Washed Out in the Valley

SANTA CLARA, Calif. -- Venture capital activity may have slowed down, but there is no shortage of tense negotiations and politics going on in the boardrooms of Silicon Valley.

The gossip these days tends to focus on who's got the latest “washout” round, a later-round financing that wipes out earlier investors’ stakes but recapitalizes the company and resets the employee option pool. Caspian Networks, which is actively seeking funding right now, is involved in one such potential deal.

Several sources have told Light Reading that Caspian is currently seeking about $50 million at a pre-money valuation of approximately $5 million. Considering that Caspian last raised money at a valuation in the hundreds of millions of dollars, that would all but wipe out earlier investors.

"The deal is still in flux," says Caspian spokesman Dallas Kachan. "We are closing on a substantial round of financing. The staff equity positions will be protected."

Other washouts are in the making. At least two other high-profile networking companies are seeking large amounts of funding right now, and sources say such companies are not likely to get the money unless they submit to a washout scenario.

Veteran venture capitalists (VCs) say such deals are symptomatic of the sudden lack of investor interest and depressed valuations of technology startups.

“This type of situation is happening more often because there continue to be a lot of companies having trouble finding outside money and they have to come back to the inside investors” says James Wei, a partner with WorldView Technology Partners, which is not involved in the Caspian deal but is familiar with washout rounds. “When you do a washout, you have to come up with the right amount of money and the right amount of ownership that the managers should own. It’s pretty dicey. For example, I’m not going to invest if the managers end up owning only 20 percent of the company.”

Why the sudden flood of washouts? For one, many of the networking companies seeking funding last received money in 2000, at the height of the bubble, when valuations were sky high -- in many case, such as Caspian, as high as $500 million. Now that valuations have plummeted, they have little leverage in the investment community. It’s often a case of taking money at any terms or going bankrupt.

In the washout, the lead VCs, rather than diluting a company with a “down-round” that chips away at the employee ownership of the company, propose a recaptialization of the company that prints up new shares for the company management and dilutes away the stakes of investors from earlier rounds (including themselves).

“In a washout, previous investors get creamed and they’re redoing the capital structure,” says Peter Wagner, a partner at Accel Partners. “When you do a financing that’s at a really low price, you have to create new ownership for the management.”

Such a dynamic can lead to tense discussions, because it forces existing investors to reconsider their commitment to the company, at the potential cost of having their previous investments nullified. In the words of VCs, they must “pay to play” in the company from here on out. If the VCs invest in the new round, they get a new stake in the company. If not, then their previous investment is all but worthless. Hence the weaker investors are “washed out.”

The technique is not new in venture capital; it’s just that it hasn’t been seen in a while. Washouts are characteristic of down markets.

“It’s all part of the economic cycle," says Wagner. “There were things like this in the 70s and the 80s. The cycle was particularly sharp this time, but that's a reaction to how high things got.”

Yes, the funding term "washout" is apt. In many ways, the washout rounds are washing Silcon Valley clean of the inflated senses of worth created during the days of the bubble.

— R. Scott Raynovich, Executive Editor, Light Reading
http://www.lightreading.com