The Thrill of the Chase
Where can a serious entrepreneur find venture backing in 2003? Go back to the future. That's where the venture capital industry is headed. According to the "MoneyTree Survey" from PricewaterhouseCoopers, Thomson Venture Economics and the National Venture Capital Association, total venture capital investing in 2002 fell to $21.2 billion, its lowest level in five years. A special analysis prepared exclusively for Entrepreneur shows that out of a total of 3,000 firms attracting venture capital, only 530 start-up and early-stage companies got their first round of funding in 2002--the fewest since 1994.
The trends may seem discouraging, but they represent a return to historical norms after a spike of unsustainable proportions. Bill Elmore, general partner of Foundation Capital, a Silicon Valley fund with $200 million under management, puts it this way: "Too many companies were funded over the last three or four years, and the failure rate jumped. Today, the hurdle to make a new investment is way up. But don't mistake patience for pessimism."
Roger Novak, general partner of Novak-Biddle in McLean, Virginia, another fund with $200 million under management, agrees: "This is a good time to be an early-stage investor. The entrepreneurs we're seeing have well-thought-out business models. Furthermore, when we fund a company, we're not seeing eight or 10 competitors coming in behind them in 12 to 18 months."
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Successful firms that were founded in tough economic times are the stuff legends are made of--companies like Compaq Computer and Lotus Development in the early 1980s and Palm Computing and Starbucks in the early 1990s. The market today is more akin to those time periods than to the boom that peaked in 2000. Mark Heesen, president of the National Venture Capital Association, notes this return to a traditional approach. "Venture capitalists are still taking calculated risks on new companies but realize that these new relationships will likely span many years and require several additional rounds of capital," he says.
An entrepreneur today has to banish the notion that every new idea will be given its due, that "every dog has its day." That may have been partially true during the boom years, but a lot of those companies turned out to be real dogs. These days, only the best of the best get venture backing. "Survival of the fittest" is better guidance. --T.T.L.
Persistence Pays Off
Anthony Hayward, 44, and Shoba Purushothamaman, 41
New York City
Sales: $2 million
Founded in April 2000, The Newsmarket Inc. is a news video archive company that digitally transmits data to TV outlets. After investing all their savings to get the company off the ground, Anthony Hayward and Shoba Purushothamaman sought $3 million in first-round venture capital in 2002 to increase their distribution capability. To achieve the company's financial goal, Purushothamaman got an "in" with some investors at the Springboard Venture Capital Forum, a competitive, bootcamp-style program that brings women entrepreneurs together with venture capitalists.
Describe the process of finding funding through the Springboard Venture Capital Forum.
Shoba Purushothamaman: They selected 23 finalists from the 240 that applied. Once you've been [chosen] as a finalist, you're trained for about six weeks. You're assigned a VC coach who trains you to deliver your pitch. You go up on stage [on] the big day, then the VCs interested in your business follow up with you, or you go out proactively to people you've identified in the audience as your targets and engage in conversations. There were 12 to 15 VCs [I met at the forum that] I really focused on; I did a lot of research and e-mailed and called those individuals persistently. The investors that funded us were the ones I called half a dozen times before I got anywhere with them.
What do you think made the difference for you? What sealed the deal?
Purushothamaman: I would say there were five factors that played a role. One was that the amount of money required in this business was not huge; we were looking to raise $2 million. I think the investors were attracted to that. It was not a business that was going to require millions upon millions to build. We had a very strong revenue model--a subscription-based model with recurring revenue. And [it was a] business that had low capital expenditures and fixed costs.
The other very clear thing was there was a lot of value placed on domain experience. This is the second business [for my co-founder and I]. We had built another company over a 12-year period and had successfully sold it. So people felt comfortable that we had some of the key experiences needed. And there wasn't a whole lot to fund out there in terms of companies that had revenues going for them.
What advice do you have for other entrepreneurs trying to get capital in a tough market?
Purushothamaman: I really think it's sticking with it. You've just got to keep trying, and never give up. --N.L.T.
Building Trust and Credibility
Rick Holt, 35, and David Grano, 39
Sales: $4.2 million
At the helm of a financial company that develops and markets wireless banking technology, Rick Holt and David Grano went looking for $1.5 million in venture capital funding in 2002. It was APTUS Financial's first foray into investment capital, but the pair had experience and connections in both the technology arena and the investment community through their previous positions: Grano as the head of a company that provided independent ATMs and Holt as the VP of sales at E*Trade.
How did you get in contact with the venture capitalists?
David Grano: Based on the economic environment, we didn't intend to go out to the venture capital community in a traditional way--we first put our own money into the business to the point where we could begin the hiring process. We had a successful track record in a like industry segment, so we weren't trying something that none of us had been involved in before where we were initiating new relationships.
