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No Mercy

Are VCs sucking the life out of your business? Maybe you're better off without them.

Remember when the entrepreneurs who couldn't get venture capital funding were the unfortunates, the wallflowers, forced to sit on the sidelines and envy those with VC partners? Well, if you were one of those wallflowers, now might be your time to gloat.

Playing with VCs is not the fun it used to be. The once enviable deals have increasingly devolved into ugly wars over tougher terms and lower valuations, with entrepreneurs caught between prior investors and opportunistic new "vulture capital" partners. On one side are the VCs who have already invested substantial cash in a given company; they had expected to exit the deal many months ago, but, because of the nonexistent IPO market and the sluggish M&A environment, they have no immediate hopes for liquidity. Now they are either unwilling or unable to sink more cash into the venture, which likely needs another capital infusion to survive the dismal economic climate.

Consequently, companies are forced to seek funds from other VCs. But the new investors are drastically reducing old valuations and demanding exceedingly harsh terms. "It's a buyer's market right now," says Dan Primack, editor-at-large for Venture Economics, a Thompson Financial subsidiary that monitors the venture capital industry. "The VCs completely control this thing."

They're insisting on returns of two to three times the amount they put in-or more-before management and other shareholders see a personal return on the investment. "That [puts] management and common owners down the line," says Scott Ungerer, founder and managing director of VC firm Enertech Capital in Wayne, Pennsylvania.

One way to remedy the situation is by arranging "sidebar agreements" between management and the investors, which say the management team will start getting bonuses after the first liquidation preferences are paid out. It's to the VC's benefit to make sure those running the firm are rewarded. "If management isn't motivated, who is?" Ungerer says.

But, logic notwithstanding, VCs are adding perks for themselves that make deals less attractive for founders. One is the "participating preferred" agreement-previously not uncommon but fast becoming standard-which gives the VC an ownership stake in the company, plus priority in recovering their original investment. In some cases, VCs are also winning more control over management, capping salaries and predetermining whether the company can seek additional funding at a later stage.

For small companies, the drop in valuation is the hardest pill to swallow. Where once upon a time it was only those companies with no product revenue, little expense history and an incomplete management team that had to worry about lower valuations, these days, even companies with established products and revenue are seeing values drop by 50 to 60 percent. That's bad news for those who already have a stake in the company.

And not all investors will take that lying down. When online wine retailer Wine.com (formerly eVineyard Inc.) was facing bankruptcy and seeking more capital earlier this year, tensions ran high between Chris Kitze, a serial entrepreneur and major investor in Wine.com who had begun personally bankrolling the company when its funds were depleted, and many of the company's 60 or so investors. The VCs who had plunked down cash in the 2000 round were furious over the prospect of a new round of funding and a new valuation of $2 million. But they also refused to cough up more money to protect their investment and threatened to sue the company if it didn't go bankrupt. "They were waiting to the last second to see if we would agree to these ridiculous terms," says CEO Peter Ekman, 40. "It was the ultimate vulture behavior." Eventually, Kitze convinced them that his offer of 5 cents on the dollar was better than the zero they would have gotten in bankruptcy.

But the experience was grueling-and convinced Kitze the company was better off without VC involvement. None of the investors in the July round of financing, which raised $9 million for Wine.com, were VCs. "If you are an entrepreneur and had the misfortune of taking their money, you're an expendable piece of Kleenex," he says.

Avoiding new VC investment may not be a bad idea, at least until the IPO market returns to full health and offers VCs more liquidity. For now, in the current harsh environment, entrepreneurs in search of VCs will still have to do their due diligence whether the price of capital is worth the sacrifice.


C.J. Prince is executive editor of CEO Magazine. She can be reached at jprince@chiefexecutive.net.

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This article was originally published in the December 2002 print edition of Entrepreneur with the headline: No Mercy.

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