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For VCs, the early bird catches the firm, April 24, 2001
By Matthew DeBellis

Early-stage venture capitalists may be the only investors still having fun.

The early-stage venture capital market has gone from sweet to sweeter. Valuations of companies just forming continue to drop and are near rock-bottom prices, early-stage VCs say. They continue to review new deals, dive into due diligence, and steadily make new investments in a market that's searching for stability. Equally important, early-stage VCs say that deal flow is better than they've seen in years, especially in the networking infrastructure, digital storage, and communications sectors.

"Both the valuations and the quality of the investments are unlike any I've seen in the past five years," says Bob Roeper, managing director of Venture Investment Management Company, a Boston-based early-stage investor that has made three new investments this year. "It's an exceptional time."

Early-stage venture capital firms are an exception to the current investing climate. These days, exit strategies for middle- and late-stage venture investors are unpromising. The IPO window remains closed, and even the acquisitions market for technology companies is dormant.

"The Street has become so sensitive to business models and profitability [that M&A] deals do not fly as they did 18 months ago," says Bryan Rutberg, CEO of Rutberg & Company, a research-centric investment bank in San Francisco that focuses on raising private equity capital for startups. There's a "complete lack of e-commerce M&A," he says.

In just the past 60 days, typical valuations have dropped from $10 million pre-venture investment to $5 million, Mr. Roeper says. This drop is affecting startups in sectors including software, Internet infrastructure, and wireless applications. It took several months for entrepreneurs to accept the low valuations. "There was objection in September, resistance in January, and acceptance in March," Mr. Roeper says.

Now entrepreneurs are ready to start bargaining when they walk through the door. "The starting point for negotiations is at a reasonable level," says Charles Beeler, a general partner at El Dorado Ventures.

That pleases VCs, who, when they pay less for shares in an unknown startup, can reap bigger investment returns if the company hits the big time. For example, for 2000, early/seed-stage funds outperformed other fund classes with an average 51.2 percent return to their limited partners, and 93.7 percent for the last three years, according to research firm Venture Economics.

The venture capitalists that are poised to take advantage of the low valuations are early-stage firms with the time to research new opportunities.

"This is a buyer's market," says Vince Occhipinti, chairman of the Early Stage Venture Capital Alliance and managing director and cofounder of Woodside Fund.

Woodside is carefully sifting through the quality deal flow and seizing the moment. The Silicon Valley firm, which invests in software, Internet infrastructure, networking, and telecommunications technologies, is slightly ahead of its normal investment pace of six to eight new investments each year. It has invested in five new companies in the past six months, Mr. Occhipinti says. To handle the load, the firm has hired an additional venture partner in January; it hired one more analyst in October.

Onset Ventures, also of Silicon Valley, continues to make new investments as the economy downshifts. Because each of the firm's six partners does one to two deals each year, they have time to look at new deals, says general partner Susan Mason. The firm invests in 6 to 12 new startups each year, and in the past six months has done three deals, one in each of its core areas of communications, enterprise software, and medical technology, Ms. Mason says. "Steady pace, that's our style," she says. "We've done this for 17 years."

Valuations of startups have dropped so far that companies seeking second rounds of venture capital are hitting up early-stage firms, which typically stick with first-time, first-round investments. These companies are contacting early-stage firms knowing that if they do receive funding, it will be at or below the valuation of the company at the time of the first round.

So far this year, hundreds of companies seeking second-round funding have pitched early-stage investor El Dorado. Intrigued, the firm's partners have met with about 25 such companies that are already several months along, have dozens of employees, and have a significant burn rate, Mr. Beeler says.

Though El Dorado has listened, it hasn't invested in any of these companies, generally because they need to be relaunched and repositioned for very different -- harsh -- market conditions, Mr. Beeler says. "We just passed on another one today."

To relaunch a young company is a complicated endeavor that El Dorado and most early-stage firms aren't willing to take on, he says. The companies have been plugging away for several months and already have many employees and substantial burn rates. Such investments are too risky and time-consuming even for investors in the high-risk investment business. The bottom line is that a company scrounging for a second round with an unchanged valuation "missed its market opportunity," Mr. Beeler says.

Though startup valuations may have hit bottom, VCs should refrain from taking unfair advantage of such low valuations by buying more than 40 percent of startups, Mr. Roeper says. VCs can sap the drive and motivation of a company if they own too much of a startup too soon. To keep morale strong at startups, a young company's management team and employees should walk away with at least 60 percent of the company after a first round of venture financing, he says.



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