At a recent meeting of the Silicon Garden NJAngels.net's (njangels.net) "Best of the Best: Angel-Backed Success Stories," noted venture investor Fred Beste made the following remarks concerning the state of the Venture Capital Industry.

Groundhog Year
presentation by Fred Beste
Venture Capitalist, Mid-Atlantic Venture Funds

I trust that like all good, red-blooded Americans, each of you has seen the movie Groundhog Day several times? Well, for VCs, of late it's felt like Groundhog Year.

Things started stinking badly for us in late 2000, and by January of 2001, the outlook sucked. So, we suffered through inarguably the longest, most depressing year in the history of the industry, and twelve months later, in January of 2002, things looked no better and we were considerably more worn down. Then the year just ended felt like ten, and now here we are at January of 2003. And nothing's changed.

The market for raising venture capital is moribund — indescribably difficult (but not impossible!). VCs are still mostly hunkered down trying to save their cash-struggling mistakes of yesteryear. "IPO market" has become an oxymoron. No one's any longer predicting a near-term jump in IT market activity, and telecomm is still in a depression which some industry wags are now telling us will be the case until 2006!

I put my thoughts together on the state of the VC market for a talk a year ago this month. Three months later another group asked me to speak on the same subject and I gave essentially the same talk. I went back and took a look at what I had put together for that audience of entrepreneurs then, and decided that as much as I'm willing to go to the end of the world to do my best for Dan Conley, the truth then is still the truth now. The good news though is that my thoughts then made more sense (to me, at least!) than anything anyone else has put together on the subject then or since, for the simple reason that it was brutally honest, a quality that a lot of VCs, and particularly the more vocal ones, find it hard to bring to bear on their views and prognostications, for whatever reason. In any event, I hope that my thoughts, including suggestions on how to emerge victorious from the 2003 money-raising wars, proves useful to you.

For all of this depressing climate though, let me state as strongly as I can that I am virtually certain that 2002 and 2003 will be looked back upon with great fondness with respect to launching and investing in new enterprises. And while I don't claim omniscience, I've been living in the thick of the venture capital start-up world since 1968, so at the very least I have considerable perspective. Additionally, kindergarten-level common sense will lead you to the same conclusion. Emerging growth companies need time to develop both product and market place momentum, and doesn't it make sense then to prefer to incubate during a recession and storm the market when things are getting better, than vice-versa. The investment side of the prediction is no more complicated — not only would one prefer to invest at such a point in the traditional economic cycle, but, in addition, sanity in all of its wonderful manifestations has returned to venture investing. No longer are our doors being beaten down by literally hordes of Bozo the Clown look-alikes seeking embarrassingly large fundings at even more embarrassingly large valuations to pursue truly embarrassing, copycat business plans that counted on multi-billion dollar market cap IPOs upon the 18-month anniversary of launch, to be followed by projected operating losses that were measurable as a percentage of the GDP.

Now… if you're an entrepreneur in the audience this afternoon, you're probably thinking to yourself, "OK, Mr. VC wise guy, if it's such a great time to start a business and invest, why am I having so much trouble raising money?"

Unfortunately, there are a host of reasons, and even more unfortunately, some of them are actually good ones. And they all relate to the current VC state of mind. Mind you, I'm not looking for sympathy, because we don't deserve it. I'm just trying to help you understand the strength of the current of the River of Psychology against which you're swimming.

Here are seven of those reasons:

1. We're shell-shocked. There is unprecedented devastation all around us, and most of our personal rubble was bought with our investors' money, at our instigation.

2. We're scared. Who's brave enough to be the first one back into the water after most of yesterday's bathers got ripped to shreds; and even after the sharks have reportedly left the area, and the water appears warm and inviting?

3. We're embarrassed. We knew better, but almost all of us couldn't help ourselves. And the only thing more embarrassing than being stupid with your own money is being stupid with someone else's who left it in your care under the assumption that you knew what you were doing.

4. We're distracted. Most of us are sitting on too many Boards of Directors of too many companies that are literally fighting for their lives. Companies in trouble are time sinks, and most of us are attempting to attend to bunches of them.

