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Funding for startups

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
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ARBoy 12/4/2012 | 10:58:14 PM
re: Washed Out in the Valley Anyone heard how Caspian's search for funding is coming along? Does anyone know for sure how many people work at Caspian? VCs are keying in on burn rate these days so if they're overstaffed, there are layoffs in the future without a doubt. Is there a product in our future?
steve 12/4/2012 | 11:00:37 PM
re: Washed Out in the Valley just to be a little bit more legalesee about the washout thing: each class of preferred stock has various rights embedded into it (liquidation preference, etc). Those rights cannot be changed without a vote of the owners of that class (A, B C, etc,) and you usually need 2/3rds or 3/4rs. So why would someone agree to rescind their rights - because the other choice is liquidation or bankruptcy - with no assets to be distributed.
The tradeoff is I get a chance at a small payout in the future or nada today. These things are usually structured so that if, as a preceding investor you participate in the washout financing you get to keep some small part of your original investment. Is it legal? To get around any potential litigation you should make the new financing available to ALL existing shareholders, including common - of course the employees usually do not have the scratch to participate - which is why you need to refresh the option plan
skeptic 12/4/2012 | 11:00:40 PM
re: Washed Out in the Valley Of all router startups, Chiaro seems to be
the most promising one. Skeptic, what's your
take on that company?
----------------

Promising based on what? There is little
(if any) information available about them
and its not clear from whats available
that they are a router startup or what their
product actually is.
qqq 12/4/2012 | 11:00:41 PM
re: Washed Out in the Valley Of all router startups, Chiaro seems to be
the most promising one. Skeptic, what's your
take on that company?
optical_man 12/4/2012 | 11:01:02 PM
re: Washed Out in the Valley one thing I forgot, lest the employees be forgotten in this whole thing.....

It's up to YOU to ask "Can I see "the capitalization contracts that this company has entered into before I start work here?".
Now, will you?
Hell no!
Some friend of a friend just got you an interview with some TOP movers and shakers in xxx(pick your town: the Valley, I-495, Telecom Corridor) who are gonna conquer the WORLD, AND have offered you 20,000 shares Pre IPO. Are you going to question it? Again, Hell no!
That's the quandry we are all in. If you are not a Founder, you are an employee. Just ask the folks at Enron about "conquering the World" and retiring rich off Stock Options.
Keep your eyes open. Good luck, and God bless America!
optical_man 12/4/2012 | 11:01:03 PM
re: Washed Out in the Valley "Can this be done legally?
I don't have any knowledge of how these washouts work. but one obviously problems is that even you can"

Palycat,
Short answer: Yes.

Long Answer: This is legal. Remember, this isn't a public company. This is a "private" business deal between bankers and moneymen. When they go into a deal, part's of the contract will say "you agree to, in the event of, wholly and under....." basically it's a contract. They gamble that the company will work out in a big financial way, or they lose some interest (sometimes all interest) in what carries forward.
There are not 6 million shareholders asking the federal gov't for assitance and investigations. It is between a visionary group of engineers and the bankers. Depending on the perceived strength of the founders, they can get the vc to agree to any 'hamstring' clauses. If the vc is Vinod caliber, then the vc is gonna call the shots when it comes time to 'sign here to get our check'. It's a fair deal on both sides. If the companies founders didn't like it, they shoulda called the next vc group, and vice versa.
Legal? Yes. Capitalism at it's finest.
nagogpark2002 12/4/2012 | 11:01:04 PM
re: Washed Out in the Valley Down round is one thing but 400m->50m is pretty low. Main problem is that no carrier is planning to replace their ATM core equipement for atleast another year or two. Word on the street is that layoffs are a precondition for the next round.
nagogpark2002 12/4/2012 | 11:01:05 PM
re: Washed Out in the Valley Down round is one thing but 400m->50m is pretty low. Main problem is that no carrier is planning to replace their ATM core equipement for atleast another year or two. Word on the street is that layoffs are a precondition for the next round.
palycat 12/4/2012 | 11:01:05 PM
re: Washed Out in the Valley The dilution and how to protect the employees stocks and options is one piont. The other point is the VCs extra rights such as Liquidation Preference right. If they get factor of 2 on their investments, and assuming total investment of $50M in the company, then how many companies will have exit much higher than $100M-$150M ? . In most cases the employees will see nothing even in an exit.

--------------------

Can this be done legally?

I don't have any knowledge of how these washouts work. but one obviously problems is that even you can dilute previous investor's percentage through a washout, you cannot change the existing contracts on their liquidation preference. unless the company eventually become a big success so that the diluted shares still overwrite the liquidation preference, how this can help?
steve 12/4/2012 | 11:01:13 PM
re: Washed Out in the Valley Any VC with a brain will put in place a pool that sits senior or paripassu to the preferred liquidation preference, ranging in size from 8% to 15% of the deal, to be allocated to management/key employees. This is in addition to the common pool, which will be worthless in most acquisitions.

Also, a $5mm pre money deal is not ridiculous - it is just another tool to wipe out the previous investors who dont want to play in a subsequent round/recapitalization (however, should go hand in hand with refreshing/repricing the option pool)
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