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VCs & Startups Go to the Mat

Startup angst abounds as investors crack down on companies and try to save their investments

April 10, 2002

6 Min Read
VCs & Startups Go to the Mat

Maybe it's time for group therapy?

With cutbacks mounting and the telecom industry recovery still beyond the horizon, relations between startup executives and venture capitalists are deteriorating into a swirling melee of finger-pointing and boardroom scuffles.

Telecom startup execs are increasingly miffed that the VCs are gaining control over their companies and scaling back support. Ultimately, they fear that shortsighted decisions by VCs will ruin the industry.

Venture capitalists counter that their modus operandi hasn’t changed -- they've always tried to build good companies. But they note that their first allegiance is to their limited partners, who pay them large fees to manage assets and make money. And, privately, VCs fault entrepreneurs for being inexperienced and unrealistic about how to value companies and cut costs.

"The pendulum has definitely swung too far the other way," says Ravi Chiruvolu, a general partner at Charter Venture Capital. "Some good companies with good business models aren't getting funded and, as with any downturn, there are victims on both sides."

Granted, the argument is as silly as two bald men tugging on the ends of a comb. Both parties ultimately want to make a buck. But many entrepreneurs don’t seem able to move past the windfall expectations of the bubble years of 1998 through 2000. Conversely, many VCs are exacting revenge on entrepreneurs for their collective arrogance during those years.

So how, exactly, did things get so weird? In the bubble days, VCs guided companies to hire talented people and to spend liberally on their marketing efforts, according to several current and former startup executives, most of whom would only speak on the condition of not being named. A healthy headcount helped drive up valuations. Heavy marketing raised a startup's profile and drew interest from investment banks -- boosting its chances for an IPO (or an acquisition).

Slash Happy

These days, though, headcount and marketing are the first things the VCs want to cut. VCs are telling startups' CEOs to get their burn rate down as low as it can go -- and that often means reducing all jobs that don't have a revenue figure attached to them.

Several startups have cut back so much for so long that they're in "walking dead" mode, says Turin Networks Inc. CEO John Webley. "[Startups] are being asked to [stretch their capital and] survive for a few years with no revenues. But you have to wonder, if they do survive, whether they'll be competitive in 2004 with 70 employees and an old product."

Such radical changes inevitably strain relations in the corporate boardroom. After all, most boards consist of little more than a few of the VCs and a few of the founders, with virtually no outsiders. It's not surprising that in such a scenario the investors' voices become the loudest.

On top of the constant cutbacks is the fact that VC funds are shrinking. Kleiner Perkins Caufield & Byers, Redpoint Ventures, Mohr Davidow Ventures, and Accel Partners are among those trimming the size of their funds.

This raises some big questions: Namely, if the VCs demand such steep cutbacks, why not just kill more of the companies they believe are weak and back the winners? Likewise, if the investors believe the company will survive -- why not put some conviction into it?

Bottom line: It's all about the cash, and people not wanting to part with it. To wit, a startup CEO can wear out the knees of several pairs of trousers while begging for money. "For the next 12 months, terms to get funding are going to be tough, and there'll be a lot of strings attached," Charter Venture's Chiruvolu says. "But those tough terms can be aligned in a way that gives everyone an incentive to build a company's value."

Even when a startup does secure funding these days, it is usually not getting a check for the entire amount it announces. Often the company must hit product and revenue milestones every few months before VCs dole out the next incremental funds. If and when the startup fails to hit said milestones, the investors carve off a bigger slice of the company for themselves.

Blocked ExitsMake no mistake, VCs are slash-happy because their exit strategies look so awful. There have only been two venture-backed IPOs in the communications and networking sector in the past 15 months, according to VentureOne. The sector's largest M&A deal in the first quarter of this year was Tellabs Inc.'s (Nasdaq: TLAB; Frankfurt: BTLA) purchase of Ocular Networks, but how many companies have that kind of cash?

Things needn't be so grim. Chiruvolu says smart VCs will make sure they give their companies' managers the right incentives to keep their costs low and hit their revenue targets. This also helps avoid what one entrepreneur calls "managing by my board's shopping list."

What would also help, startup executives say, is if VCs would look at their own portfolios, pick one in each space, and back that company wholeheartedly. They point to firms such as Sequoia Capital, which have multiple bets in metro, long-haul, and access equipment.

Also, VCs should try not to string companies along before deciding whether to invest, startup executives say. "It's a huge distraction to have to make several trips to meet with VCs who won't give you a firm 'yes' or 'no,' " says one startup CEO.

VCs say they're appropriately slow to invest. "Has the venture industry gone back to historical valuations? Yes. But I don't know from which part of history," says a partner at one Silicon Valley VC firm.

Then, of course, there are those VCs that hesitate to invest because they were burned by telecom deals wherein a startup exaggerated its customer interest. "They'd present a purchase order that had more outs than a baseball stadium and this is supposed to impress investors?" asks one venture capitalist. "Meanwhile the guy that issued the purchase order owns shares of the startup and is trying to get a good enough markup to cover the cost of his equipment. Gimme a break!"

VCs also note the scenario in which the entrepreneurs aren't experienced enough to build a company, and, rather than step aside, they hang onto the top job too long. "When you start a company, you have what you have and either you can sell it or you can't," says one routing industry veteran. "If the VCs can sell it or find someone who can, why not let them?"

***Where does this finger pointing and complaining leave us? It only confirms that the industry is experiencing a classic overcorrection to the bubble.

"Entrepreneurs used to raise scads of money, they drew huge salaries, and they gave up hardly any ownership of their companies," says one telecom equipment executive and angel investor. "They thought they were geniuses, but what had really happened is that they won the lottery."

Eventually, he says, both sides will revert to their pre-bubble roles. In the meantime, however, "there's a lot of natural selection that needs to happen."

— Phil Harvey, Senior Editor, Light Reading

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