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

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the audience: q & a

Ms. Smith:  Thank you so much, Laura.  Our Netpreneur den mother, the ever-efficient Ms. MacPherson, has given me not only a couple of question ideas but a list of questions that came through email before the program started.  I'll throw out one to kick off the discussion and encourage any of you who have questions to line up at the microphones on either aisle.

        To our panel, you all have done a good job of talking about your focus, but let's talk a little bit about your ideal target investment.  I'm sure you have changed the way you evaluate companies, to some degree, as well as how you set valuations, negotiate terms and so forth.

Mr. Putney:  We have $30 million under management and 165 investors, many of whom are technology executives in the region, such as Vice Presidents of IBM and EDS, or Dan Bannister, the chairman of Dyncorp and a lot of people like that.  Even before we invest in a company, we bring our own investors in to look at them and help us work with the companies.  We offer a lot of expertise as we grow the companies.

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          We never jumped fully on the dot.com bandwagon.  We were pretty conservative looking for basic technology, and we’re pretty much doing the same thing now.  I like what Jeff said about disruptive change.  We're certainly looking for companies that have something very significant.  I see a lot of companies that have incremental ideas.  They're better than what's out there, but they’re not going to make a major change in terms of the way the world is going to operate.  We're looking at funding the way the world changes, hopefully creating better lives for all of us five and 10 years from now.

          Valuations are down a lot.  A year ago, a lot of companies were coming in wanting $10 million pre-money valuations with just an idea.  Now we're looking at companies that are up and running with valuations maybe in the $3 million to $6 million range -- a lot lower rounds.  We have to look at the growth potential and the profit potential of a company in order to work back to a present valuation.  That's a process of both trying to decide where the company's going and negotiation.

Ms. Winston:  Steve Walker & Associates is the management company for Walker Ventures, which has the Walker Investment Funds.  We also are the management company for the Tech Council of Maryland's Maryland Angel Council (MAC), which is more of dinner club format with 75 local business executives and technology people.  Most of what I'll be talking about refers to Walker Ventures, unless I specifically mention MAC, because the criteria and the format are a little bit different.

          We typically like to be among the first outside money in a company, but we are not just one-shot investors.  We usually try to maintain pro rata share over the next couple of rounds.  Our sweet spot is the softer side of information technology; we're looking for companies that can transform business.  The main focus is software infrastructure technologies, things that will change at least particular aspects of business.  Examples are two of our more recent new investments.  One is AperServ, a technology and service company that will let businesses monitor service level agreement performance in real time against the contracted levels and let them become aware of service issues before they become service problems.  We think this is going to change a lot of ways that outsourcing is done and readjust the balance of power more in favor of the customers.  The other example is Butterfly.net, which provides an infrastructure and development environment for massively-multiplayer games.  This can transform both the way these games are developed and the way they are distributed and built.

          When we look at valuation, we have to consider our participation and look at the long haul.  Is the pricing going to be such that you're going to be able to get your next two rounds?  We do a similar thing, working backwards from what the potential market cap might be to what you are realistically valued at now.  There's a lot of comparability analyses going on, too.  Not comparability with respect to publicly-traded companies, but comparability with respect to other kinds of deals we're seeing in the area.  Again, we are a collegial community.  We see a lot of the same deals and we know what goes on.  The most important thing is what was said about ego and greed.  It's better to get funded than to hold out for a valuation that you think you deserve and never get any funding at all.

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Mr. Weiss:  What's the ideal investment?  The ideal investment is one that arguably creates disruptive change, and I mean that seriously.  I know that it's a very high bar, but I want to emphasize that as you think about your idea and what your business is doing, think about the customers.  Think about what’s changing and what they're doing.

          I was with the top person at a multi-hundred-million-dollar company earlier this week talking about one of our companies.  He said, “That's our Achilles heel.”  When he said that I thought, “I've got him.  That's good.  If it's his Achilles heel, we might be able to sell to him.”

