By Al Emid

These are bad days for the business community, and the spirits of investors and entrepreneurs who voice a “We’ve seen the worst of it” rallying cry are often dampened by the latest newspaper headlines.

The slide began in March 2000. The first dot-coms evaporated from equity listings, investor portfolios and the marketplace.

Then came revelations about the mega-dollar bankruptcies at former blue-chip giants such as Houston-based Enron Corp. and Clinton, Mass.-based WorldCom Inc., followed by allegations of Alice-in-Wonderland mathematics at AOL, one of the largest e-business icons.

Shortly afterwards, financial services darling Sandy Weill—who built New York-based Citigroup Inc. into a huge conglomerate, and good-living doyenne Martha Stewart—became enmeshed in allegations of questionable dealings. At the same time, investors lost faith in those on whom they relied traditionally for protection of their interests: powerful corporate chieftains, accountants, auditors and market analysts.

For investors, those fiascos added up to large doses of fear, distrust, suspicion and doubt as the toll worsened during the summer. Taken together, they mean most e-entrepreneurs will not be able to raise funds through selling common shares on the stock market until this year at best. At worst, even later.

This near-closed door has slowed the conventional transformation of privately funded venture to publicly held corporation, leaving early-stage private investors worried about monetizing (cashing out) their holdings when a venture lacks what is known as an “effective exit strategy,” said David Brown, a private equity lawyer at WeirFoulds LLP in Toronto.

Also, financing techniques such as private placements, venture capital funds and strategic investors have become more demanding than before March 2000, said Gavin Graham, vice-president and director of investments at the Guardian Group of Funds in Toronto, and a former investment manager in Great Britain, the United States and Japan.

Executives at PhotoChannel would likely agree with Graham after their experiences with those three financing strategies. “After what I’ve been through, just being alive today is half the battle,” said Peter Scarth, the company’s chairman and CEO, laughing wearily during a telephone interview from his Vancouver head office. “We are living proof of trying anything and everything.” In October 2001, the company completed a $2.65 million private placement injected by Scarth and other investors, and in August 2002 completed another placement, this one for $854,200.

In June 2002, Vancouver-based Telus became a strategic investor when it and Vancouver-based Discovery Capital, a venture capital fund specializing in technology companies, invested $1.25 million in PhotoChannel.

Separately, in August 2002, Telus added another piece to its role as strategic investor by agreeing to accept warrants in lieu of brokerage commissions for projects and deals it would obtain for PhotoChannel.

Telus qualifies as a strategic investor since it has a clear interest in PhotoChannel’s continued viability.

Telus supplies transmission, domain hosting, data storage and other specialized telecommunications facilities.

Pre-boom rules Starting with the private placement, each potential stage has become more difficult. The rules of the game have not changed so much as reverted back to those of pre-bubble days.

“The situation is very different from a couple of years ago when anybody with a business plan and even some people without business plans were able to raise large amounts of money,” Graham said, adding that the re-emphasis on old rules includes a return to the requirement for airtight business plans. He sees them as a crucial ingredient and “something people got away from during the bubble.”

Other rules from pre-bubble days include the need to show the commitment of an experienced management team capable of ensuring the realization of projected revenues, Brown said, adding that was also sometimes lost during the earlier gold rush. “There was a herd mentality that developed where venture financiers just thought, ‘If we don’t do this we’re going to lose opportunities.’”

Having a strategic investor sounds like a wonderful option since they have a bottom-line interest in a venture, as in the case of Telus. However, this approach does not come with guarantees, Graham warned. “Telecom companies have their own cash constraints because they are under the gun from lenders, investors and rating agencies to get the cash flow positive.”

More accountability Those lucky contenders who succeed in getting a go-ahead— and a cheque—from a venture capital fund can now expect tighter reins on their activities and their own cheque writing, according to David Ferguson, managing partner at VenGrowth Capital Management Inc., which will invest between $120 and $150 million during 2002.

VenGrowth typically takes two seats on the board of directors of companies in which it invests, giving it a close view of those expenditures.

“You just end up being very critical about every single line item and expense item with a company and really asking [whether it is] absolutely necessary to make this expense [or] travel to this prospective customer,” Ferguson said.

Venture capital funds have also reverted to other prebubble practices, Graham said. These include keeping the venture as a privately held concern for up to five years or more before going public and raising money through sale of common shares.

Graham said the pre-March 2000 frenzy meant too many companies went public too soon as venture capital funds, like individual and retail investors, rushed to cash in on the bonanza instead of going through more gradual, structured and timeconsuming phases of development and financing.

“Now those phases are back.”

This means that the timeline for the evolution from privately held venture to publicly held corporation has returned to pre-bubble standard procedure.

For example, Ferguson said VenGrowth sold a company from its portfolio to Nortel Networks seven months after investing in it, and another to Microsoft after only 11 months.

“I’d say we were averaging about two years. We recognize that now we’re back to a much more conventional time frame,” he said, defining “conventional” as ranging up to five years.

The bottom-line cost of the investment for the entrepreneur has become higher in terms of control to be surrendered, Ferguson said. “Financing now is a lot more dilutive,” he said, meaning that a post-bubble financing often dilutes—literally —the entrepreneur’s share of his or her own business.

For example, a company that might have attracted a valuation of $100 million before March 2000 and needed $10 million, would have to have surrendered 10 per cent of its shares—the proportion of capital raised compared with total valuation. Now, in the harsh glare of late 2002, the same company might only attract a valuation of $20 million. However, the $10 million likely contained fixed costs such as salaries and rents and could not be reduced in proportion to the drop in valuation. Therefore, the same injection of $10 million means the entrepreneur has to give up 50 per cent of the total shares in the company.

Ironically, the same market tumult that has made life difficult for start-up e-business ventures may have actually created some extra opportunities for them. In order to appease the stock market by reducing costs, companies such as Nortel have radically downsized operations, including deep cuts to research and development divisions—the main launching pad for future products.

By comparison, privately funded ventures do not have to face the harsh glare of an unsympathetic and untrusting stock market and equally unsympathetic and untrusting analysts scrutinizing their expenses at the end of each quarter. That leaves them freer to undertake longer-range product developments, setting themselves up for eventual acquisition by companies such as Nortel and Lucent when they start looking for new profit-makers. For example, Nortel may need a new generation of optical switch, Ferguson said. “They are going to be looking to do more acquisitions.”

W e b b u s i n e s s
Guardian Group http://www.guardianfunds.com
Nortel http://www.nortelnetworks.com
PhotoChannel http://www.photochannel.com
Telus http://www.telus.ca
VenGrowth http://www.vengrowth.com
WeirFoulds http://www.weirfoulds.com