to want to do is talk to your customers or your potential customers.  You may just have a technology idea, and that's okay, but, when you start to figure out your feature/functions on a switch, for example, have you talked to anyone in your community of people that you used to work with or sell to?  Can I call them up and ask them what they think of your idea?  If I can't do that, you haven't done enough of your homework.  You haven't put enough sweat into getting your idea launched, and that's a problem for me.  I may think you have a wonderful idea; I may even mention it to some of my venture colleagues who may think it's a good idea also, but I can't go any further because you haven't helped me.  I can't do it for you.

          All of us love to help the companies we work with, but there are only so many hours in a day, so you have to help us as well.  That means that when I give you an idea -- certainly, we're not always right -- but if we do give you a suggestion, well, go see the venture fund we referred you to, or the technologist or potential advisory board member.  Sometimes, if we're really excited or we think we're going to do the deal, we'll go with you or make the call for you, but we need you to take that step to drive it.  I'll hear comments back like, “Well, aren't you going to do that for me?”  Or, a lot of times, “I can't.”  I need you to show a great deal of initiative and drive and enthusiasm that you're going to go to town.

          One last thing.  I spent the weekend in Los Angeles at an optical components symposium which was attended heavily by technologists, investment banks and venture capitalists.  What we're starting to see is an example of the “Loudcloud IPO phenomenon.”  At their last private round, Loudcloud was valued at $17.33, I believe.  They went public at $6, which was way below their prior valuation.  They went public at that lower valuation because the one they would have gotten from their private equity investors would have been worse.  When I looked in the paper this morning, it closed yesterday at $5.13, or something like that.  While I was at the conference in LA, I was hearing that there are probably a lot more companies like that in the pipeline.  That means that there is probably going to be a trickle-down effect for valuations all through the food chain, and it's probably going to start to hit in December or in the last quarter of this year most severely within the private follow-on and IPO rounds.  I think that just tells us all that we have to work harder than ever.

[continued]

Page one of two | Next page