          It's a very high bar, but the good thing is that if you work hard enough and figure out something in the space, you can sell it.  Laura was saying that she's going to go out with you to see customers.  I just gave you an example of doing that.  It's critical because lots of ideas can be analyzed and there are a lot very bright people, but customers buy for all sorts of reasons.  You want to understand why they're going to buy, what turns them on, when they're going to pay for it and how.

          Another comment.  There is a secret in the venture capital community which I haven't heard today that goes to the part of your question about valuation.  Almost all of these rounds close with the venture investors buying about 30-40% of the company.  Also, the rounds used to be shorter.  Before, we'd fund for about six months, now it’s 12 to 18 months.  That's because we don't know when the next round is going to be.  We're less confident, so we want to have a sense that you can really make it.  There may not be a next round, and, with many of the rounds today, they have to get you to cash flow break-even.  You do the math.  You have to get to cash flow break-even, you've got to be at least 12 to 18 months out and they're going to buy 30-40% of the company.  You do the math and figure out what your valuation is.  In the momentum market, people said, “These other companies were at this, this and this; therefore this is what I should be valued at.”  Now it's coming way back from that because of the way the math works.

          The final point here is that there are no more benchmarks.  Laura's Loudcloud example is now a benchmark from a negative point of view.  If a venture investor wants to invest $1 and get $10 back, or at least have a reasonable shot at doing that, and if there are no benchmarks in the public markets or in the private sales for what creates a certain dollar-value company, you have to be much more pragmatic.  That's taking valuations way down.

Ms. Smith:  Laura, to follow up on this question, do you think the down valuations and private rounds will create any kind of shareholder litigation among some of the venture funds, particularly the ones that, perhaps, have not exercised as good judgment?

Ms. Lukaczyk:  You mean from the private side?  Well, I'm not really an expert on that.  When you invest in a venture fund, however, you really need to have more money than sense, especially if you're an individual investor because it's at the riskier distribution of the profile.  At one end you have money market accounts in cash; and at the other and you have venture capital.  It doesn't get any riskier than that.

          Historically, there have been down years.  My relationship with NEA goes back to 1986 when I was a student at the Darden School of Business at the University of Virginia and I was hired by Art Marks to work for the NEA firm in Baltimore.  I've worked for other firms through the years, and 1988-1992 was a pretty bad venture time when a lot of funds had single-digit returns.

          One of the things I saw when forming my fund last June, and it was incubated right out of the NEA office in Reston, was a lot of money being thrown at a lot of companies and a lot of money being put into venture funds.  I figured out pretty quickly that if I was going to survive with a new fund, I needed to get as much experienced help around my table as I could.  That’s why I singled out Glassmeier, for example, and Art Marks and Betsy Atkins, who was a founder at Ascend Communication and sits on the board of Lucent Technologies.  I sought out these people and their advice, such as Frank Bonsall, who has seen lots of ups and down, and I've talked very closely with Roger Novak as well.  You have a different set of criteria during tougher times than you do during the good times.

          Getting back to the shareholder issue, the expectations for returns among the institutions I've talked to have diminished to the more traditional levels, although maybe not for the individuals, yet, because they probably haven't been through as many cycles.  The traditional median venture return over a 20- or 25-year cycle is only about 24-25%.

Audience Member:  I’m Tom Mandel, a serial entrepreneur.  I've founded a bunch of companies and I've been in this game since the early eighties.

        Silicon Valley is a deep-rooted entrepreneurial community that has had five generations of new technology companies, and there's a tremendous sense of excitement and opportunity.  I also think of four companies -- Apple, Novell, Netscape, AOL -- that didn’t have customers when they were founded, but had a technology vision and a vision of customers in the future.  I'd like to know if you see the equivalent kind of opportunity for entrepreneurs in this region and what you advise them to do in terms of vision and technology.

Ms. Lukaczyk:  I think the Greater Washington region is a wonderful area.  From the time I first moved here in 1985 to today, it's developed a lot of the elements of Silicon Valley.

