By Sheldon Gordon

Lynda Partner realized last June that the music was dying on her company GotMarketing.com. She had already raised $2 million in seed financing from venture capitalists ( VCs) Celtic House International and BCE Capital Inc., as well as from angel investors. Now the Ottawa-based IT entrepreneur was seeking a second round of funding from Celtic House, BCE, XDL Intervest Capital Corp. and the U.K. incubator Protégé.gé.

"It was difficult to maintain a consistent valuation in day-to-day conversations given that the Nasdaq was dropping every day," recalls Partner. "There was significant pressure [from the VCs] to lower the valuation." Ultimately, the VCs maintained the original valuation and Partner raised US$8 million. "We were able to close our financing before anybody could quite appreciate the magnitude of the downward spiral."

Sitting in a VC's boardroom as a supplicant is "not a pretty place to be right now," says Partner of companies in need of initial or follow-on funding. Today, most VCs either spurn new deals altogether or insist on lower valuations (demanding more equity for each dollar, for example) when they do invest. And VCs are postponing their exits from their existing investees and emphasizing the need to conserve cash.

Smaller VCs are especially wary of potential new clients and concentrate on their current customers. "Since you're uncertain about how your existing portfolio of companies will be able to raise their next round of financing, you tend to preserve more of your own capital to ensure that you can continue to work with them," says Barrie Laver, managing partner of Toronto-based CastleHill Ventures.

Valuations drop

VenGrowth Funds, a $1 billion high-tech VC based in Toronto, is a notable exception in taking new deals. Says Dave Ferguson, a managing director: "We look at this market as being a real opportunity to invest in attractive but undervalued technology situations." The firm has invested $150 million annually over the last two calendar years and expects to maintain that amount this year, according to Ferguson.

But like other VCs, VenGrowth wants more for its money today. It has kept its target rate of return at 35 to 60 per cent. "If you still want to make your target rate of return," says Ferguson, "the only way you'll do that is if you go in with a lower valuation."

Ferguson says his gut instinct is that a private company today commands a valuation 30 to 40 per cent lower than what that same company, at the same stage of development, would have fetched a year ago. This applies to enterprise software, communications or semiconductor firms, the focus of VenGrowth's investing. "Dot-com valuations would be down 90 per cent, assuming they could even get funded."

But he notes it's still possible for the valuation in a private company's follow-on round of financing to be higher than in the original round if the firm has shown progress-if, for example, the product has been developed or the firm has customers.

VCs are structuring their financing differently today, using convertible preferred shares as a cushion against risk. The convertible shares guarantee a regular, fixed-interest dividend and are convertible into common shares. "So you have the same equity upside, but more downside protection," says Ferguson. "If the company doesn't do well, the VC at least makes a modest rate of return. In Canada, VCs used to use preferreds 50 per cent of the time, now we use them 95 per cent of the time."

These days VCs are more willing to follow an existing investment firm into a second or third round of financing, whereas previously they might have looked at later-stage financing as the end-point of the relationship. "There are five or six companies in the VenGrowth portfolio that, had the IPO [initial public offering] market been more favourable, would have been able to get public offerings done," says Ferguson. "There are many companies in our portfolio, at least 50 per cent, where we've done a third round."

Playing to strengths

Celtic House International, established by Newbridge Networks founder Terry Matthews, is also providing more follow-on funding for its investees. The Ottawa firm's first VC fund invested only seed capital (deals of $2 million to $5 million involving infrastructure companies). Now, with a second fund of US$250 million, it is funding its portfolio companies through later rounds.

"You're going to put more money in [existing investees] now just to make sure these companies are well-funded through the tough times," says Andrew Waitman, managing general partner at Celtic House. "We committed substantial funds in a follow-on round [with some of its companies, namely Tropic Networks and BlueArc Corp.] and would have done it regardless of the times."

But Waitman says the second-round funding of GotMarketing.com, Lynda Partner's company, "is a situation where we need to make sure they can get as far as they need to in order to be profitable. A year ago, they would have had many, many people trying to fund what they're doing. Now the environment is just tougher."

While Celtic House has done a dozen new deals in the past year, Waitman says "the bar is extremely high. There are a lot of deals that we turned down [in the past six to eight months] that we might not have turned down had the environment not changed."

While most of those rejections consisted of new deals, Celtic House and its co-investors also rebuffed an existing client: IronBridge Networks of Boston, Mass. "In November, because of the skittishness of the market, we had to make a tough decision-whether we would continue to support a company with a pretty substantial burn rate," says Waitman. In the end, all the investors walked, and the company folded.

Conditional funds

Some VCs have become more aggressive about demanding that the company founder step aside as a condition of financing. Bernie Grybowski, president of HDL Capital Corp., says that in the current climate, "the founders of the companies who come to see us have to be prepared that at some point-maybe earlier than they would like-we're going to get new management."

In the past, VCs avoided setting a management change as a condition of financing, fearing the CEO might turn to a rival VC. "You've got to do that upfront now," says Grybowski, "because the founders have a certain skill set, and you have to augment that as soon as you can. The classic case would be that the founders might be more technology-oriented and you need a good sales/marketing person. If the founder wants to become the CEO, then egos have to be put on the shelf." HDL Capital has already bumped the founders of two of its investee companies, changes Grybowski says were "relatively painless."

Still other VCs are changing the strategic advice they proffer. TechnoCap Inc. of Montreal has a portfolio consisting of a dozen firms specializing in networking, telecom and enterprise software. Eighteen months ago, says president and CEO Richard Prytula, TechnoCap was telling its investees to position their companies for massive scalability-"two to three orders of [performance] magnitude more than anyone else was doing because of the huge demand in the networks of the world."

This year, however, the imperative is to cut costs. "You must position your company to dramatically reduce the operating costs of their client-not by one-tenth but to one-tenth of what they were."

Last year, says Prytula, he advised investees to "spend like crazy to get to the market first. This year, he tells them to build customer by customer, investor by investor, and "watch every penny."

The old mantra was first to market with products wins. The new mantra is first to financing will win. "If you get to financing first and get the most amount of financing, you will survive," says Prytula. "And it's the survivors who own the market."

Not that TechnoCap is shy to invest these days. In fact, having recently increased its capital to $250 million from $100 million, it is investing more than ever. It did four new deals just before December, three more than it had done in the preceding 12 months. "These are the best of times to be doing start-ups, if you're in the venture business, because they can't get financing anywhere else," says Prytula. "You get to choose the best of them."