Down Rounds Syndrome

David J. Blumberg, Blumberg Capital

The March 6, 2001 San Francisco Chronicle contained an article by Carol Emert that I have excerpted as follows:

"Livemind Inc., a San Francisco wireless startup, is facing a mass defection by employees who claim that venture capitalists are making off with an unfair share of the company's equity and leaving them with virtually nothing. ...most of Livemind's staff of 35 to 40 stayed home yesterday, jarred by the firing of (the) CEO...and (the terms of) a related controversial bridge loan proposed by the VC firm.

The primary demanding a "liquidation preference" of four times its money back for a proposed $3 million bridge loan, according to sources who have seen (the) term sheet. Liquidation preferences give the holder first dibs on any proceeds from a sale, so (the investor) would reap $12 million from its $3 million loan.

"I was given a sizable amount of equity which is now not worth anything," said Iain Scholnick, Livemind's chief technology officer. "Eighty to 90 percent of the staff's not going (to work) and I'm not going in," said Scholnick, who was the No. 2 executive until yesterday."

This is scary stuff! Like the old medical "cure" of bloodletting; for many ailments, the treatment was worse than the disease. But as frightening as this scenario is, there are many lessons we can learn from it.

But first, let's take a look at how we got here. The last half of '90's was a sellers market in which deals were increasingly overpriced and under-investigated. Investors were impatient, inexperienced and overconfident. Today, with the market sell-off and the downturn in the economy, we are in a buyer's market. `Once burned, twice shy' investors are hesitant to make new investments, and many would describe the current state of VCs as wounded, paralyzed, vengeful, nasty, and overreaching.

To make up for prior bad investments and protect themselves from incurring similar losses, many VCs today are seeking protection and retribution in new term sheets with onerous, almost `angry' clauses. To paraphrase Queen Elizabeth I, 'anger makes men witty, but keeps them poor'. Thus, we have an epidemic of widespread "Down Rounds Syndrome". But before we rush to tighten terms and demand 4X liquidation preferences and full ratchet anti-dilution clauses, let's recall master strategist Augustus Caesar, who said "Hasten slowly". While there are many gravely ill patients, what we really need is preventative medicine.

The vaccine for "Down Rounds Syndrome" comes in many forms, and I think that learning lessons from the past can prevent future outbreaks. There are lessons to be learned by everyone involved in the private equity process, Entrepreneurs, VC's, Angel Investors and Corporate Strategic Investors.

Entrepreneurs should take away the following lessons from these events:

  1. Be Realistic - Realistic projections will allow you to get funded at market clearing price.
  2. Be Conservative - Overly aggressive forecasts can come back to haunt you. Higher projections lead to higher valuations, and potentially to down rounds when overly aggressive forecasts are not met.
  3. Be Credible
  4. Be Cost Conscious - Getting to cash flow breakeven is critical, because it will reduce your dependence on VCs and help you avoid being forced to accept unfavorable valuations.

Founders must also remember that in good markets, they will likely end up with 5-15% of the company (pre-IPO), and in down markets this will be only 1-3% after all rounds and dilution. However, what may seem like a small stake can be very valuable, if you do a good job of creating value with your products.

As an example, Blumberg Capital worked closely with the three founders of Check Point Software from Israel by driving the first 18 months of the US and Japanese business development, marketing and PR efforts. Initially, the founders sold half of the equity for only $200,000 in seed financing. Nevertheless, the low initial valuation didn't hurt the founders because the company was ultimately very successful. The $200,000 was ultimately turned into $10 Billion.

On the VC side, many of the heavily invested VC funds are in serious triage mode, and the VC industry in general should issue a collective mea culpa. VCs overpaid, were hasty, careless, and lacking in humility. Many deals were over financed, and many VCs pressured entrepreneurs to take more money, scale faster, and spend more. My first VC mentor Fred Adler says, "The size of the start-up company's office is inversely proportional to the future success of the company." In the old days, we learned that bootstrapping is good discipline, and the easy cash of the last few years was too much of a good thing.