          If you have a great technology idea, the way to go after it is to pull together as broad a team as you can and network into all the elements of a team that you need.  By that, I mean that you need to have not only the technology idea, you also need to have somebody who understands the business community, how to articulate your vision for reaching profitability and what your costs are going to be.  I can't tell you how many great ideas I've seen where they can't get that done, so I can't fund them even through the second round cycle.  I would love to write them a check, but I can't.

          The other part of the team is the customer sense, and that doesn't necessarily mean the salesperson or a marketer, but somebody who understands the customer, can articulate how that sales call is going to go, the cycle and why those customers need you.  If you can do that and network as much as possible, it is a good foundation.

          There are a number of angels in this area.  I know several of them, and they call me a lot because they get really excited about a company they've seen in the area.  They'd like to write a check, but they'd like to work alongside someone like myself or some of my other colleagues here.  What we'll do, though, is go through all those different pieces.  We'll have you talk to people within our network, either technologists or customers we know who get a kick out of seeing the leading edge stuff.  They'll talk to you for a while or they'll meet with you to form a view of where we think you're going to go.

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Mr. Putney:  I'd like to say, also, that I think great technology ideas are going to get funded.  The problem that I see is that so many ideas are only small changes, such as another way to set up an ASP or provide a slightly different service to companies, but still great technology.  The kind of things you mentioned are all absolute breakthrough, radical ideas at the time in terms of new ways to do things or a way to change life in a quantum leap.  Those are the kinds of ideas we're looking for.  If we see things that are radical changes, we'll look at them very, very closely.  The good ones will get funded for sure.  We're dying for those kinds of really great ideas.

Ms. Smith:  Have you seen any decrease in deal flow?  I think the answer is probably yes, but let's take a show of hands...Jeff and Laura are shaking their heads no; Joan, yes...Zim?

Mr. Putney:  Yes.

Ms. Smith:  Okay, how much?

Mr. Putney:  I'd say, for us, probably 20-30% less in terms of companies coming around.  Something like that.

Ms. Winston:  In terms of new companies and the number of opportunities we see in a week or a month, it’s probably only down about 10-15%, but that's because so many companies are still coming back and looking. I think that new flow is definitely down by about 20%, but the quality of what's coming in is actually quite good.

Mr. Weiss:  We have a lot of companies knocking on the door.  They’re opportunities to work with.

Ms. Lukaczyk:  I haven't really dealt with any of the dot.coms.  In my technology there's a huge need to advance the state of the market, so I'm continuing to see lots of good things.

Audience Member:  Let me first thank you for providing us with all of these comments and insights.  My question is for Jeff.  You said that disruptive change means creating new markets, slashing costs and making improvements, and you said that 20% does not cut it.  Are you suggesting that if a change needs to happen it has to be 20% more than what it is today?  That is quite a bit of change in these kinds of market conditions.

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Mr. Weiss:  I really do mean that.  I don't mean 20% literally, but I mean the figurative 20% that makes it disruptive.  When you see customers and they say, “That's my Achilles heel,” well, helping someone with their Achilles heel is disruptive, and the result is more than a 20% change.

Audience Member:  But suppose that you’re in a space where 20% is a lot to put forward, even though there is a change that needs to be done?

Ms. Smith:  I think you're addressing a problem that all early-stage entrepreneurs have to deal with, and that is answering the question, “Do I have a venture style company or do I have a good business?”  A lot of wonderful businesses fall into the “good business” category.  They are probably not suitable vehicles for venture stage investment, though they may be right for funding from friends and family, maybe even your customers and that kind of thing.  Would you all agree?

Ms. Lukaczyk:  Absolutely.  There are a lot of businesses I've been seeing out there that could probably be bootstrapped with friends and family and have a nice $10 million or $20 million revenue stream.  I also agree with Jeff.  In my sectors, components, for example, unless you drop the price by 50% there's not enough of a value proposition to go forward with it.  If you're not going to grow your revenue ramp significantly so that you're in IPO territory, that's probably not a venture deal for me, but there are other people out there who love that space, and other avenues you can use to get funding.

