Venture Capitalists Are Taking the Gloves Off
By LYNNLEY BROWNING
The New York Times
July 28, 2002
The venture capital world is looking less like a genteel club and more like a brawling barroom.
Venture capitalists are offering the companies they bankroll increasingly hard-knuckled deals that leave little wealth for a start-up's managers or original backers. The moves are leading some entrepreneurs, desperate for money, to decry today's investors as bullies. Some venture capitalists are even suing rival venture firms, asserting that the tough new terms are wiping out the value of their previous investments.
"People are playing hardball," said Ted Dintersmith, a general partner at Charles River Ventures, based in Waltham, Mass.
The bursting of the Internet stock bubble more than two years ago wiped out many venture investments in dot-coms. Now, amid the bear market in stocks and limited prospects for investors or young companies to make money soon, venture capitalists are looking for novel ways to make money. As a result, "private companies are facing the most onerous terms from venture capitalists that we have seen in 20 years," said Steven E. Bochner, a securities lawyer at Wilson Sonsini Goodrich & Rosati in Palo Alto, Calif., who represents venture firms.
In the boom of the late 1990's, venture capitalists chose one of two options. They could be paid back their invested capital, share in profits and receive dividends. Or they could convert their preferred shares into common stock when the private company held an initial public offering or was sold. During that time of huge payouts for newly public and acquired companies, they usually chose No. 2.
But with markets now all but dead for initial public offerings and mergers and acquisitions, venture capitalists from Silicon Valley to the East Coast are increasingly demanding — and getting — both options. This "double dip," known as "participating preferred," leaves far less potential wealth for a company's founders and previous investors. Venture capitalists are also negotiating more deals with heightened "liquidation preferences," in which start-ups agree to pay back the initial investment at least two or three times over.
Previously, venture capitalists handed over money to a start-up in a lump sum. But more are now parceling out funds in tranches, and then only when the new companies reach certain milestones — a sales target, for example, or the hiring of a particular chief executive.
They are even trying to protect their investments through veto rights that permit them to block future investments from other venture capitalists who might dilute their stakes, said Mark G. Borden, chairman of the corporate department at Hale & Dorr, a law firm based in Boston. As a result, Mr. Borden said, a start-up company that casts its lot with a particular venture capitalist or group of investors may find itself tethered to those backers and unable to raise new money elsewhere.
ENTREPRENEURS particularly dislike one recent trend: venture capitalists have been pushing young companies to agree, retroactively, to lower the prices that investors now pay for shares should the start-up be worth less when it tries to raise more money later. Such a move, known as a "full ratchet," is intended to prevent an investor's stake from being diluted. But it can significantly reduce or even wipe out the stakes of a company's original investors and managers, giving the new investors most of the company for a song.
"If you were in the first round of investors, you generally now get crushed" when a start-up raises more money later, said J. Edmund Colloton, general partner and chief operating officer of Bessemer Venture Partners, based in Wellesley Hills, Mass.
Consider Mahi Networks, a private optical networking start-up. In three rounds of financing, from September 1999 to November 2001, Mahi raised $110 million from blue-chip venture firms like Benchmark Capital, Sequoia Capital, the GE Capital unit of General Electric and the venture arm of Goldman Sachs. At one point during the Internet boom, Mahi was valued at more than $180 million.
Last month, though, a new group of smaller-name investors, led by St. Paul Venture Capital of Minneapolis, acquired about three-quarters of the company for $75 million in financing. Before that, Mahi was valued at only $25 million, said Chris Rust, Mahi's president and chief executive. But most of that was tied up in employee incentives, including stock options, leaving almost no value for existing investors.
Despite having nurtured Mahi with money and advice, the early investors chose not to back the company further. With the new, lower valuation, "there was effectively no value attributed to all of our previous investments," said one venture capitalist whose firm was an early backer. "We were all completely washed out" in the last round, said the investor, who spoke on condition of anonymity.
There is no hard data on the prevalence of the newer, tougher terms. Venture capitalists are famously secretive about their deals, which are private and largely unregulated. But ask venture capitalists or securities lawyers who work with start-ups, and tales of onerous terms will abound. "At the end of the day, the money is coming with strings attached," said Mark G. Heesen, president of the National Venture Capital Association, a trade group based in Arlington, Va.
The shift has turned the conventional wisdom on its head. Venture capitalists once loved risk, but no more. The Internet bust and Wall Street's slump have left them scrambling to make money to repay their own investors and to justify their management fees.
Venture capitalists once clamored to be first in the door of a hot new company. Now they can usually make money only by being the most recent investor. "We're certainly looking for later-stage deals, where you get the benefit of the previous investors having taken the risk," said Todd Dagres, a general partner at Battery Ventures in Wellesley, Mass.
Some entrepreneurs agree to the harsh new terms simply because they have no other way to raise cash to survive. But other managers now shun the investors, whom they call "vulture capitalists," bent on picking the meat off a young or struggling start-up. Today's venture capitalists "want to take advantage of you," said George R. Waller, chief executive of Strike Force Technologies, an employee-financed software maker in West Orange, N.J. Mr. Waller said he had turned away 30 venture firms in recent months because they had demanded, among other things, hard-to-reach sales milestones.
George J. Nassef, chief executive of ValetNoir, a start-up based in New York that makes marketing software for casinos, said several venture firms had even asked in recent months to have their potential investments secured with receivables, or money owed to ValetNoir by its customers. He turned them all down.
NOT surprisingly, the shift in financing terms is upsetting some venture firms that were early investors in start-ups but are now suffering as the companies seek to raise additional money at bargain-basement prices.
In one high-profile case, Benchmark Capital, a blue-chip Silicon Valley firm, sued the Canadian Imperial Bank of Commerce and Juniper Financial this month. Benchmark was an early investor in Juniper, an online financial services concern, having put $20 million into it in early 2000, just before the Internet bubble burst. It also contributed to a second, $94 million round that September. Juniper, based in Wilmington, Del., is seeking to raise $50 million from Canadian Imperial, which already owns around half the company, but on terms that would sharply dilute Benchmark's original, unspecified stake. Benchmark sued to prevent the start-up from raising the money. All the parties declined to comment on the case, which a Delaware judge threw out last week.
Such friction was rare during the boom, when venture capitalists operated like a competitive but tight-knit fraternity, channeling deals to one another. Start-ups and their backers saw their interests as allied. But in tighter markets, "there's a lot of ugly behavior coming out," said Mr. Bochner, the Wilson Sonsini lawyer. "There's going to be much more litigation like this."
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