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STRATEGY

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.

Interest in M&A grew even stronger after eBay acquired the European VoIP provider Skype for more than $3 billion last September. The business world hailed the deal as a brilliant move on Skype's part, one that other VCs and entrepreneurs should emulate. "I go to a lot of board meetings where investors are pushing for acquisitions so they can forgo the risks of waiting to go public," says Steven E. Bochner, a partner at Wilson Sonsini Goodrich & Rosati, a well-known Silicon Valley law firm.

Interestingly, one of Skype's VCs now says that sale was premature. "If they had given it a couple more years, Skype would have been worth far more than that," says Steve Jurvetson, a partner at Draper Fisher Jurvetson in Menlo Park, Calif.

Less Great Expectations

It's long been common for entrepreneurs, even those with start-ups, to say that they consider a sale a likely exit strategy. But that's different from grooming a company for a sale from day one, which is happening now. Some entrepreneurs have been encouraged to maximize their attractiveness to frequent acquirers such as Cisco, News Corp., and Google. This may be a lucrative strategy. It may also keep a company from trying anything too radical, even though radical ideas are what distinguish the most successful entrepreneurs.

Aiming for an acquisition also circumscribes the role of the founder. These days, CEOs are coached by big-time investors to act more like them, thinking rationally rather than emotionally about their companies. Be prepared to leave after five or six years, they are told. The emphasis on M&A reinforces this view because "more often than not, the entrepreneur who sells his company to a strategic buyer is not going to be interested in hanging around a bureaucratic big-company culture,"says Presidio's Horsey.

A quick exit can enrich a founder and satisfy the VCs, but it's not necessarily good for the business itself or the remaining shareholders. Several studies, including one published in the June 2003 issue of the Journal of Finance, have found that companies in which the founder is still active outperform companies run by professional managers.

Then there's the bigger picture to consider. Identifying the next great company, rather than just another good acquisition, used to be a venture capitalist's mission. "If a company gets bought out by Intel or Johnson & Johnson, it's nothing to get excited about," says Mark Heesen, president of the National Venture Capital Association. "We need to inspire entrepreneurs by finding more Googles."

Once attitudes change, however, it can be hard to change them back. Consider Karbon Systems, the high-flying tech company that several VCs are currently courting. Could it turn into an extraordinary success? Its founders don't think so. "An IPO just isn't realistic anymore," says Emeka Okereke. "We're planning for an acquisition all the way."

Darren Dahl can be reached at ddahl@inc.com.

Last updated: Feb 1, 2006

DARREN DAHL is a contributing editor at Inc. Magazine, which he has written for since 2004. He also works as a collaborative writer and editor and has partnered with several high-profile authors. Dahl lives in Asheville, NC.




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