Audience Member:  I'm basically a person working out of the basement with a technical background and a zeal to do more than just sit and program.  For the past two years I have been doing part-time consulting to get some money, working the rest of the time researching and developing certain products which I think are useful and needed by various groups.  Six firms are testing them.  As a single person like this, how do I approach the right people?  Money is just one aspect.  I’m also talking about marketing people, salespeople, branding people and the other people to make it happen.  And please don't say “networking.”

Ms. Smith:  Before I ask the panel to respond, I want to point out that at Netpreneur.org’s Funding & Finance area has an extensive resource of venture capital funds and people in the venture community, the kinds of things they're interested in and so forth.  That ought to be everybody's first stop.  Does anybody have other advice for this person?

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Ms. Winston:  I'll take a crack at it, but you're not going to like my answer because it involves networking.

          I do a lot of quotes from Clint Eastwood movies, and a person has got to know his or her limitations.  You understand your great strength, the technology aspect and coming up with products, but before you can get outside funding, certainly from a VC or even an early-stage institution, you're going to need to do some networking to find people to help you who can complement your skills.  Part of what you do as an  entrepreneur is selling your risk to other people.  You need to get some other individuals to buy in and help you understand how the marketplace works and what kind of things you'll need to get done.  Netpreneur is a good place to do that.  You're going to need to find some colleagues so that you're not just yourself in the basement, maybe just two or three who have contacts and can help you plan how to go forward.

Audience Member:  I took my Internet work to be my networking.  That's my research.

Ms. Smith:  Well, personally is better.

Ms. Lukaczyk:  Here is something I was taught, and had to learn the hard way, and I'm learning it still: It's not what you know so much as who you know.  It's a lot of hard work getting to know other people, especially if you're a little bit shy, but it's the only way you're going to get help.  You've got to get people excited about what you're doing because a lot of us will take an interest in it if we hear about you through one of the people we work with, and we work with a lot of people, such as law firms, etc.  If you can't network into those referred sources that we hear from, it's hard for us because we have to verify and we have to hear from other people about what you're doing.  You just have to work hard at it.

Audience Member:  Is there any place where all the VC's get together, such as shows?

Ms. Smith:  There are, and if you get on the Netpreneur site you can find out about them, but, let me tell you, you've got six customers who are beta testing your product.  They know something about it.  You got them somehow.  Why don't you ask them how you can take this further?  Who do they know?  Do they know an attorney?  Do they know a patent attorney?  Do they know a marketer for a related company?  Start with where you are and you've got something going.

Mr. Putney:  If you can write a simple business plan, send it off to people like us and Steve Walker.  If it looks like a great idea, we may ask you to come in to one of our pitch days.  We have a pitch day every Wednesday where we bring in a few companies, and we have other people interested in becoming CEO's or CFO's of companies.  Maybe we can put you in contact with some of those folks.

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Audience Member:  Good morning.  My name is Jason Hardebeck with WhoGlue.  Over the past couple of years everybody's revenue model looked like a hockey stick because we had to justify the expectation that you're going to get a 50-100 times return in two years or less.  Is there a more realistic expectation among institutional investors now?

Ms. Lukaczyk:  Yes.  Traditionally, when I first started working for NEA until about 1997, the expectation was a three to five times return.  It was only a ten times expectation in the last two, two-and-a-half years when the market started to go through the roof.  Those days are gone, and I don't know that we'll ever see those kinds of returns again.  As I said earlier, historically venture returns have only been in the 25% annualized return rate, so, yes, expectations have gone down.