5. We're once burnt, twice shy. We're reserving record percentages of our capital for existing portfolio companies. Seed and start-up stage VCs like us are suddenly often the only sources of Series B and C capital for our portfolio companies. Recently some of our cutest babies that we have been unable to afford to support to maturity have been thrown out with the bath water. We're determined not to allow that to happen again.

6. We're buying time. It's a miserable time to launch a new fund, and particularly in the shadow of so many of our cute babies being "bathwatered," so most of us are raising the new investment bar so as to slow our investment pace and delay having to hit up our battered LPs for more capital to start a new fund. Also, we think (like you do!) that time's on our side — the longer we can delay the launch of our next fund, the better our story will be (or, at the very least, might be!).

7. We're depressed... and grumpy! Take everything I've listed above and tack on a mild national and international recession. Add on a severe information technology recession. Now layer on a telecommunications industry depression. Top it off with the real and psychological implications of September 11 and a likely war with Iraq. The combination does not make for happy venture capital campers.

Were I in your shoes, here are the ten things I would do to maximize my chances of raising money and succeeding this year:

1. Face up to it - things have never been worse (to deny it is to make your task impossible).

2. Research who's currently making investments (don't waste your time trying to convince a firm which has made one new investment in the past twelve months that you merit being the second — that bar's just too damn high relative to the value of your time).

3. Get yourself well-introduced by Morgan Lewis-quality professional service firms (this is always important, but more so today than ever before; and if you want to know who's well connected and respected by the venture capital community, just ask Dan Conley).

4. Develop VC relationships before you need the money (call me 9-12 months before you're going to ask me for money; introduce yourself, tell me what you hope to accomplish in the next year with your own money and keep me informed of your progress; then when you need venture capital, I'll not only know you, but hopefully you'll have done what you told me you were going to do, and I'll be positively predisposed toward investing in your company).

5. Get your first round investors to commit, up front, to doing your second round (it's a smart request that is quite likely to be honored, but be prepared to perform to milestones to trigger that second round).

6. Take a harder look at strategic investors (not corporate — strategic — do a Hertz vs. Avis bit — play the industry leader, who's afraid of getting caught by the industry up-and-comer, off against the industry up-and-comer, who's trying to catch the industry leader).

7. Line up interested customer prospects as deeply as you can (from a start-up investor's standpoint, there is simply nothing more comforting than looking at a long list of sophisticated prospects who are excited about what you're up to).

8. Be flexible on valuation, but don't give away the farm (and rely on your professional advisors to help you tell the difference between the two).

9. Succeed the old-fashioned way - starve yourself to success! This is really the most important item on this list. Suffice it to say that The Drunken Sailor Path to Riches is history until further notice, and don't hold your breath.

Let's look at an example: You've got a team, a plan and $100,000, and you're looking to raise $3 million. You find a VC who says that he'll come up with the money in exchange for 60% of the company. Now I ask you… do you want to part with a majority of your company's stock out of the starting gate? Of course not! The solution?… DON'T RAISE $3 MILLION!!!!!!!!!!!!!!!!!!!

Cut your salary instead… offer equity instead of six-figure starting salaries to your early hires. Start off with six 70-hour/week employees instead of eight or nine 50-hour/week ones. Locate in a strip mall instead of an office park. Buy your furniture used. Instead of flying, drive to Pittsburgh for that sales call. Bring your lunches in from home. Pay no bonuses until profitability has been reached. It's amazing how you can stretch a dollar when you respect it.

As an aside, let me note that the longer the industry malaise lasts, the more I think that this factor has been a big, big factor in the downfall. In the old days, entrepreneurs took sacrificial salaries upon starting up their business, even after it raised meaningful venture capital, and respected the value of a dollar in a thousand other ways. These days, even post-bubble, everything's full price. This reduces the efficiency of my investors' capital and our prospective return; much more importantly though, it psychologically creates a feeling of arrival, comfort and yes, even success, to the start-up team. Again in my view, the likelihood of true success is inversely proportional to the existence of those feelings. Stated positively, the more scared you are, the better you're likely to perform. When we were launched in the mid-80s, we backed all kinds of successes which consumed less than a million dollars of equity capital. Today, it's three million out of the box, and seven-to-forty more thereafter. Hell, if I had that kind of money behind me, I'd lose my edge too. This is an insidious, destructive variety of this era's sense of entitlement, and it isn't serving entrepreneurs any better than it's serving VCs. If you want to succeed, tighten up your cash flow, meaningfully.

