At DEMO, VCs Have Stern Advice for Startups

Venture capital investor Christine Herron has a bit of advice for technology startups: Start each board meeting by asking how much cash is on hand and how many weeks it will last.

That's the kind of question that tends to focus the entrepreneurial mind, says Herron, a principal at San Francisco VC First Round Capital, in an interview at the DEMO 2009 conference in Palm Desert, Calif. "It tells you how many weeks you have to get done the things you need to do," she says. "When capital was easier to come by, people didn't pay as much attention to that."

Venture capitalists had plenty of such attention-focusing questions for new companies making their debut at the conference, which wrapped on Mar. 3. Many startups head to the desert seeking their first rounds of funding. But at a time when less money is available to entrepreneurs, the outlook for Web advertising sales is worsening, and fewer startups are getting bought, VCs say that they're more than ever pushing their portfolio companies to focus on frugality. Would-be funders are also taking longer to evaluate investments and are quicker to give the hook to wayward business plans.

Bigger Chunks of Money

VCs are also looking to give founders of their portfolio companies greater incentives to steer their companies through the rough seas. In another hopeful sign for the startups vying for the limelight at DEMO, early "seed stage" rounds of financing are getting larger, up from $250,000 or $500,000 a few years ago to $1 million or $2 million today.

David Hornik, a general partner at August Capital, says portfolio companies' founders need sufficient financial incentives to make their enterprises successful. More equity in a startup can reward VCs more richly when the venture gets sold, but too fat a stake can work against them, says Hornik. "The reality is that I'm not going to buy half a company for $1 million," since that doesn't leave founders with enough of an interest, he says. "People say it's a good time to invest because you can get a lot of equity, but the founders have to care about the outcome. If I have an extra 10% of a company that the founders don't care about, that does me no good."

Nor does it do much good when it's clear the initial business model isn't working. During a panel discussion at the conference, Eric Tilenius, founder and managing partner of Tilenius Investments, a specialist in seed-round funding, related how he pulled the plug on a failed business model last year. After buying a stake in Mixbook, whose Web site lets consumers create books from their photographs, he helped yank a plan to hawk the service to Facebook's 175 million users to build momentum. "What we found out pretty quickly was that Facebook users don't buy anything," Tilenius said.

Frozen Market for IPOs

That forced an abrupt change in business plans, and a focus on selling the service through more conventional Web marketing. "We sat down with the company, especially as the economy was going down, and said: 'Look, you have to focus heads-down on selling your product. Figure out what it is that someone is going to buy, and sell it.'" Sales at Mixbook have surged, Tilenius said, and the company's management believes it won't have to raise more funding.

Good thing, since it's getting harder to line up funding in the first place. The valuations of startups are falling as profit-generating acquisitions have tapered off, and the market for initial public offerings remains essentially frozen.

Venture capitalists invested $28.3 billion in 3,808 deals in 2008, an 8% drop in investments and a 4% decline in the overall number of deals from 2007, according to a Jan. 24 report by PricewaterhouseCoopers and the National Venture Capital Assn. It was the first annual decline in dollars invested since 2003. The fourth quarter of 2008 was especially lean, as VCs invested $5.4 billion in 818 deals, a sequential drop of more than 25%.

Besides casting a gimlet eye on the companies they fund, VCs are also slowing down. Funding rounds are taking longer to assemble, partly because many firms are teaming up in "syndicates" that co-invest in companies to mitigate risk, says First Round's Herron. VCs are also spending longer studying the companies they invest in. "Everything is slowing down, and people are doing a lot more homework before placing the bet," she says. "That's not bad, but it does take longer. And you're getting smarter investors when the deal gets done, because they've spent a lot more time studying your business."

Need to Eke Out the Seed Money

Perhaps. But VCs' more deliberative style means startups need to make their money last. Fortunately for the youngest companies, initial seed rounds are swelling. Investments in companies at their seed stage were $1.5 billion in 2008, the highest level since 2000, according to the PricewaterhouseCoopers report.

With the stock market tanking as investors reassess the value of publicly held companies, there's a trickle-down effect on startups, VCs said. If large companies are worth less than before, startups must be, too. So investors can take larger stakes in early-stage companies for less money.

VCs are grabbing the opportunity. "Where it used to take a few hundred thousand dollars to kick the ball out 9 to 12 months, we're now looking at $1 [million] to $2 million as a seed round these days," Bryce Roberts, a managing director at O'Reilly AlphaTech Ventures, said during the panel.

A fortunate group of companies are seeking funding not because they need it to build a business, but to meet pent-up demand. Instead of entrepreneurs saying "'I really need this money because I need to pay myself a salary'…it's more like 'I really need this money because I have two signed contracts,'" Herron says. "They've got business sitting there. That's really exciting when that happens."

Her most recent investment has been in, online bookkeeping software for the self-employed. First Round teamed with Shasta Ventures to invest $2 million in Outright, whose founders, Kevin Reeth and Ben Curren, are veterans of personal finance software maker Intuit (INTU).

"They're very smart, very cheap entrepreneurs—my kind of guys," Herron says. "They're going to make that money last as long as possible." Stretching every dollar out was the watchword from the investors scouting DEMO—and a dose of the new reality for the flock of companies that make the twice yearly pilgrimage to get discovered.

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