Case Study

Outside the sixth-story windows of CollabNet Inc.'s offices in Brisbane, Calif., palm trees swayed almost imperceptibly and the sun glistened off San Francisco Bay. But the serene vista contrasted sharply with the intense discussion going on in the company's conference room. It was a Monday in March 2002 -- time for the regular 10 a.m. meeting. CEO Bill Portelli sat down with seven of his top executives, including founder and CTO Brian Behlendorf, who had first conceived of CollabNet's Internet-based tools for collaborative software development.

Portelli called the meeting to discuss whether or not to seek new funding through what is called a "down round" -- a stage of venture capital financing that results in a lower company valuation. For the past decade, down rounds have been considered the funding of last resort, a sign of a failing company and poor management. But times have changed.

CollabNet's position was far different from the one it had enjoyed just a few years earlier, when the company was a darling of venture capital firms. Benchmark Capital, Hewlett-Packard, and Intel Capital, among others, sunk in $38 million from the company's founding in 1999 through 2000. Then the bubble burst, sending the stock market and IT spending plummeting. To survive, Portelli ditched research projects and product lines, and laid off about a third of his 120-person staff. He refocused his remaining resources on SourceCast, a software development tool for programmers.

Demand for SourceCast grew steadily. But while the company was close to surviving on cash flow, by early 2002 it had not yet turned a profit. Portelli worried that if the economy took another dive CollabNet would meet the same grim fate as many other tech companies. But maybe, he thought, he could "provide a cushion" for CollabNet -- one made of cash. Securing a new round of financing would be difficult. Venture money had been drying up, with $21.2 billion invested in 2002, compared with $106.6 billion in 2000. Still, Portelli figured that looking for funding when the company wasn't desperate for cash might allow him to negotiate better terms than if he waited.

But he also knew that a cash infusion through a down round can have unpleasant side effects. CollabNet had finished its second round of financing in 2000, near the height of the tech boom, with an extremely inflated valuation of about $70 million. After this third round of financing, the company could end up having a valuation closer to $20 million. (Portelli would not disclose precise valuation figures. These estimates are based on interviews with a key competitor and several financial experts.)

PUT DILUTION IN THE BASKET: Bill Portelli's business wasn't desperate for cash, so why consider a down round?

A down round would also dilute the equity stake of previous investors. CollabNet could sell 50% of its equity to new investors for $10 million, for example. But that would mean that second-round investors -- unless they chose to reinvest -- would end up having paid $35 million for half as much equity. "In a normal world, you invest in a company and then you invest a few years later and the valuation is higher," says Portelli. "That's what people are accustomed to."

Early stage investors occasionally sue companies over what they consider to be unfair terms in a down round. In fact, Benchmark, which could see its more than 20% stake in CollabNet decrease in value by millions of dollars, filed just such a suit against a Canadian bank last year. "Lawsuits are certainly a concern in a down round," says Barry Kramer, partner at Fenwick & West, a law firm that tracks down-round financings. "There haven't been a great deal of lawsuits, but there are certainly more than in the past, because the terms are very tough."

Founder Behlendorf recalls additional concerns expressed by some of the investors, "like 'Are you guys really going to make it fly with this new money? Will you refrain from the temptation to dive into the new pool of money too much?" Portelli adds, "There were certainly those who thought that we could get to profitability without additional funding. There were those who thought we were strong enough that we didn't need it."

"In a normal world, you invest in a company and then, a few years later, the valuation is higher."

Portelli and his team had to weigh their personal ambitions, too. They always had the option of shopping CollabNet as an acquisition to corporations like Borland, Sun Microsystems, or Oracle. And Portelli says he had been courted by potential buyers. Selling the company would certainly provide early stage investors with liquidity. However, this option did not sit well with founder and CTO Behlendorf, who disliked the idea of handing over his baby to corporate overseers.

As the meeting drew to a close, Portelli looked around the conference table -- at Behlendorf and his other top managers, all of whom had fairly sizable stakes in the company. The value of their equity and the size of their stakes would drop if they took the financing. Then again, the additional money might allow them to keep the company on a growth track. It was time to make a choice.

The Decision

In January 2003, CollabNet finalized a $13 million third round of funding led by Norwest Ventures. Most shareholders, including Benchmark and Oracle, did reinvest; notably, Hewlett-Packard and Novell did not. In a statement, a Novell spokesperson says, "The primary reason we did not participate is that we are no longer making venture capital investments. Furthermore, we are a small investor and do not have a seat on their board; our participation was not critical."

Seed-round investor Tim O'Reilly, whose stake in CollabNet dropped to 5% from 25%, says: "It's a big enough opportunity that it's still going to be a big win for all of us." His sentiment seems to be shared throughout the organization and among shareholders. "Some people's shares might appear to be diluted, but if the company's stronger and healthier, then any shares you have are going to become more valuable," says Portelli. Both the CEO and Behlendorf consider the round to have been a great success.

The Experts Weigh In

WILLIAM M. KUSHNER, an associate at law firm Perkins Coie's Menlo Park, Calif., office who has completed a large number of venture capital financings.

This is one of those situations where lawyers are a necessary evil. If this company augments its war chest at the cost of significant dilution, it could result in potential liability. In a down round, it's extremely important to treat all investors fairly. You want to ensure that founders and early investors who were diluted can't claim they were coerced or defrauded in any way. A company without severe cash restraints, like CollabNet, should have a lawyer send out a detailed information statement and investor questionnaire to all shareholders, providing full disclosure of the reasons behind the deal and explaining their rights to participate. Those are the most pivotal tools to protect the company from future litigation.

ADAM DELL, managing general partner at Impact Venture Partners, a New York City firm that invests in early stage companies.

One thing to remember in a down round is that management needs incentive. If a company has raised $30 million and then raises an additional $10 million in fresh money, it should reevaluate liquidation preferences. These typically favor venture capitalists. Common shareholders in management won't have much of an incentive if they need to create $40 million in enterprise value before they ever see a dime. I recommend that a company like CollabNet work with its investors to wipe out the old liquidation preferences in exchange for new terms. Another approach is to create a special management carve-out, which allows management and investors to share equally in the proceeds from a sale of the company.

K. CYRUS HADAVI, CEO and founder of Adexa, a Los Angeles software firm that completed a $15 million down round in August 2002.

A lot of companies see a down round as a defeat, but really you just have to make a mental adjustment. Running a real company is not about what it's worth today, but about building value that will last through the good times and the bad. You shouldn't focus too much on your valuation because any company -- whether private or public -- has a share price that fluctuates. That said, we had a more negative experience than CollabNet did. We were about to have an IPO at a valuation of about $2 billion in 2000, but then we backed out. The following year, our revenue dropped 17%. We didn't know how long the storm would continue. We saw all of the dot-coms dropping like flies. And things weren't looking good for the enterprise software companies. Like Portelli, we wanted a cushion, plus some more cash so that we could take advantage of bargains and buy up some new technology. Though our valuation dropped a lot, we went ahead with a down round. The valuation we had in 2000 -- it was nothing more than a dream, a fallacy.

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