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Early-stage deals take center stage as exit strategies blur
by Katherine Goncharoff Posted 04:45 EST, 2, Jan 2001



As exit strategies have become far less predictable, VCs active in early-stage deals will become even more cautious. And they'll play a far more controlling role in the companies in which they do invest.

That's the sober assessment of what's next in early-stage venture activity, according to analysts, attorneys and VCs themselves.

"It was one great party for about five years. But now everybody literally has a hangover," said Scott Sandell, a general partner at New Enterprise Associates, whose billion-dollar-plus fund continues to play an active role in early-stage investments.

On the upside, the quality of many early-stage deals and the size of the financings may actually increase. After all, established funds such as NEA, Accel Partners, Menlo Ventures and Oak Investment Partners have raised megafunds lately, with sizable amounts fully committed to early-stage investments.

Still, the consensus is that the early-stage sector has doffed its collective party hat. Other signs: Valuations for many investment sectors are way down and VCs are spending much more time doing research and due diligence on their investments.

"It used to take six weeks to raise money for a startup; now the average amount of time is anywhere from three to six months," Sandell said.

"The amount of time it takes before a company will actually see a term sheet on the table has definitely gotten longer," said Stanley Tims, a managing director at early-stage investment fund TL Ventures in Austin, Texas. While the average time to fund a deal a year ago was about two to three months, he noted, that has increased to an average of five to six months.

"We used to see a company on Monday and would have to make an investment decision on Friday," said Noel Fenton, a general partner at early-stage specialists Trinity Ventures in Menlo Park, Calif. "Now we have a lot more time to consider a deal."

Fenton added that he looks forward to being much more selective about his early-stage investments.

Frank Occhipinti, a general partner at the Woodside Fund and chairman of the Early Stage Venture Capital Alliance, reported that while the average size of early-stage investments has reached an all-time high of $12 million in the past year--and may even get higher in the age of megafunds--he believes there will be far fewer disbursements in 2001.

That's in part because early-stage investing always takes more time and requires far more advisory input on the part of VCs.

The new megafunds, Occhipinti said, will not have the time or staff resources to participate, particularly when many are devoting more resources to portfolio companies already further along in their development.

"The sort of seed fundings that VCs used to make will be an increasingly underserved area, as VCs will not have the time or the bandwidth to spend on these types of investments," Occhipinti said.

While valuations for early-stage companies in hot sectors such as fiber optics and telecom are not expected to change much, VCs say a drop in valuations is to be expected in all other sectors.

"Early-stage valuations usually lag public markets by six to 12 months, so you won't see the big adjustment in valuations until the first half of 2001," said Terry Opendyk, a general partner at Onset Enterprise Associates LP, an early-stage fund created by partners at NEA and Kleiner Perkins Caufield & Byers.

"We're going to see valuations that are 50% to 70% less; as a result, VCs will be getting more ownership for far less money," Occhipinti said.

Tims echoes those thoughts, noting that in sectors such as Internet and enterprise software, valuations are already half of what they were a year ago.

"The trend is a shift away from full acceleration on vesting to partial acceleration, and I'm seeing far more double-tranche deals and ratchets," said Mark White, a founding partner at White & Lee, a law firm that works with both startups and venture capital firms in Silicon Valley.

Double-tranche deals are early-stage fundings in two stages where the second part of the funding does not occur until certain milestones or performance demands are met. Ratchets are a form of dilution and valuation protection for investors. It is less favorable to company founders and employees who may have ownership in the company.

"I started to see this right after the market correction in the spring," White noted.

Said Mel Weinberg, an adviser to both startups and venture capital firms at Parker Chapin llp in New York, a firm that will soon merge with Jenkens & Gilchrist: "Frankly, I was shocked when I started to see ratchets make a comeback earlier last year. But now I expect to see them in 50% of the early-stage deals I will be working on in the months ahead."

Both White and Weinberg pointed out, however, that deal terms shouldn't get too onerous because no investor wants their managers to walk out the door.

Some VC observers, however, envision funding more optimistically. In their view, with valuations down, the VC party is only just beginning. It's just that many VCs don't want to admit it.

"The party is starting for the franchise firms: the NEAs and the Kleiner Perkins that are well-funded and well-known early-stage investors who bring some degree of certainty to an underwriting process," said John LeClaire, an attorney in the private equity practice at Goodwin, Procter & Hoar llp in Boston.

"That's because now is the time to invest at far more reasonable valuations and prices, though it will take far longer to gestate these firms."

Stephen (Steve) Lisson, founder and editor of an industry newsletter and Web site called InsiderVC.com, based in Austin, Texas, would agree about the advent of good times for early-stage VCs and entrepreneurs as well.

"If I were an entrepreneur looking for early-stage funding, the landscape couldn't be more beautiful," he said.

"The pace of funding may be slower, but the riff-raff has been separated out, the entrepreneurs with the goods have been left standing, and all those record-setting amounts of money we've been hearing about will have to be spent, in large part, on early-stage investments."

CORRECTION In the article "Early stage deals take center stage as exit strategies blur" (Wed., Jan 5, page 9), the name of the founder and editor of InsiderVC.com was misspelled. It is Stephen N. (Steve) Lisson.



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