VCs should take away the following lessons from these events:

  1. Triage / Salvage - VCs must work hand-in-hand with the companies that they funded in order to salvage them. Harsh deal terms and squeezing out employees and founders will not go a long way in returning lost capital (as the epilogue of the Livemind story shows.)
  2. Back to classic venture capital formulas - Rigorous valuation models with realistic assumptions need to be employed before investments are made. Throwing cash at the latest trends will not produce positive returns.
  3. Caution - Investments need to be researched, including in depth analysis of the management, competitive landscape, and marketing plan. If an investment seems too good to be true, it just might be.
  4. Karma - What goes around comes around, so be careful whom you crush.

Michael Collins of Testa Hurwitz says he is seeing VC clients tending to band in tighter consortiums with groups they trust, working on multiple shared deals rather than doing deals helter skelter and opportunistically. He counsels clients to seek reasonable balance between stakeholders, optimal discussion, transparency, open information, and processes for dispassionate decision making.
Angel Investors

While it appeared for a while that Angel Investors could make significant returns by investing very early in new ventures, Angel Investors have also learned some difficult lessons, including:

  1. High Risk - Early stage technology investing is a tough business, with low odds of success.
  2. Commitment - A serious or full time commitment is required. Careful due diligence and extensive research must be done before an investment is made.
  3. Wide Range of Skills Demanded - Once and investment is made, early stage companies need more than just cash, they need mentoring, contacts and advice.
  4. Diversification - As in all investing, diversification is critical part of the equation. However, this is typically hard for angels to accomplish, given their limited access to dealfow.
  5. Deep Pockets - Early round investments will not pay off if the early money is completely diluted in later down round. A lot of money may be required to invest in future rounds if a company is a winner.

Thus, Angels must proceed with caution. This is a risky playing field for experienced investors, and you must know your limits to participate. Ideally you should invest through VC funds to achieve more diversification, and use co-investment rights to leverage skill-set and resources of a professional investment team. Corporate Strategic investors

On the corporate side, there was too much of the "tail wagging the dog" whereby corporations tried to invest in start-up firms in the hope they would create more demand for the investor corporation's products. It generally hasn't worked very well because the corporate investors didn't bring the financial / venture expertise nor did the managers have the long-term perspective traditionally required for this asset class investment. I recently heard about one large software company VC fund in Silicon Valley where 27 of 31 investments were either dead or on life support. Again, investing through independent venture capital firms is probably a better route for most corporate investors.

But it is not all bad news. Who would recommend investing in technology VC funds or start-up companies now? Well, as Mark Twain said about Wagner's music, "It's not as bad as it sounds."

The beneficiaries of the current environment are newly formed, early-stage VC funds. As long as these new funds learn their lessons and don't make the same mistakes seen in the recent past, they have certain advantages, such as:

  1. No legacy portfolio in need of repair - New funds can focus on making investments, rather than spending time helping past investments stay afloat.
  2. Partner Time - Fewer investments and no triage means there is also more time for the Partners to help new portfolio companies.
  3. Bargains - The positive side of down rounds is that dramatically lower valuations abound, so current investors can find great deals.
  4. Boring Deals - The end of the gold rush means there are less "MBA deals" floating around, with a slick business plan and no innovation or technological base. There are more "boring" deals from Engineers and PhDs, based on technical research. This is just what good VCs like.
  5. Early Pick of the Litter - Early-stage VCs can choose the best young companies, and then feed second round deals to larger established VC firms.

Finally, let me add among all the gloom and doom, that entrepreneurs are like artists, they create companies because they have a need to do so, and great entrepreneurs create companies that bring forth products and services of real value tapping into latent demand in fast growing markets. While it seems the worst of the market downturn is not yet over, in the longer term, the best is yet to come. Follow your dreams, and hire a good attorney!

All Rights Reserved c 2001
David J. Blumberg, Managing Partner
Blumberg Capital
580 Howard Street, Suite 401, San Francisco, CA 94109