In any event, should you end up succeeding, your stock will never be cheaper than when you launch; ergo, minimize your capital raise when you come out of the box. Better yet, use yours and your team's money to scratch your way to higher, more compelling ground for when you raise outside money. The key here, of course, is that you can't afford to stumble — so if you decide to take this route… don't.

Let me comment on the example I offered up, however. Is it financial rape? Heck no!! Subtract the $100,000 of founder money from the $2 million pre-money valuation being offered ($3 million buys 60% of the company, so what was there before is being valued by the VC at $2 million), and our hypothetical investor is telling you that he's willing to give you $1.9 million of credit for what you've come up with so far — an idea, a team and a business plan — probably no more than a few hundred hours of work. $1.9 million for a few hundred hours of work — not exactly an insult. Most people I know would be willing to make that trade. The problem here isn't the rapaciousness of the VC — it's the fact that $3 million is a heckuva lot of money to toss into a company that consists of nothing more than a newly organized and totally unproven team, a business plan and $100,000. Sure, you're bringing your experience, the team you've assembled, and your commitment to bust your tails for 4-7 years, but in our example the VC is providing 96+% of the cost of the effort, and is highly likely to lose every penny of it if you don't perform up to snuff. If you don't blow through your outside capital like a cold North wind, you and your team will likely end up with 15-35% of a company possibly worth $100 million or more, and maybe much more. But if you can build momentum with less than $3 million (and preferably a lot less), you'll do even better ownership-wise.

Remember this also as you're out there raising money… these days there is only one intelligent answer to the question as to what valuation you're hoping to get, and that is "We're in the process of finding out what the market value is for this company."

Once you have the answer, you can either take it or not — it's your baby, it's our investors' money… but remember one thing, it IS market value — the price a representative buyer is willing to pay, just like the valuations in 1999 were market value.

You should keep something else in mind as well — no quality firm is going to stick it to you, even if they can. We're entering into a long-term relationship with you — many have analogized it to a marriage — and no successful marriage I'm aware of ever started off with one partner taking advantage of the other, even if he or she could.

A week after the venture capital industry implosion at the end of 2000, it was as clear as a bell to me that the world had not only changed, it had done a one-eighty, and at a Board meeting of one of our just-backed ventures the next week I tried to explain this to the team, and I suggested to them the adoption of the mantra "This is war. Beat the plan." If anything, things have turned out to be even grimmer than I had imagined, and then of course September 11 exerted a national paralysis on everyone, which in many respects has not yet fully thawed. And so, if my late-2000 mantra was "This is war — beat the plan," my early 2003 mantra has been toughened up to my tenth and last money-raising suggestion to you …

10. Adopt the mantra … This is war ... beat the plan … no second chances … no excuses.

In summary… whether you're a Lutheran or a Muslim or a Catholic or a Buddhist or a Jew, if you're an entrepreneur, it's Protestant ethic time again — work hard, work long and work smart, and you should willingly, nay happily, make short-term sacrifices in the hope of producing long-term gains. Until further notice, success will likely come only to those who abide by these principles. And to those of you out there on the money-raising trail, good luck… it's tough out there right now, but it's not a wasteland.

And lastly, if you haven't already, come see us. We're doin' deals, though we're pretty damned picky right now.

Transcript of the presentation made by Fred Beste at Dan Conley's "Best of the Best: Angel Backed Success Stories," January 8, 2003.

Fred Beste
Venture Capitalist
Mid-Atlantic Venture Funds
125 Goodman Drive
Bethlehem, PA 18015
phone: 610-865-6550
email: fred@mavf.com
website: www.mavf.com