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Today's 'Down Rounds' Bring Startups Pain

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From The Wall Street Journal Online

Fledgling companies are being forced to pay a financial price these days to survive.

PolyFuel Inc., a fuel-cell maker, learned this lesson the hard way. In mid-2000, the Menlo Park, Calif., start-up company had raised $6 million in venture-capital financing, all it needed to start work on developing fuel cells to power portable electronic devices. Less than a year later, the company had burned through nearly all its initial cash and was in need of a follow-on round of financing.

The cash crunch couldn't have come at a worse time for PolyFuel and its initial investors. Venture capital had all but dried up for companies seeking follow-on rounds of financing. During the past 12 months, it hasn't gotten any better as venture financing, the lifeblood of start-up companies, hit its lowest level in four years, with investments down 50% from a year earlier, according to an industry survey.

That has left companies like PolyFuel in a struggle to come up with follow-on financing. After nine months of tense negotiations and with just $17,000 remaining in its bank account, PolyFuel managed to arrange a second lifeline, but it came at a price: PolyFuel employees and its seed investors had to give up equity and the company's valuation was cut from the first round.

Consider the action of Mayfield Fund, an original investor in PolyFuel. Its initial $4 million investment bought it a 26% stake, but under the terms of the second round, that stake was cut to just 3%. Mayfield then invested an additional $5 million for an 18.5% stake, giving it a total stake of 21.5%.

"In normal times, we probably would have put in $3.5 million and increased our ownership," said David Ladd, a partner at Mayfield, the 20-year-old Menlo Park venture fund. "We definitely would expect to get two times our money, because you're taking a huge amount of risk."

In the second round, the per-share price received by PolyFuel's investors was one-fifth of what it was in the first round. Those investors who decided not to put in more money had their investment all but wiped out. Unheard of during the late 1990s, the practice is becoming more common today.

The company's valuation was sliced as well, to $11.5 million in the second round, down from $12 million in the first round. While that doesn't sound like a big cut, it is a reversal from the late '90s, when second-round valuations often were at least double the first-round figures.

And PolyFuel's employees' stock options were diluted to 1% in the latest round, down from 20% originally. But to maintain an incentive for employees, the new investors agreed to give up some of their options and increase the employee option pool to 19.3% of equity.

PolyFuel's experience isn't new. But it has become common these days, with few companies raising as much cash as they did in previous financing, known as a "down round." The pain is being felt at start-ups from Silicon Valley to Silicon Alley that are struggling to deal with the steep change in valuations since the late 1990s and the skittishness by some venture capitalists to invest new money.

According to PricewaterhouseCoopers/Venture Economics/National Venture Capital Association MoneyTree Survey, venture investments dropped to $21.2 billion last year, down 50% from 2001 and down sharply from $106.6 billion raised in 2000, the top year for venture investing. The result: More start-ups are being funded at discounts while still others are being forced to close.

"The consequence of not doing a down round is that you go out of business," said Mr. Ladd of Mayfield. "Webvan and Pets.com didn't get down rounds; they got nothing."

PolyFuel was spun out in 1999 from SRI International, a Menlo Park nonprofit research institute. The start-up is developing a fuel cell that would prolong battery life in portable devices such as laptops to between seven and nine hours from between the two and three hours common today.

Gregg Semler, PolyFuel's then-chief executive, said he learned the environment had changed one Monday in July 2001, when he met with Mayfield's partners to solicit more money.

His one-hour presentation, he conceded later, bombed. Mr. Semler was too casual and didn't clearly explain the progress the company had made or how it had used the money received in the first round. His casual delivery left the partners at Mayfield leery of investing more money into the nascent company. "The numbers aren't that good. Are you sure we should do it?" asked the Mayfield partners in the meeting, according to Mr. Ladd, an attendee.

A month later, after seeking help from a professional coach, Mr. Semler made a second effort and persuaded Mayfield to invest an additional $5 million. But then the company, with just one prototype and no customers or revenue, hit a wall. More than 60 phone calls were placed to prospective investors and dozens of trips to New York and Boston were made, but PolyFuel got serious interest from just three firms.

"Dave said this is going to be a slam dunk," recalled Mr. Semler, who left the company in August to pursue other ventures. "It didn't turn out that way.";

As money was getting tight, meetings with venture capitalists continued. Vanguard Ventures, a 21-year-old Palo Alto-based venture firm, spent eight weeks poring over financials, visiting PolyFuel's lab and consulting industry specialists, amassing enough research to build a 3-inch-thick file on PolyFuel. Vanguard liked Mr. Semler and PolyFuel's management team and thought the technology had the potential to be pioneering. Where PolyFuel fell short, says Don Wood, a Vanguard general partner, was that it was unclear that PolyFuel could be a leader in the field. Vanguard didn't invest.

PolyFuel eventually won the support of David Berkowitz, a partner at Ventures West, a Vancouver, British Columbia, venture firm that focuses on energy. Ventures West agreed to invest $4 million and lead the round. By January, a working term-sheet was on the table. Interest was brimming, capped with the addition of a strategic partner, Intel Corp.'s venture arm, Intel Capital, which would later invest $2 million. PolyFuel was on track to exceeding its goal of raising $15 million, with interest now topping $26.5 million.

But just as PolyFuel was ironing out terms of the investment agreement, it missed a milestone. PolyFuel was to deliver a prototype of a fuel-cell-powered cellphone by the end of January, but the prototype needed to be significantly reworked. That sent investors back to the drawing board. The terms of the deal were cut: Instead of increasing the company's valuation, it now turned into a down round. PolyFuel raised $15.6 million in March 2002, resulting in an $11.5 million valuation, $500,000 less than in the first round.

Copyright © 2003 Dow Jones & Company, Inc. All Rights Reserved

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Last updated: Mar 12, 2003




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