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VCs urge start-ups to keep plugging

Despite the scarcity of funding for start-ups, venture capitalists say it is still one of the best times to be raising capital.

With funding tightening and start-ups no longer calling the shots, venture capitalists say entrepreneurs need to start entertaining single-digit valuations and seek boutique venture firms as a funding source.

"I'm sick and tired of hearing all the hand-wringing and moaning about the markets...it's one of the best times to be raising capital," said William Reichert, president of venture capital investment bank Garage.com.

Once an entrepreneur has grabbed an investor's attention, they need to demonstrate their business can ultimately grow beyond $40 million in annual revenue, Reichert said on a panel here Wednesday on fund raising and valuation strategies.

"Your dream may be a beautiful dream," he said, "but if all you have is a business that will generate between $20 million to $40 million annually, the upside is you won't likely get venture backing. You're going to have to create a great company by bootstrapping the business."

Venture capitalists, especially those with $1 billion funds, generally need to invest in companies that have a potential to generate $100 million in revenue or more to generate the type of returns that their investors seek, he said.

And because angel investors need VCs to invest in their portfolio companies as they mature, angel investors are adopting criteria similar to the venture firms, Reichert said.

Reichert, on a panel at the Breakthrough 2001 conference, advised start-ups to seek out boutique venture firms because they operate smaller funds and specialize in a particular industry. Boulder, Colo.-based Boulder Ventures, one such firm for example, primarily invests in information technology companies.

"These firms are their best shot," he said. "They have no baggage of a lot of older portfolio companies they have to bail out, because the larger firms squeezed them out during" the market's rally.

Falling valuations
While valuations can range dramatically based on the industry, valuations for first-round investments have generally fallen under $10 million, Reichert noted.

Valuations are based on the amount of funds a company receives in its previous round and the number of shares it holds. This figure is referred to as "pre-money valuation," or its value prior to the next round of funding.

Companies that are seeking their second round of funding, at a minimum, need to show they have already accomplished revenue growth and have customers who can validate their pricing strategy, said Alex Gove, vice president of venture firm WaldenVC.

But even these companies may still receive a valuation that is less than $10 million, Reichert said. Companies that can show not only revenue growth but also a list of large, blue chip customers may be lucky enough to receive valuations of $20 million to $30 million for their second round, he noted.

VentureOne, a venture research firm, reported the median valuation venture-backed companies received in the fourth quarter was $27 million. The figure includes all rounds of funding and the valuation given prior to the companies receiving their latest round.

The bar to receive funding in the third round also dramatically increases.

"Companies that are raising their (third) round need to show a clear path to profitability. We usually like to see this happen in 12 to 18 months," Gove said.

Don't sink the ship
Despite the importance entrepreneurs place on valuations for their companies, it is a deal sinker if that is the first issue discussed when seeking funding, VCs say.

Gove, for example, said he prefers to learn about the achievements and failures of entrepreneurs before they launch into their company pitch.

But when the discussion of valuations arises, Reichert said, entrepreneurs should avoid locking into the attitude that they cannot accept a lower valuation than they got in the previous round.

"If you're not an advocate for your company, it may send the wrong message to the investor," he said.

Andrew Beebe, chairman of e-commerce site builder and services company BigStep, encouraged entrepreneurs to create a sense of urgency when holding funding talks with venture firms.

"They need a sense of urgency to act, otherwise they can string you along until your money runs out," said Beebe, whose company raised a $50 million third round last year. "You need to get a competing offer or show where the break points are when you'll turn off discussions and seek other investors or show that you don't necessarily need them."

He said the best valuation argument to present is how the company's valuation is increasing every day that the investor waits, given the growth in the company's customers and revenue.

"I wouldn't argue why the valuation is lower today than it was yesterday," he said.