Ms. Winston:  We have finance people at Steve Walker & Associates who look carefully at the modeling, but when I'm seeing somebody at one of our fast pitch days or looking at an executive summary -- you can send them to plans@stevewalker.com, by the way -- I'm looking for the pattern.  In other words, the fundamental questions are: How much are you trying to raise?  What stage will that get you to?  When will that be, and what do you have to do next?  I'm actually looking much more for internal consistency between those linchpins than I am at the absolute number at that point.  If they're not internally consistent, that tells me either that you haven't thought it through or that there is some fundamental logical flaw in what you're doing.  Internal consistency in asking yourself those questions and how you answered them to the casual observer will get you a long way, especially at the early stage.

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Audience Member:   I have a follow-up about some of the figures that have been tossed about.  If we're looking at funding for 12 to 18 months or to break even, and we're looking at pre-money valuations of, say, $3 million, and we're looking at rounds where the high end is 40% of the company, then pre-money of $ 3million and 40% post-money, means you can raise $2 million.  So the question is, if you've got $4 million or $5 million or $6 million to break even, where does that leave you? Something has to give somewhere, either the time or the pre-money or the percentage of the company that gets sold. Is it the case that you just don't get there from here anymore in this market?

Mr. Weiss:  That's a very good question.  What we're seeing in lots of companies is that the whole calculus of the company is changing as a result of what you're asking.  In the extreme of the momentum market, it was the first mover and you had to get the whole market right away.  If you really believe in that, you needed to throw a lot of money at it.  Now the definition of what is a market, the definition of how to bootstrap, the definition of what you're talking about, is that venture money has gotten much more expensive.  For a brief window of time it was less expensive, now it's very expensive.  The alternatives, which are customers, partners, channels and other forms of funding, are critical and have to be part of the plan.  They have to be part of where the cash is coming from.  It’s critical to figure out what's enough.

          There are lots of companies that say they need $5 million, but why?  When you go through all the elements of it, there's a lot of creativity that happens earlier on.  The stair steps are getting much smaller, so you might not need it.  Can you accomplish exactly the same thing for $1 million instead of $5 million?  Probably not, but will you be on the path to proving that you have momentum and that you might sustain the company?  You might.

Audience Member:  Sometimes it seems that there may be a focus trade-off implied in what you're saying.  For example, a software company might have the ability to generate some outside revenues by providing services, although people generally don't want to touch a consulting model, or by reselling software that other people have developed.  That would mean that their attention is not fully and completely on the development and marketing of the core product.  Is that an approach you're talking about when you say customer funding?  Obviously, there's also customer investment.  Does that play or is it a weak way to raise money?

Mr. Putney:  We often see companies that are something like a software development house.  They are developing a product and want us to invest in it.  We don't look at the business they have developing software because that's not the kind of business we'd invest in.  From your point of view, you may find it beneficial to be able to do that to bring in some other money, but the VCs are not going to look at the other businesses.

Audience Member:  Will they look at the source of funds if there's a gap and I can raise the other $3 million by doing ancillary activities?

Mr. Putney:  If they're directly related, yes, that could count in terms of source of funds.  By the way, those terms of valuation are all negotiable.  If you have a really great idea, it may be a lot more than a $3 million pre-money valuation.

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Ms. Smith:  The good news is that you can stay alive while you find out the answer to your question.

Audience Member:  I'm Larry Busse with FedNet.  Our products deal with the public policy arena and one of the problems we've had over the last 12 to 18 months is that the VCs didn't want to have anything to do with anything that involved the federal government.  Are you finding that companies that have the federal government or public policy of any sort as part of their equation are better received now in light of their supposedly reduced risk?

Ms. Winston:  That's a good question.  I'm not sure, in general, what the answer is.  This is the Washington area.  People who are particularly interested in ventures with a government focus do tend to be here.  We've seen a lot of them.  It hasn't traditionally been one of our focuses, but it reminds me of another role that the government plays which was important to Steve Walker's company, Trusted Information Systems.  You can use the government as a non-equity venture investor through agencies like DARPA or the SBIR or technology accelerator programs.  Even at the state level, there are efforts like Maryland DBID that has a matching grants program that is very good since the government doesn't take equity in most cases, at least the federal government doesn't.

