Facing the Capital Gap

There's plenty of capital out there. So why are so many companies struggling to raise money?

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Karbon Systems is one of those companies that venture capitalists love. A five-year-old business that manages the Web component of BlackBerry and Treo systems, Karbon has always been profitable, has doubled revenue every year, and has signed multiyear deals with Verizon and Sprint. It is no wonder that the business, which has offices in Virginia and California, has been offered roughly $12 million by three different venture capital firms.

But Karbon hasn't always been so popular. Four years ago, when its founders were hunting for seed capital, they were rejected by numerous VCs, including firms on Silicon Valley's storied Sand Hill Road. Granted, 2001 wasn't the ideal time to raise money, but VCs still invested more than $40 billion for the year (compared with an estimated $20 billion in 2005). For Karbon, though, a hot technology was not enough to qualify for funding. "They told us to come back when we were ready to take on Google," says co-founder Emeka Okereke.

Karbon's experience reflects a fundamental shift in venture capital. If you have an established company (especially one that makes an obvious acquisition target) or are a seasoned serial entrepreneur, capital is cheap and abundant. At the same time, early-stage companies are struggling to raise money. Jeffrey Sohl of the Center for Venture Research at the University of New Hampshire calls it "the capital gap"--the difficulty faced by entrepreneurs trying to raise between $250,000 and $5 million, even if the companies are growing nicely.

"The business is changing," says William R. Hambrecht, the veteran investment banker who runs San Francisco-based WR Hambrecht & Co. "VCs are looking for less risky deals."

"The probability of VCs investing in a start-up is far less likely than it was in 1999," agrees Josh Lerner, a professor at Harvard Business School. "And that's bad news for entrepreneurs."

Passing on the "Bread and Butter"

Oddly enough, the capital gap is largely the result of a glut of money. Even after 13 consecutive increases in the federal funds rate by the Federal Reserve Board, interest rates remain relatively low, inspiring private and institutional investors to plow money into VC funds.

With billions of dollars to manage, VC firms face a choice. They can add partners to cover more companies, or they can simply invest their cash in larger chunks. The vast majority of firms have done the latter. Most deals now range in size from $10 million to $25 million, up from "the bite-size $1 million to $2 million investments that used to be their bread and butter," says R. Revell Horsey, managing director of Presidio Merchant Partners, an investment bank in San Francisco. One seasoned entrepreneur who recently went looking for $6 million was told she could have $12 million--take it or leave it (she took it).

Naturally, most VCs today are looking for mature companies that can absorb such large sums. And nobody is suggesting that VCs shouldn't show more prudence than they did at the height of the bubble. But VCs originally split off from traditional private equity funds to focus on riskier start-ups. Now they're shying away from start-ups--only 19% of venture capital, some $4 billion, went toward early-stage firms last year. That's one-seventh of what start-ups raised in 2000. Angel investors are moving into the territory that VCs are leaving behind, but the gap between the ceiling for an angel investment and the floor for a VC deal is still quite wide.

A Blocked Exit

Another reason VCs are turning their backs on start-ups is that nobody can bank on an initial public offering anymore. There were 194 IPOs in 2005, compared with 406 IPOs in 2000. What's more striking is that fewer than 100 VC-backed businesses went public last year, even though every business backed by VCs was, in the past at least, assumed to be on the IPO track.

The few companies that did go out in 2005 were--like those that received venture capital--larger, older businesses. The average age of companies completing IPOs in 2005 was 21, compared with 10 in 2000. "It's taking more time and more capital to build companies to a scale where they can go public," says Walter Kortschak, a managing partner based in Summit Partners' office in Palo Alto, Calif.

Since VCs don't want to hold on to an investment for more than five years, backing older companies makes more sense to them. Meanwhile, younger businesses that have already been funded are prepped for another outcome: acquisition. "M&A has become the default liquidity event," says Tom Taulli, founder of CurrentOfferings, a financial research firm in Newport Beach, Calif., and author of The Complete M&A Handbook.

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