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Tech Industry

Market swings change rules for start-ups

As tech stocks continue a steep month-long decline, companies are increasingly facing a tough audience of investors when raising capital.

As tech stocks continue a steep month-long decline, companies are increasingly facing a tough audience of investors when raising capital.

The market swings and investors' actions have reverberated down the food chain from initial public offerings to early venture funding.

There's still plenty of money, but investors are more selective in where they place their bets, what they demand in a company's business plan, and what valuations they're willing to pay, according to investment bankers and venture capitalists.

Although e-tailers were among the first to find investor interest slip, other sectors may also be feeling pressure, given the Nasdaq composite index's 25 percent decline since March 10. Start-ups are facing new demands from institutional investors.

"Before there was less pressure on the management teams to show a time frame for profitability or cash flow. Now investors want to see that achieved in two years," said Tony Meneghetti, managing director of Deutsche Banc Alex Brown's West Coast Technology Internet Banking group.

Investors also want a company's IPO funds to last through the period until it is profitable, rather than serve as the first of several capital-raising events, he added.

"Most companies will now have to be at or near profitability to do an IPO," he said.

One start-up that still has venture firms tapping on its door, digital photography company Mslide, fits the new model because it's in a hot market and has a path to profitability through licensing its technology.

Mslide founder and chief executive Dan Hobin plans to seek a second round of financing next week; he expects it will be as easy as the first round in January, when the company raised $4 million.

"Originally we were going to wait until the fall, but because there's so much interest in (digital photography) we decided to go out for new funds," Hobin said. "The valuation for the company has come up a lot faster than we thought it would because of some major partnerships."

But many companies may find a more difficult road, according to bankers and venture capitalists.

"Before, 75 percent of the business plans didn't have anything about revenue enhancement and cost improvement. Now it has dropped to 25 percent," said Roland Van der Meer, a partner with ComVentures.

Tim Spicer, general partner of eCompanies Venture Group, said e-commerce companies that focus on selling goods are going to have a harder time getting funding.

"Business-to-business Will B2B's magic last?stocks can fall just as precipitously as business-to-consumer shares. If they're not creating a real demand or real value, they can fall," he said. "E-commerce isn't dead, but hopefuls have to be able to differentiate themselves."

Spicer added that the keys to securing investments are in a start-up's management team, its path to profitability, and its competitive advantage in its market.

A shift has also occurred in the funding methods of these companies.

"There's been subtle and not-so-subtle changes in early-stage financing. Investors are taking a harder look at valuations now than six weeks ago," said Mark Menell, a partner with TMCT Ventures. "If the public market valuations come down, then valuations for start-ups also come down."

As a result, a start-up is left to raise less money and to give a larger percentage of the company than anticipated.

And as companies seek their third or fourth round of financing, which usually tides a company over until it goes public, late-stage investors may be scarce.

"Last year, late-stage investing was like momentum investing. You got in, got the company public and made money," said William Elmore, general partner with Foundation Capital, an early-stage investor.

But given the market's recent volatility, the last part of the equation has become more uncertain and has made late investors more selective, Elmore said.

With fewer late investors participating in deals, early investors will often be forced to put more funds into keeping the company on track. In some cases, a company is willing to raise another round of financing by assigning a lower valuation than the previous round. That move, however, may anger early investors who paid more for their slice of the company.

Even for a start-up in a favored market such as digital photography, courting the right venture capitalists can be crucial.

"If you go after the best-looking girl in school and you don't get her, you look pretty bad," Mslide's Hobin said. Instead, he said the company is looking to an "A minus" firm. "We're not going out with the dogs."