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Tech VCs toughen up on funding terms

When the market was hot, agreeing to strict stipulations as a condition of getting venture capital was all but unheard of. Now it's all the rage.

With venture capital mired in the doldrums and scant demand for initial public offerings, technology entrepreneurs are jumping through increasingly onerous hoops to get funding.

Some struggling start-ups are forcing company founders to accept stock options that vest over longer terms, such as five or 10 years instead of two or four, to ensure that they don't jump ship shortly after an IPO and destroy the management team.

Some executives have gone so far as to agree to "automatic conversion," which guarantees the venture capitalist a high return on the investment after an IPO--regardless of how the stock fares on the open market. And many entrepreneurs must meet stringent benchmarks in order to get successive rounds of funding--a sharp contrast to the late 1990s, when VCs doled out as much as $100 million in a single financing round.

"During the bubble, no venture capitalist would bring (terms like this) up because nobody would put up with it," said Mike Homer, chief executive of peer-to-peer content distribution start-up Kontiki, a Mountain View, Calif.-based company that received an initial funding of $18 million in August. "Now, that's all you discuss."

The harsh measures come as the venture capital niche--one of the hottest sectors during the 1990s stock market bubble--hits a 10-year low. According to a report from VentureOne, U.S. VCs invested $6.3 billion into U.S. companies in the fourth quarter of 2001, a 4 percent drop from the same quarter in 2000. The amount of money that VCs invested dropped 65 percent between 2000 and 2001, according to VentureOne, shrinking the pool of funded companies from 5,779 to 2,780.

Given the sharp downturn in the number of companies they are choosing to fund, it is no surprise that VCs are scrutinizing their investments with a more critical eye. VCs say they are increasingly asking entrepreneurs to meet a series of fixed "milestones"--market or financial goals that must be met as often as every three weeks or every month. Though this type of requirement isn't new, the timetables have been dramatically compressed in recent months.

For example, a company that announced completed financing of $30 million might actually get an initial lump of $10 million, and would get $10 million more a month later when it ships its first product. It would receive a third round of $10 million a month after that when it hires an acclaimed chief financial officer or sells a certain number of products or signs up a certain number of new clients. By contrast, three years ago, the same company would have received an initial grant of $30 million or more, with no conditions for further financing.

Steve Spurlock, a partner with Menlo Park, Calif.-based Benchmark Capital, said the milestone approach is most common among capital-intensive companies such as communications-equipment companies.

"People are less likely to commit freely. They want to hedge," Spurlock said. "Investors have more leverage and they can get more rights. They can make a case for not putting any more into companies."

New rules stir controversy
One of the most controversial new funding rules hinges on "antidilution protections," executives and VCs agree. These terms can let VCs usurp or wipe out outstanding shares held by previous investors, founders and employees in order to protect or boost their stake in the company.

Antidilution protections are bitter pills for proud founders, but they are particularly tough to swallow for a company formed from numerous smaller companies that might have dozens of founders. VCs agree that it is difficult to get companies to agree to financing if it erases the stakes of a large percentage of founders--and in some cases antidilution protections sap morale and cause management defections and more turmoil for the company.

"The really tough terms are coming in recapitalization and in squeezing out old money," said Roland Van der Meer, a partner at ComVentures, a Palo Alto, Calif.-based venture firm specializing in telecommunications companies. "The choice is to let them go bankrupt or sell the assets."

Because the previous investors, who often have a seat on a company's board, have to approve antidilution protections, negotiations often become bitter, drawn-out affairs. As executives and VCs bargain over terms, companies often watch their cash dwindle to nothing.

"It's almost guaranteed that you won't be able to raise money until you're almost out of money," said one entrepreneur who recently closed a round of financing worth more than $50 million. "It's a contentious and not very gentlemanly process."

Antidilution protections aren't necessarily the strictest terms that VC-backed companies must swallow. Others include:

• Liquidation preferences: VCs boost the amount of money they receive if a company is sold--in some cases requiring a return of double or triple their original investment. In the old days, they could have been guaranteed their original investment plus a cut of the proceeds.

• Founder vesting: VCs require founders' stock options to vest over longer periods to ensure that key managers don't quit if the stock performs well immediately after the IPO.

• Automatic conversion: VCs get a guaranteed return--sometimes double or triple their original investment--as soon as the company goes public, regardless of what happens to the company's stock price.

Tougher rules, better management?
VCs insist that the tougher rules are not meant to penalize entrepreneurs but to help them achieve sustainable growth over the long term. The milestone approach, they say, has been particularly effective in galvanizing the management team around specific goals.

"It makes the board meetings a lot more focused," said Richard Couch, chief executive of Diablo Management Group, a San Ramon, Calif.-based crisis-management firm that often works with troubled start-ups.

Still, entrepreneurs question the motives of VCs. Some say the pay-for-performance strategy is a clever way of disguising the fact that VCs' coffers are dwindling to dangerously low levels and they can no longer afford generous, lump-sum payments.

"The downturn has affected them as much as anyone," said one CEO, who asked to remain anonymous.

Venture capitalists agree that their funds have shriveled, but some say they are eager to provide hitch-free financing--if solid management teams create blockbuster business proposals with a clear opportunity for a return on investment in the near term. Some VCs say that if they have gut-level faith in a company's initial pitch, they don't necessarily require the entrepreneur to sign harsh contracts.

"You either have faith in a company or you don't," said Warren Packard, a managing partner at Redwood City, Calif.-based Draper Fisher Jurvetson, which generally avoids the strictest rules when funding start-ups. "We're going to back those companies we think are really good and we're going to pull the plug on those we don't think are going to work out."

Others wonder whether entrepreneurs' bristling reflects less on the harshness of the new rules than on the laissez-faire funding attitude of the late 1990s.

"It's the same rules we used to play by," Van der Meer said. "But everyone forgot about them for a while."