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The new VC mantra: Adapt or die

Tom Taulli writes that the methods of the past are clearly not working and venture capitalists will need to completely rethink their business or choose another line of work.

    It is amazing that a boat ride in the 1830s would provide so much guidance for business--even now. It was then that the 20-something Charles Darwin sailed the HMS Beagle along the Galapagos Islands. It turned out to be a tremendous laboratory that led to one of the most influential discoveries in science.

    Interestingly enough, it would behoove venture capitalists to look at some of the lessons from Darwin. Perhaps the most important one is: adapt or die.

    It is really that simple. Many great species have died out because they were unwilling to adapt to change. The same is the case with another interesting species: venture capitalists.

    It looks like it may be quite a while until the IPO market comes back.
    In this harsh environment, the methods of the past are clearly not working and VCs will need to completely rethink their business.

    How will this be done? Well, for the most part, it will be the result of brutal market forces (Darwin called it natural selection). In other words, it is pretty tough for any one to predict what the correct path will be. Although, there are some interesting trends that are already showing up.

    Traditionally, a VC will look for emerging private companies that need funding, advice and lots of TLC. The VC will help mold the business and prep it for the initial public offering. While this makes sense on the surface, it is quite difficult with little IPO activity.

    And it looks like it may be quite a while until the IPO market comes back. After all, there were a rash of start-up companies that went public from 1997 to 2000. Many of these companies were mostly raw, and the failure rate has been high. Yet there are still companies that are alive. The big problem is that their stock prices are low and Wall Street analysts have abandoned these orphans.

    Ironically enough, for some VCs, this represents an opportunity. First, these companies had an IPO and perhaps even a secondary offering, which meant that huge sums have been spent building-out strong technologies. Next, there is likely to be an existing customer base and experience about what works and what does not work regarding the product line. Moreover, there is some degree of liquidity for investors. True, it is not great (just try selling 1 million shares of a stock that trades 10,000 shares per day), but it is something.

    The way VCs participate in these companies is through a vehicle known as a PIPE, which stands for private investment in public equity. Basically, this is a private placement of securities sold to sophisticated investors such as institutions and wealthy individuals. Because of this fact, the costs and the disclosure requirements are lower than a traditional public offering. It is also faster to negotiate and structure a PIPE transaction.

    It is very clear that the ways of the past will be of little help to VCs now.

    PIPEs have been around for many years and have typically focused on more traditional businesses. A long-time player in the PIPE market is Andre Peschong, a partner at Bridgewater Capital and a manager of the Triton Private Equities Fund. In fact, VCs are learning his techniques for structuring PIPE deals to take advantage of the low valuation environment while at the same time drafting terms that protect investors on the downside.

    An example of a recent deal was the $61 million PIPE for enterprise software developer dDivine. The lead investor was Oak Investment Partners, one of the oldest VCs in the United States, with a great track record (the firm funded Compaq Computer, Wellfleet and Polycom).

    Another example is 24/7 Media. In July, the company closed a PIPE transaction for $5 million (with an option for $2 million extra), payable in stages. The lead on the deal was the venture capital firm of Merchants Group International.

    Even though it is smart that VCs are entering the PIPE marketplace, there are still problems. Perhaps the biggest is the paternalism; that is, it is almost instinctual for VCs to try to nurture companies. Applying this model to public companies, though, can be a big mistake. If anything, these PIPE deals may be more short-term in nature, giving VCs an opportunity to get some much-needed gains to offset huge losses.

    Adapt or die. This is very clear for VCs. Does this mean VCs need to do PIPE deals? Not necessarily. Only history will tell. But it is very clear that the ways of the past will be of little help to VCs now.