What were the VC reactions this time, as opposed to fundings in your previous enterprises?
Grano: All of them asked if we were insane to be starting up in this environment. It boiled down to being able to demonstrate we were taking steps in something we'd done before--and, frankly, a lot more selling than we've done in the past, especially on the financial side.
Did you feel you had to agree to harsher terms than you originally intended to?
Grano: To avoid ending up with disadvantageous terms, our investors had to understand on a granular level how we were going to realize the revenue for the business and utilize the capital. That's part of developing the trust.
Rick Holt: One of the reasons we got the terms we wanted was that we had so much skin in the game to start--not only with experience but with our own capital already at play. That lent a lot of credibility.
Your money-raising strategy seemed to focus on relationships. How do you build and keep these good business and investment relationships?
Holt: It's a grass-roots effort of ongoing, open communication. It's sharing our successes--telling our story.
What advice would you give to other entrepreneurs searching for venture funding in a difficult economy?
Grano: Do everything within your power to bring a customer along with a business model to the table in this market. --N.L.T.
Giving Yourself Wiggle Room
Jim Kerstein, 44
Edison, New Jersey
Sales: $3 million
At the reins of a company that recycles waste plastics into plastic lumber for industrial use, such as building bridges, decks and railroad ties, Jim Kerstein wasn't a run-of-the-mill VC candidate. Still, in 2002, he signed a deal securing $4 million to be delivered in stages--the first installment was $500,000. Kerstein had one experience with raising half a million dollars in 2000 from individual investors. But even with that experience under his belt, it was slightly different this time around.
How did you hook up with the venture capitalists?
Jim Kerstein: We spent a year working with a major paper company [that] was very interested in buying us, and those negotiations--on a very cordial basis--fell apart. But a couple of key executives at that company remained extremely interested and committed to Polywood and loved the idea.
One of them had been an entrepreneur, and as he approached retirement, he decided he wanted to start working on other projects and get involved in investing in small businesses. He and another gentleman were the primary driving forces of putting money into us. Through them, we've had the opportunity [to] meet other individuals and start to line up the potential for the rest of this investment.
Was your funding in 2000 with this same group of people?
Kerstein: It was a completely different group of people. I did not even know the current group at that time.
Did you approach them?
Kerstein: No, actually, this company had a group they called the Radical Innovation Group. Their job was to go out and look for things that were completely off the beaten path, so they would travel and talk to leading technology universities. While they were at Rutgers one time, our name came up, and literally that day, they came over to meet with us.
How were you involved with Rutgers?
Kerstein: We licensed a technology from Rutgers and through the New Jersey Commission on Science and Technology, a funding arm of the New Jersey Department of Commerce. We were awarded research dollars and invested that in Rutgers to help develop our railroad-tie business.
What do you think made the difference for you? What sealed the deal?
Kerstein: It was a truly compelling story: a pro-business and pro-environment type of product, and one that has virtually unlimited growth potential. I think they just felt we were on the right path.
Do you have any words of advice for entrepreneurs who are looking for VC money in a bad economy?
Kerstein: Certainly not to wait until you're desperate for the money. You have to start working on it when you have some negotiating position and you have the ability to step away from a deal when it's not good for you. --N.L.T.
VC Funding in 2003
The first time is always the hardest. And it got harder in the first quarter of 2003, according to the "MoneyTree Survey." The number of companies receiving venture capital for the first time fell to 131. Of those, 95 were in the start-up or early phases of their development, generally less than 2 years old. The remaining 36 were further along, in the expansion or later stages of development.
It has been widely acknowledged that venture capitalists have raised the bar on what it takes to get funding in the first place. More surprising is what they have not done--they have not abandoned nascent companies in favor of more established ones. As the chart below shows, when it comes to first-time financings, venture capitalists continue to favor formative-stage companies. More than 70 percent of funded companies in the first quarter of 2003 were in the start-up or early stages.
More encouraging still, the trend data shows that the percentage of those companies has tended to drift upward over time. Through the inevitable business cycles, including the post-boom years of 2001 and 2002, venture capitalists continue to weight their initial bets toward a future that can be five to seven years away. That's how long it can take for a first-time investment in a start-up to pay off.
The entrepreneurs who make the cut in today's economic environment will be a hardy lot. Exploiting innovation, finding venture backing and building a successful business is a marathon, not a sprint. For many, it's a race worth running. --K.W.
Tracy T. Lefteroff is the global managing partner of the Venture Capital Practice at PricewaterhouseCoopers. Kirk Walden is national director of venture capital research for PricewaterhouseCoopers