BusinessWeek

MAY 16, 2002

VENTURE CAPITAL

VCs Turn the Screws

Today's venture capitalists are demanding onerous terms. That could hurt both innovation and investors.

Richard LaPierre is a frustrated man. His startup, ViewWriter Technologies in Waltham, Mass., is a rare bird these days -- a 2-year-old company that boasts a working product, a patented technology, and customers, including the U.S. government. Yet LaPierre is having trouble nailing down venture financing for ViewWriter, which markets a multimedia training tool.

It's not that venture capitalists aren't interested. It's just that they'll only write a check if LaPierre agrees to terms so onerous that he and his team would get scant compensation for all the work they've put into building a business from scratch. Not only would they end up with less than 50% ownership of ViewWriter, there would be little likelihood of a big payday unless the company achieved all but impossible growth targets. "I'd close it down before accepting that," says LaPierre, who is also seeking funding from corporate investors. "[VCs] lost all their money on the dot-coms, and this is how they're trying to make it back."

NEGATIVE RETURNS. It's the latest brutal twist of trickle-down economics. VCs are under intense pressure from their own investors to improve their dismal performance, slash fees, and return uncommitted funds to investors. Venture-capital investing has always had manic swings, and right now, it's on a downer that's the worst on record. Year-over-year fund returns have fallen to -32.4%, according to researcher Venture Economics.

In response, VCs -- supposedly some of the biggest risk-takers in the investment business -- are acting like Chicken Little. To improve their chances of a payoff, they're putting the screws to entrepreneurs, their teams, and other VCs. Talks have become so long and tortuous that the legal costs for venture financing have doubled. "There is a frenzy of extraordinarily draconian terms going on right now," says Craig Johnson, a lawyer at Venture Law Group who represents startups.

That's particularly the case with the hardest-pressed venture-capital firms, many of them relative newcomers to the business. The most distressed firms are inking deals that, in the event of a sale, ensure returns of up to five times their investment before anyone else sees a dime, including management.

FINE PRINT. Just two years ago, standard practice was for VCs to simply get back what they put in before proceeds were divvied up. Another new term promises venture funding only when startups meet certain milestones, such as acquisition of customers or revenue targets. Two years ago, funding was handed out up front in one lump payment.

Industry experts say VCs are hurting only themselves. Instead of pumping up returns, their behavior is likely to create resentment, a swath of bankruptcies, and a further shakeout within the venture community. After all, say entrepreneurs, why stick around if they're going to be treated only like employees of venture funds? What if the talent becomes so resentful that they walk mid-project, leaving VCs with nothing?

Worse, these industry experts fear this shortsightedness will keep many talented entrepreneurs and executives on the sidelines, crippling the quality of startups. "What's happening in the marketplace stifles innovation and leads to underinvestment," says Raphael Amit, a professor of entrepreneurship at the University of Pennsylvania's Wharton School. "VCs feel they need to guarantee themselves that, no matter what, they will make money. But they only make money if startup teams are incented to do the right things."

LATECOMERS' LOOT. Seasoned VCs say the turmoil is just how the business responds to a tough economy. They say the Internet frenzy gave startups unrealistic expectations and attracted an influx of both inexperienced venture investors and fly-by-night entrepreneurs. Now that the pendulum has swung back, marginal players will be weeded out. "The business has a certain ebb and flow to it," says Jonathan M. Silver, founder of Core Capital Partners, a venture firm in Washington. "We'll know when we're where we ought to be when the investor and entrepreneur believe, at the end of a negotiation, that we have achieved a win-win situation. We aren't there yet."

Just how far off the industry is from that optimal place is clear by looking at how today's harsh terms have turned the traditional venture-capital process on its ear. Typically, the first VCs to back a startup get stock at a very low price, since they're taking the greatest risk. Subsequent investors pay more because the company is making progress, which increases its value.

Now, with valuations plummeting, tough-minded investors are buying in at prices substantially below those paid by initial investors. That dilutes the stakes of earlier investors. Angel Investors, for instance, a small, early-stage venture firm in Silicon Valley that will not be raising another fund, says it has lost some $8 million invested in seed-funding rounds because so-called later-stage VCs took so much stock at such low prices that their positions were washed out.

WINNING HAND. "The state of affairs is so ugly that the last investor in, with the smallest amount of money, can now get the biggest share of a company, without regard to prior investments," says Ronald C. Conway, founding general partner of Angel Investors.

The trend is widespread. Even Mike Homer, a veteran of Apple Computer and Netscape Communications Corp., says he saw antidilution protections for the first time in his last round of funding in August for Kontiki, which develops software and services for distributing audio and video over the Internet. Homer's investors, which include Benchmark Capital and Barksdale Group, got a virtual guarantee that they'll maintain the same ownership stakes -- even if Kontiki takes subsequent investors in at lower prices. "VCs have all the cards now," he says.

That's why some top entrepreneurs are staying on the sidelines. Mark Pincus, who founded software startup Support.com as well as another successful company, says he wants to get back in the game. But the current financing environment, coupled with the down economy, make it likely he'll make that move later rather than sooner. Pincus concedes that his negative attitude means missed opportunities -- for himself and investors alike. "Three years from now, I know we'll see categories that I should have been betting on," he says.

HARD, CRUEL WORLD. Of course, the most successful entrepreneurs and most compelling ideas aren't wanting for money. Apple Computer co-founder Steve Wozniak, a superstar when it comes to founding companies, raised $6 million in January for his new wireless startup with not much more than a single breakfast meeting.

Likewise, some top-tier VCs have tweaked terms to reflect the new realities, but they haven't taken the extreme positions the newer VCs have. "Firms that think they'll make money by cramming onerous terms down entrepreneurs' throats will not be successful long term," says Magdalena Yesil, a partner at U.S. Venture Partners.

Today's unpleasantness isn't likely to change soon. So some entrepreneurs say their colleagues need to toughen up. "When I hear people bellyaching about VCs, I say, 'Hey guys, welcome to the real world,"' says Mark Gainey, co-founder of software maker KANA, which got its financing in pre-bubble 1997. "They should be thrilled just to get something done." These days, there aren't many alternatives.

By Linda Himelstein in San Mateo, Calif.

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