          I actually don't know the answer to your main question.  It may be true that the risk will be less, but one of the issues that venture investors had was looking at overall return and whether it is really a fundamental transforming technology.  For technologies that will transform government processes, to the extent that they also transform commercial processes they can quite possibly do well.

Mr. Putney:  One problem is that the profits available in government contracts are usually low, in the 7% range.  VCs are not interested in that, so they generally tend to shy away from them.

Mr. Busse:  It doesn't sell to the government; it actually receives from the government and sells to the public policy arena, such as the lobbying organizations and the lawyers.

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Mr. Putney:  The question is, is it leverageable?  If it's something beyond just selling people's time, it could certainly be of interest.

Audience Member:  I'm Ben Cruz from Synchromedia.  Perhaps because of the dot.com crash, I’ve been noticing a number of developers and consultants who are beginning to take some equity in exchange for their services.  I see this as possible competition to incubators like ASAP Ventures, for example.  Jeff, you mentioned the 30-40% equity VCs take and I'm curious if it’s the same for incubators?

Mr. Weiss:  I don't think there's any one answer.  At ASAP, because what we do is so broad-ranging, from the incubator route where we have companies come in with two people and a business plan, to companies that are much further along and where we're providing more incremental help.  It ranges from the single digits to the twenties in terms of the percentage of the company that we get.

Mr. Cruz:  How do VCs see a company that grew its presence in the marketplace with an incubator so that the team will not be there over the long-term?

Mr. Putney:  You have to have a strong team.  You've got to pick them up somewhere and you have to have a path for bringing them into the organization because that's who we're investing in.

Audience Member:  First, I would like to thank you for taking the risk that somebody like me might come along.  I went to the doctor the other day and he told me that I have an eye/ear disease.  I said, “What's that?”  He said, “Well, what you hear you don't see, and what you see you don't hear.”

        What I hear is that we have to have good management, we have to have a good valuation, we have to know the market and we have to have a good plan.  All of this makes a lot of sense to me.  What I don't see is how you, as investors, can actually see that because when we submit a plan or an executive summary it ends up in the trash.  I sent my executive summary, but I didn't hear anything back, which tells me that it ended up in the trash.  If you're receiving, let's say, 200 business plans a month and you don't read 99% of them, how can you really say if what you received is valid or not?

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Ms. Winston:  First I'm very sorry you never heard back.  Typically, we get about a hundred plans a month.  If you sent it to plans@stevewalker.com you should get an autorespond back within a few days when it got logged.  If you don't get the autorespond, send it again, please, and indicate that you did so.  Please try again.

          One of the reasons why you may feel that you got a rather quick rejection without having a chance to come in gets back to what I was saying about space.  We actually see on the order of 20-40% of the companies that submit to us, depending on the flow and the pattern.  There are patterns of ideas that come in clusters or waves, as I'm sure my colleagues would agree.  If it's not a space that we're interested in or one where we have satisfied our portfolio appetite already, that's something we can tell you rather quickly.  Sadly, no matter how wonderful the management team, it may not be a place where we can go.  But if you do send something and you don't hear anything back after about two weeks, even an autorespond, try sending it again because email does have its foibles.  We do actually read everything that comes in.

Mr. Putney:  The other thing is to look carefully at what the funds say that they want to invest in.  I don't know what your idea is, but we are all pretty well focused in terms of specifics.  I think we look at all of the plans that come in.

Ms. Lukaczyk:  Getting a response out is one of the most difficult challenges and is a common courtesy all of us strive to attain in one way or another.  I guess you're saying that we have to work a little harder at common business courtesy.  One of the ways you can assure yourself of a more targeted hit is to take a look at Web sites and talk to some of the lawyers or accounting firms around town that deal with early stage companies to figure out where we have invested in the past and what our investment criteria is.  If you're not in there, we're not going to be able to do the deal.

Ms. Smith:  This has been a great panel.  I really have had a lot of fun.  Great questions from the heart.  We're going to close the meeting and hope to see you again at another Netpreneur event.

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