Is Dilution the Only Solution?

Many entrepreneurs seeking next-round financing for their startups face a bitter choice: Go under or surrender control

If you're lucky, they let you live. But they make you sign away your soul and nearly all of your company in the process. An exaggeration, of course, but that's the bitter complaint from some entrepreneurs in the face of shrinking valuations of their companies by venture capitalists as they negotiate second- or third-round financing in today's decidedly down market.

Many investment contracts for startups guarantee that the original investors' share of the company won't be diluted in subsequent rounds of financing. If the venture capitalists refuse to let their piece of the pie shrink, the founders are the ones who end up with tiny slices, as yesterday's $20 million company becomes today's $10 million one.

Few company founders will share this suffering on the record: Still reliant on their investors, they don't want to acknowledge how far the valuations have fallen, or how diluted their stakes have become. Also, some see it as bad form to gripe about financing terms when so many companies can't get financing at all.


  "What's going on right now is an issue of survival," says Stephen King, founder of Virtual Growth, a Web-based accounting service. The majority of King's clients are dot-coms, and it's his business to know their financial business. "We're hearing that once they get over the shock of dilution, they realize that having the investment and keeping the company alive is better than the alternative," he says.

The drop in valuations is reasonable, says Andrew Rico, senior vice-president at Silicon Valley Bank's branch in Durham, N.C., because what a company is worth to the venture capitalist depends upon what the public is willing to pay for it at IPO time, or what another company is willing to pay to acquire it. Says Rico: "When exits are limited, as they are now, valuations need to be lower."

Andrew Taylor, vice-president for finance at Abridge Inc., keeps in mind the hammering that both the public and private financing markets have taken as his company looks for third-round financing. "Now, it's much more about survival than about battling with VCs over a million here, a million there, on valuation," says Taylor, who declines to discuss specific dollar amounts for Abridge, which provides e-mail-management technology and other Web-based tools.


  The "S word," survival, is on the minds of many technology execs. Eighty percent of the venture-backed tech startups from Silicon Valley and North Carolina's Research Triangle Park won't be around at the end of the year, predicts Vivek Wadhwa, CEO of Relativity Technologies. But there's a limit to how little the survivors should settle for, he says. "We never behaved like a dot-com, we never spent like a dot-com, but we were being punished like a dot-com," says Wadhwa, citing his recent search for fourth-round financing. "Why should I dilute my company and my partners and the current investors?"

Wadha's company modernizes the legacy-technology infrastructure of large corporations, "cleaning up the messes made over the last year or two, as Web sites were thrown up but not integrated to the operations of the firm," as he explains it. The company netted $1 million from Wakefield Group in North Carolina in its first round of financing in August, 1997. In return, Wakefield got 15% of the company, then valued at $5.6 million. A year later, Wakefield and two other venture funds invested $5 million, and the company valuation had risen to $25 million. In November, 1999, with Intel as the lead investor, the company received a $6 million infusion. By that time, the valuation had risen to $70 million.

Four months ago, when it became clear that Relativity will not be following through on its original plans for an IPO in spring, 2001, Wadhwa started returning the phone calls of VCs who had expressed interest in Relativity. One immediately said too many of his current companies were in trouble to consider any new investments. Another told him, "We're very interested. By the way, you have to be psychologically prepared for a significant cut in valuation." Says Wadhwa: "Without knowing anything about the company...they told me I had to take a 50% cut in valuation."


  Because Relativity has quickly climbing revenue and diminishing losses, as well as valuable proprietary technology, it doesn't deserve such a drop in valuation, Wadhwa argues. To get around it, the company is taking a loan from GATX Capital and a line of credit from Silicon Valley Bank totaling $5 million.

Relativity's healthy balance sheet, intellectual property, and strong management make it a good risk, says Silicon Valley Bank's Andrew Rico. "Relativity has some choice by virtue of the performance they've been able to demonstrate," he says, acknowledging that many companies don't have the option of a bank loan. They are left to negotiate with VCs, some of whom feel it's not healthy to let the management team's share in a company shrink too small, and some of whom use the repricing negotiations to push people out.

"If management is really left with a minuscule stake, another message is being delivered: Resignations would be accepted, were they tendered," says Jeffrey G. Grody, a lawyer who works on financing contracts for startups. He would advise against antidilution clauses in favor of preemptive-rights provisions, in which first-round investors get to protect their positions by having the opportunity to buy into subsequent rounds but don't get a "free ride."

To some entrepreneurs, however, the size of the stake is less important than the company's survival. "The key is to get profitable so you don't have to be relying on VC money," says Abridge's Taylor. A tiny share of success is better than a big share of failure.

By Theresa Forsman in New York

Edited by Robin J. Phillips

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