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Washed Out in the Valley

Light Reading
News Analysis
Light Reading
1/25/2002

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

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Phiber_Phreak
Phiber_Phreak
12/4/2012 | 11:01:35 PM
re: Washed Out in the Valley
"At least two other high-profile networking companies are seeking large amounts of funding right now"

Names? Any guesses?
etherguy
etherguy
12/4/2012 | 11:01:35 PM
re: Washed Out in the Valley
to the new investors? what happens with the cap structure exactly? caspian's product will probably end up working with enough time, and i've heard there are actually a couple of large carriers who have committed to this architecture. so, there's probably some value in this deal somewhere. exactly how will it get unlocked and for whom?
skeptic
skeptic
12/4/2012 | 11:01:34 PM
re: Washed Out in the Valley
"At least two other high-profile networking companies are seeking large amounts of funding right now"

Names? Any guesses?
---------------------------------
Procket and Pluris. There are rumors that
procket's round is already finished, but its
never been confirmed.

As far as Procket goes, their previous valuation
is going to result in a washout no matter what
they do. It may still be a large valuation for
this market, but it will still be a washout
because of the billion-plus valuation they got
last time.
Phiber_Phreak
Phiber_Phreak
12/4/2012 | 11:01:34 PM
re: Washed Out in the Valley
"to new investors?"

_What_ new investors? Caspian is negotiating now, but not a done deal. I have a hard time believing any investor would pony up $$ for a company whose valuation went from 100s of millions to 5M.

Then again, VCs have made lots of bad calls before :(
etherguy
etherguy
12/4/2012 | 11:01:33 PM
re: Washed Out in the Valley
they had a round that was open for awhile and investors approached them unsolicited for months, giving them money. round was the largest i have ever seen save zhone's $500m lbo $ that was really not even venture money. and the company was set up like a group of llc's so really not even a fair comparison. i heard procket had raised $200m plus...round "closed"around january or feb if i recall correctly.
skeptic
skeptic
12/4/2012 | 11:01:33 PM
re: Washed Out in the Valley
skeptic, i have tremendous respect for your insights usually...but here you are wrong. procket has enough money to last well into 03 under any imaginable scenario.
--------------
I believe they were out raising money recently.
If they completed a round in the last few months,
they certainly will have enough to last into
'03. But I'll be honest that most of what I
know about procket is vague rumor and even if
they did a round, I'm not sure there would be
a public announcement that its completed.

As far as heads rolling, they supposedly dumped
50 recently between contractors and employees
including at least one high-profile hardware
person.

I don't think that procket is going to have any
problem raising money and will probably still
raise it (if necessary) on better terms than
anyone else. But there is no way I can see
them ever coming close to 1.5 billion in
valuation in the current environment.


etherguy
etherguy
12/4/2012 | 11:01:33 PM
re: Washed Out in the Valley
skeptic, i have tremendous respect for your insights usually...but here you are wrong. procket has enough money to last well into 03 under any imaginable scenario. maybe even 04. you may be right about the valuation but if they need to raise more money, a lot of heads will roll...they should have some sort of liquidity event before that happens. we'll see.
The_Holy_Grail
The_Holy_Grail
12/4/2012 | 11:01:32 PM
re: Washed Out in the Valley
1) How does that effect employees who are still there vs those that have left?

2) Why such a low valuation? I thought Caspian had some real nice digs right off of 237.

3) Say and employee has 10K shares currently vested, are his shares worthless? Can someone post a few examples of differing scenarios?

4) When such dilution takes place, is there any reason for employees to stay?
flanker
flanker
12/4/2012 | 11:01:32 PM
re: Washed Out in the Valley
...James Wei, a partner with WorldView Technology Partners, which is not involved in the Caspian deal but is familiar with washout rounds. GǣWhen 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. ItGs pretty dicey. For example, IGm not going to invest if the managers end up owning only 20 percent of the company.Gǥ

This guy's got a point. Tough to motivate management when they have no skin in the game and no incetive to win.
BadgerAlum
BadgerAlum
12/4/2012 | 11:01:32 PM
re: Washed Out in the Valley
"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."

--------

So how does one protect staff equity, and what does that mean to the average employee? Are a certain percentage of shares guaranteed to be part of the employee pool? Are those shares re-distributed to the average Joe or Jane? If so, how are they redistributed, (performance based, flat percent, etc.)? If not, what do they plan to do with the shares?

Has anyone been through a down-round and can you share your experience on how the equity stake of the employee was affected?
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