For VCs, a World Turned Upside Down

Instead of reaping rewards, they must pony up more or lose all

Welcome to the stressful world of the down round, a new phenomenon that is turning the venture-capital business on its head. In the old days, VCs watched their investments grow in value, occasionally putting in new money in financing rounds until they cashed out when private companies were taken public or sold. But these days, the VCs are being asked to pony up extra cash to keep afloat private companies whose value is fast shrinking and that have little prospect of being sold off anytime soon.

Venture capitalists hate down rounds because they're forced to mark down the value of their investments. But the pain can be far worse for entrepreneurs: not only are their shares worth less, but they usually have to give up a bigger chunk of their own equity to get the extra cash their businesses need. For example, in early March, Livemind Inc., a San Francisco startup, hit shaky ground when its CEO was let go and many employees protested by not showing up to work. Adding salt to the wound: Technology Crossover Ventures, its largest investor, offered a $3 million loan to the cash-starved company--for an eventual $12 million payback. "That can change management from owners to employees," says Joseph Bartlett, a partner at Morrison & Foerster LLP. The company has since gone out of business.

"SHORT ARMS." With a deluge of down rounds expected this year, the venture-capital industry is in a state of paralysis. "The joke around Silicon Valley is that venture capitalists have deep pockets but short arms," says David J. Blumberg, managing partner of San Francisco's Blumberg Capital LLC. Adds Geoffrey Y. Yang, a partner at Redpoint Ventures: "No one wants to catch a falling knife in the private sector." So, VC cash is harder than ever to come by. Last year, venture capitalists plowed $108 billion into startups. This year, as little as $47 billion may be forthcoming, says VentureWire, a tracking service.

News of a down round used to be the kiss of death for a company. No major VC would invest in a down round and see the value of their investments diluted. Now, most expect it. Says Robert L. Gold, CEO of Ridgewood Capital Corp.: "I would much rather be diluted than bankrupt."

Execs at Urban Data Solutions agree. Last Thanksgiving, its co-founders, Adam Cohen and Andy Lerner, could barely catch their breath. In meeting after meeting, they pulled out large screens to display replicas of U.S. cities in virtual 3-D, accurate to within one meter. Even after the dot-com crash, investors clamored to invest in its novel software. That's why the four-year-old company, with $9 million in sales and no profits, had doubled in value, to $50 million, in six months. "We were pumped," says Chief Financial Officer David E. Farber. Today, Urban Data is valued by potential investors at about $12 million, half what it was worth last year. So it expects to raise a fraction, perhaps $6 million, of the $30 million it was seeking only four months ago.

BAILING OUT. While Urban Data may survive, some companies just give up the ghost. Consider, a software developer for Web sites that sell cars. A year ago, it was raising $50 million in a second round of financing. The aim was to take the company public at a $1 billion valuation within three years. But by last spring, before the company could raise the money, it appeared's valuation had slipped to about $15 million, 80% less than six months earlier. Suddenly, senior executives who came from high-paying corporate jobs saw their 2% stakes, formerly worth $40 million a pop, tumble to below $300,000. Rather than face a massive down round, the company shut its doors in October.

Other entrepreneurs consider themselves lucky if they end up where they started. Batnet1, a provider of online marketing services for trade groups may be forced to merge. "We're basically back to the valuation we had as a startup," says CEO and founder Christopher B. Swenson. These days, it's not easy being a survivor--but the alternative is worse.

By Debra Sparks in New York

Before it's here, it's on the Bloomberg Terminal.