"You've Got to Have Real Customers"

In this Q&A, attorney Richard Chernicoff spells out what entrepreneurs must bring to the table these days in order to obtain funding for their startups

By Karen E. Klein

VC attorney Richard Chernicoff says the process may be longer, and the demands are more rigorous, but new technology firms are still getting funded.

Richard S. Chernicoff is a partner in the Los Angeles office of Brobeck, Phleger & Harrison, a San Francisco-based law firm, where he has represented clients in mergers and acquisitions transactions valued in excess of $10 billion. A member of the firm's venture-capital group, he specializes in developing New Technology companies. He was a presenter at the May, 2001, Entrepreneurship Capital Conference in Beverly Hills, where he was interviewed by Karen E. Klein.

Q: In 2000, your firm shepherded more companies through the IPO process than any other law practice in Southern California. What has volume been like in 2001?


The number of people looking for money is down, which is fortunate because a lot of things we were seeing last year were ideas, not companies, and those people are keeping their day jobs now. But we're still seeing a solid number of serial entrepreneurs, college professors, and engineers who have hit on promising technologies that will make a company.

Q: Studies show that total VC investing was down 43% in the first quarter of 2001. What chance do those New Technology firms have of getting funded right now?


It may take longer, and the demands are more rigorous, but they're still getting funded. At the end of last year, and in the first quarter of this year, the VCs were cleaning up the wreckage of the late '90s. But I think in the last six weeks we've turned a corner and people have started writing checks again -- though at a significantly reduced rate, with lower valuations, and they're proceeding much more cautiously in terms of due diligence than they were 18 months ago.

Q: High-flying valuations were almost routine for technology companies going through the VC process in the recent past. How have company valuations changed in this market?


Valuations are now driven by a model that shows sales relating to net income, and they are customer-focused, not idea-focused. It used to be that if you could show revenue growing, you would get a higher valuation -- it didn't matter if that revenue growth resulted in net income or not. Today, you've got to show that you have real customers out there who have a need for your product. It's not enough to have a plan to create a market for your product.

Q: What happens if a company does not get a higher valuation after initial funding?


The company tries to bring the company's prospects back up, or it has to undergo what is known as a "down round" of funding. Down rounds -- subsequent financing events in which the company is valued lower than it was initially -- have been unheard of over the last four or five years, but they were well known in the early '90s, when VC money was going mostly to biotechnology companies. When the market was going up very quickly, even companies who should have had down rounds because of bad results were able to get higher valuations. Now, with an uncertain and choppy market, you could be a perfectly good company, hitting your numbers and executing on your business plan, and you could still end up with a down round through no fault of your own.

Q: What are the risks of a down round?


We're starting to see more investment term sheets that include "full ratchet anti-dilution protection" -- a provision built in by investors that says if the company sells shares at a lower valuation in a down round, those original investors automatically get a bigger piece of the company as a way of protecting themselves from dilution. So, if investors pay $10 a share at initial funding and the most you can get someone to pay six months later is $5 a share, the original investors' percentage of ownership in the company will go up without them investing any more money. Every time investors take a bigger piece of the company pie, the entrepreneur's share gets smaller.

I'd say that 12 or 14 months ago, full ratchet protection was rare, but now 40% to 50% of VC term sheets include it. Some term-sheet provisions can be negotiated, however, so entrepreneurs should make sure they have a professional working for them who knows how to do that.

Q: What can be done to make down rounds less painful for entrepreneurs?


Carve-outs can be negotiated that prevent the entrepreneur from losing equity if a down round occurs for certain reasons. If the company wants to issue employee stock options, for instance, that will create an incentive for the engineering team to stay longer and deliver on the product. Having a solid engineering team creates value for all the investors, so the theory is that VCs should not get full ratchet protection against issuing low-priced options to key members of the engineering team. Carve-outs can also be negotiated when lower-priced shares are issued in connection with acquiring another company, because an acquisition also creates value and is not an anti-dilution triggering event.

Q: With lower valuations and full ratchet protections, should entrepreneurs lower their expectations for big payoffs -- even if their ideas truly have profit potential?


It is discouraging for a lot of entrepreneurs when they realize that they started with 100% of a company, accepted outside capital, dealt with market turbulence, at by the time their product is on the market they own 6% or 8%. This is not the return they expected after all their hard work. There is a degree of understandable naïveté related to that, and an unfamiliarity with the reality of the world. But there are also strategic decisions along the way that should be made cautiously. Rather than having a $20 million "B" funding round, for instance, you might be able to avoid more VC funding by doing an equipment-lease deal, or do a "rolling closing" -- so you close on $5 million now and close on the rest of the money at a later date, but only if you really need it.

Q: What other changes should entrepreneurs be prepared for when they approach professional investors?


The due diligence process has gotten much more onerous in the last 18 months. If your business is for real, the investors will give you much more real terms in your financing. If you have three engineers right out of college, your investors will perceive a high degree of risk and they'll want to build in all kinds of protection to reduce the degree of the risk they're taking on you. If you have a management team in place, and a business plan that shows an understanding that there's a market out there, and customers who are in pain without your product, those are key points. You also want to have competent, independent advisors who are focused on protecting you in the long run.

Karen E. Klein, a freelance writer, covers Small Business issues for BusinessWeek Online. Klein writes the Smart Answers column that appears on Tuesdays and Thursdays. Have a question about running your business? Send her an e-mail at Smartanswers@businessweek.com. While we will publish only your initials and city, please include your name and phone number in case we need more information.

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