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Have You Hugged Your V.C. Today?

By Gabor Garai The dry spell for initial public offerings (IPOs) is now three years old, and it is changing the nature of the relationship between growing companies and the venture-capital firms that provide backing. The absence of a real IPO market has had the effect of extending the private stage of startups, and thus, the length of time V.C.'s firms must fund the companies in their portfolios.

Some venture-capital firms are up to the new demands, ready with additional cash and support in the form of management assistance and contacts for ever-more-vital strategic alliances. But others aren't prepared for the new pressures, and they may well react to the difficulties by pulling the plug on outfits that might have succeeded with just a bit more backing.

VITAL QUESTIONS. This new environment requires executives of growing companies in search of venture capital to do a different kind of due diligence than they once might have done in order to assess firms. More than ever, entrepreneurs must look beyond the money, to potential issues that could come up over the course of an ever-longer and ever-more-intimate relationship with venture capitalists.

Here are some questions prompted by three "relationship" considerations that every entrepreneur should consider before committing to any venture capital firm:

1. Of all the investments that a fund made in 2000, how many are still around? Try to obtain specific data. How many were sold? How many were liquidated? Of those that are still around, how many still have the founders in management, and how many lost their founders along the way? Of those founders jettisoned, what happened to their stock? Did they lose it because it hadn't vested, was it seriously diluted, or was it bought back by the venture firm? To what extent did the venture firm provide "a bridge" to fired entrepreneurs in the form of support and assistance in finding new positions?

2. What role have the venture capitalists played in supporting their portfolio companies? In other words, you want to examine not only whether money went into portfolio companies, but the form of support and the sources. A bridge loan convertible into equity during a future round may be preferable in some situations to straight investment that has the effect of seriously diluting early investors.

Also, to what extent do original venture funders introduce their portfolio companies to new venture funders, or to licensing or alliance partners that are able to provide financing support of one kind or another? Does the firm have access to outside experts who can provide assistance to portfolio companies as they encounter challenges around product development, distribution, sales, or other such matters? Or does the firm become nervous and pull back?

3. How stable has the venture fund been? This question relates to how the venture capital firm runs its own affairs. Does it have a "revolving partner" tendency? The effect of such a practice is to regularly confront portfolio companies with someone new from the firm because previous representatives have been dismissed. The new reps, of course, need to be educated from the ground up about the portfolio company. How has the venture fund performed financially? Has it been able to raise new rounds of capital?

That last question is particularly important in assessing a venture fund's ability to support companies for the long term. If there is no new fund coming up or being planned, it means any new investments will need to be supported from existing funds, which increases the pressure the produce short-term financial performance. And finally, how consistent has the fund been in its industry focus? Has it stayed with a few industries, gradually gaining more expertise, or does it jump from wireless to VOIP (voice over Internet protocol) to nanotechnology and so forth, depending on "the flavor of the month"?

Clearly, entrepreneurs need to do a significant amount of research before signing on with a venture-capital firm. Much of the research must necessarily involve speaking with entrepreneurs who have lived and worked with the particular venture fund under consideration.

THE LONG VIEW. What also becomes apparent as entrepreneurs explore the questions I have posed is that many relate as much to personal as to corporate matters. Entrepreneurs need to determine how they will be treated in terms of their stock, jobs, and availability of resources to get the job done.

We're talking about long-term relationships, and there is no sign of the relationships shortening due to an improving IPO market in the near future. Long-term relationships require more patience and give-and-take by everyone involved than the short-term relationships everyone became accustomed to during the 1990s. Gabor Garai is a partner in the Boston office of the national law firm Epstein Becker & Green, specializing in the financing and growth requirements of small and midsize companies.

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