Loaded for bear
by Shawn Regan

You had a feeling it was coming.

In late January we learned that venture capital funding had dropped to $19.6 billion in the fourth quarter last year, according to Venture Economics in Boston and the National Venture Capital Association in Arlington, Virginia.

This year-end figure was 30 percent less than the average of $27.8 billion invested in each of 2000’s first three quarters. And the number of deals done in the fourth quarter declined to 1,345, down 25 percent from the 1,794 averaged in each the three prior quarters.

This slowdown in private capital is largely seen as a reaction to the bearish public markets. A decline in the value of public equities twice hurts private placements. It leaves the investors that fuel private capital with less money to plunk down, and it reduces the viability of one of the exit strategies, an initial public offering, and investors don’t like it when their options are limited.

And there may be more bad news to come. If it’s true that the private market follows the public, then by the time you read this, private equity’s retreat may have disappeared over yonder distant hills. Recall that at the end of the fourth quarter the Nasdaq was down 51 percent from the high it reached in March 2000. But by mid-March this year, that valley was 68 percent deep.

“Money is less available,” says Bob Fink, an angel investor in Mendota Heights. “Every VC is doing fewer deals and putting less money into each deal. Early-stage companies that had been getting funding, rounding out their management teams and making progress, are now finding the money that they were expecting to get is no longer available to them. It’s been brutal.”

Paying through the nose
Companies that get funded are paying dearly for it — often more than once — as the venture capitalists that got burned last year are twice wise with their investments now. “Every VC is being more cautious,” Fink says. “The valuations are being beat up. And I’m seeing a lot more intervention from the VCs with management and the company’s direction. The VCs seem to dictate how the company’s going to be run.”

There’s nothing quite like an exception to prove the trend. That iconoclast can be found in Islet Technology Inc. in White Bear Lake. It is developing a diabetes-fighting technology that encapsulates and transplants islets, living cells from the pancreas that produce insulin. The six-employee company has yet to see any sales, but it has raised $8 million in five rounds of common equity, primarily from individuals, since it was founded in 1994.

In 1999, as Nasdaq completed an 86 percent gain for the year, Islet Technology raised $1.6 million that December, selling 320,000 shares at $5 each. Then last October, with the Nasdaq in the seventh month of its tumble, the company raised $1.75 million, selling 250,000 shares at $7 each.

“That last round was the easiest private placement we’ve ever had,” says Bill Drake, Islet Technology’s president and CEO. “When we were raising it last summer, some investors told me they thought the stock market was overvalued and that private placements were a better, long-term move. These are sophisticated people. The first half of their assessment seems to have proved right. We’ll just have to see about the second half.”

Going with the flow
The fund started by Sherpa Partners LLC, a venture capital firm in Edina, exemplifies the problem deal flow is experiencing at its source. When it launched the fund last spring the firm planned to raise $40 million, but had closed on only $15 million early this year. It now expects to hit $25 million by the end of the second quarter.

“We are pleased that we’ve been able to raise a fund at all,” says Steve Pederson, a partner at Sherpa. “We have three strikes. We’re raising seed or early-stage funding, for technology companies, in this region. Also a lot of the investors we’ve talked to are a little bit underwater right now. With their portfolios down 25 to 50 percent, they’re not liquid. They just don’t have the cash flow to do it.”

As Pederson implied, in response to the market’s changes, venture capitalists are more likely to make intermediate investments in more established companies than they are to make seed investments in start-ups, or even mezzanine investments in relatively mature companies. The reasoning is that for intermediate investments, there’s a balance between the price paid and the risk assumed. But for seed investments, while the price is low the risk is high. And for mezzanine investments, while the risk is low the price is high.

“Through the first part of last year, the public markets were doing what the VCs used to do, so the VCs had gone down to the early incubator, seed companies,” Pederson says. “Now, the VCs are swimming upstream. They’re looking for more validation in the market. Not long ago just the promise of revenues or earnings would have been enough to get you funded. Well, private equity isn’t funding promises anymore. It’s funding growth.

“Even at our seed-stage level,” Pederson says, “we need to see one of three pieces: customers, a great advisory board, or a great governing board. We don’t just look at the valuation or the promise of the technology in the market. We look more at a company’s team and their ability to provide geometric growth.”

Inside the fold
A corollary of this tendency of venture capitalists to invest in companies that are further along their growth curve, is their predisposition to use their precious supply of funds to invest in the companies that are already in their portfolios, rather than investing in a company that is outside the fold. That this tactic flies in the face of one of the basic tenets of investing — diversification — does not seem to matter very much to the venture capitalists.

“They have a vested interest in seeing that their companies survive,” Fink says. “Money is tight, so they’re saving their follow-on money for their own deals.” Pederson agrees. “While the bigger funds have more money to put to work, they’re keeping their powder dry for follow-on investments.”

David Parish, CEO of Visual Circuits Corp. in Fridley, speaks from a recent, rewarding experience when he offers companies advice regarding how they can do deals in today’s private equities market. The 40-employee manufacturer of digital video systems, components and software did $10.9 million in sales in fiscal 2000, ended in September, and closed on a $3.7 million common equity deal last December with Miller Johnson Steichen Kinnard Inc. of Golden Valley.

“You need a revenue model that works, one that achieves profitability and creates a defensible position,” Parish says. “You have to establish yourself so you have an advantage over anyone else who wants to come into your niche. A strong management can compensate for an early-stage company. If your management has an established record of performance, that carries a tremendous weight and influences how the VCs look at the investment opportunity.”

In this market, when it comes to companies positioning for exit strategies, either in their pitch to potential investors or later on in real life, “You can pick any color you like, as long as it’s black,” as Mr. Ford used to say.

“The IPO market isn’t poor,” Fink says. “It’s nonexistent. An acquisition is the only remaining exit option. But investors are looking very hard at how feasible an acquisition is for a company. It can be a deal breaker if you can’t show a path to it, with solid reasons for a company to buy you. Further, you have to show that you won’t lose customers because you’re developing a relationship with a potential acquirer that may be a competitor of your clients.”

If you can get past these potential pitfalls, venture capitalists are enthusiastically receptive to the acquisition exit. “We’re looking at technologies that maybe a Lucent, a Honeywell or a Seagate isn’t nimble enough to develop but is smart enough to buy,” Pederson says. “We like the kinds of deals that have an obvious market and a defined exit to a company in maybe two to three years. That’s very attractive to us.”

To survive a private equities market that might be going from bad to badder in 2001, Fink makes several suggestions. “There are several new sources of funding that are focused on the Twin Cities,” he says, mentioning Sherpa Partners and Brightstone Capital in Edina. “And companies can look for strategic money from a larger company that can also market the hell out of your product. Or maybe it’s time to consider merging with another smaller company, one with complementary technology, management and markets. Together you can improve your chances of getting funding.”


Bill Drake, Islet Technology Inc.:
651-779-6859; bdrake@islet.com

Bob Fink, 651-454-3635;

David Parish, Visual Circuits Corp.:

Steve Pederson, Sherpa Partners LLC:
952-942-1070; steve@sherpapartners.com