Startup Millionaires Even Before The IPO

Suddenly, Internet ad outfits are raking in money from private equity firms

Joe Speiser and Alex Zhardanovsky didn't get rich the way most Internet entrepreneurs do. Sure, they built their Markham (Ontario) online startup, Inc., into a profitable advertising business and turned some of their paper wealth into spendable greenbacks. But there was no initial public offering or big buyout by Yahoo! Inc. (YHOO ).

Last year private equity firms suddenly offered to invest in privately held AzoogleAds, which by December had expanded its annual revenues to $63.5 million (U.S.) without taking a dime from investors in its five-year history. "We kept saying: 'Not interested,"' Speiser says. But in January the founders finally agreed to a $48 million infusion, more than half going to Speiser and Zhardanovsky in exchange for part of their stake in the company, say people familiar with the deal. What's more, the duo retained majority ownership of AzoogleAds and could get an even bigger payout if the company goes public or gets bought.

These days private equity firms are using their wads of cash to buy entrepreneurs' stock before their companies reach Wall Street. In the past five months at least eight private Internet advertising and marketing companies have completed financing rounds in which founders sold shares to such investors for millions. Four years ago many of these companies couldn't get a nibble from venture capitalists. Now that they're highly profitable, outsiders are clamoring for a piece.

Internet ad companies are leading the trend. They require little startup capital, so entrepreneurs have built lucrative businesses with no outside investment. Some made out by buying ad space from online publishers cheap and reselling it at higher rates to advertisers, who pay only when people click on ads. Others pioneered fields such as generating sales leads online. Many of these businesses are now minting cash. Online ad revenues rose 32%, to $9.6 billion, last year and are expected to reach $15.6 billion by 2008.

Today founders are in the catbird seat when investors come calling. "Let's say you can write yourself a check for $3 million at the end of the year," says Richard Chiang, co-founder of LeadClick Media Inc., a San Francisco startup that generates online sales leads. "What leverage does a venture-capital firm have over you?" Investors must offer to buy founders' shares to get a foot in the door. Apart from private equity firms that have traditionally been willing to do so when they invest in established, profitable companies, VC outfits are joining in. In the past year firms such as Highland Capital Partners, Insight Venture Partners, and VantagePoint Venture Partners have all invested in profit-making Internet ad outfits by buying founders' shares.

Not all VCs are thrilled about what's happening. Steven Eskenazi, a general partner at San Francisco's WaldenVC, calls the sales of founders' shares a "very disturbing and negative trend." For one thing, founders may have little incentive to stick around after getting their windfall. "If times get tough and they have a disagreement with their board, they're going to go to the beach," Eskenazi says. In addition, if founders sell before an IPO or acquisition, it could raise questions about their confidence in the future of their companies.

Such concerns have been a drag on the recent IPO of Fastclick Inc., a Santa Barbara (Calif.) Internet ad company. Six months before going public it raised $75 million from private investors, $35 million of which went to buy shares from two founders and their families. Shortly before the private financing was completed, founders David Gross and Jeff Pryor resigned. "Why would management who started the company and built it up want to step away?" asks Sal Morreale, an institutional sales trader at Cantor Fitzgerald. "It could send up a red flag." Fastclick went public on Mar. 31 at $12 a share, the low end of the anticipated price range. The stock has since traded as low as $10.25.

But Fastclick may be the exception. Most founders stay at their companies after selling stock. Consider Eyeblaster Inc., a six-year-old New York company that makes software for tracking online advertising. In January, 2004, it raised $8 million from Insight Venture Partners. Co-founder and CEO Gal Trifon says a "significant" share of the money went to buy founders' shares. "It was a unique opportunity for me to reduce some risk at a good value," he says, by allowing him to diversify his wealth. He and his co-founder have stayed with Eyeblaster, and they're using the rest of the $8 million to expand the business.

That growth could come from acquisitions as well as sales. Researcher eMarketer Inc. expects the rise in online ad spending to slow to 12.9% in 2008, down from 20.7% this year. "Everyone expects continued consolidation in the industry," says Cherie Smith Homa, managing director at KPMG Corporate Finance LLC. So many companies have recently raised money that they are able to buy smaller outfits or lower their prices to drive out competitors.

AzoogleAds' founders are using their investors' money to develop new lines of business instead of drawing down the company's existing cash flow. Speiser says he and Zhardanovsky want to develop new revenue streams before considering an IPO. With several million in the company's treasury -- and in their personal accounts -- there's no rush.

By Justin Hibbard in San Mateo, Calif.

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