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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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palycat 12/4/2012 | 11:01:31 PM
re: Washed Out in the Valley It might be best to write off all these investment. There is no way VCs can recover their money from investment in Caspian, Procket and most companies founded post 99.

Juniper have market value only around $5b. But Juniper have far better engineering execution than hypered companies such as Procket. I have worked with procket senior hardware people( include founders) before, I was not surprised that their chips comeback not working.

It is daydreaming to expect any of these company the achieve valuation > 1 billion.


The_Holy_Grail 12/4/2012 | 11:01:31 PM
re: Washed Out in the Valley It would be nice to see a detailed article on what all this washout, down round, ...etc means to the average employee (and former emplyees).

There seems to be lots of confusion on these boards (Caspian, Procket, Astral Point,..etc) on how the employee gets impacted.

Also, what can an employee do to mitigate risk? many exercise when hired and get locked in. What if they didn't exercise? From what I am seeing with the fallout, maybe it would have been smarter NOT to have exercised. Many employees who did exercise have loans granted to them in their names. If the options become worthless, they still owe interest on the loans (over 2-4 yrs this can really add up). One way for mitigating risk as I see it is to bail after getting some vesting in.

Maybe you can consult a company that manages employees options. Just a suggestion as many employees are now worried that they may get stuck with a huge liability

dietaryfiber 12/4/2012 | 11:01:30 PM
re: Washed Out in the Valley I have been involved in one such deal. In essence, all the money up to the time of this round is worth about 0. This includes previous money in, preferred's, sweat equity that the employees have, everything. All of that money is squeezed into the pre-money valuation.

After that new shares are issued with brand new valuation. Current employees are granted new options and the new investors are given new shares. So, employees that are no longer with the firm (a group the new investors could care less about) are generally out of luck. The old investors are out of luck. Everybody else is reset with lowered expectation.

Now why might one of these deals make sense? Well, some of these companies will be worth something. Just not what the bloated round of acquisitions said they were. It does not mean that the technology, products or people are of 0 value. The product is probably close to, if not actually shipping. This represents a much lower risk profile than an early stage startup would. For lesser potential reward than such a company would offer.

dietary fiber
onehunglow 12/4/2012 | 11:01:30 PM
re: Washed Out in the Valley >Has anyone been through a down-round and can you >share your experience on how the equity stake of >the employee was affected?

Yes. My common shares at my old company were squeezed. The second to last round I had about 100K$ in stock. The last investment was a "down round," at a lower valuation. Previous investors nondilution clauses took effect and my common shares were squeezed to what I orginally payed for the stock, about 1K$. Basically, the old investors get new stock specifically created for them so they may retain their overall percentage of the company, at the expense of the current/former employees common shares. The new investors could have made all common shares worthless, but if they did the current employees, who have the same class of stock, would have been squeezed too. No a good move by new investors to piss off principle company employees.

On the other hand....for the sake of argument...forgetting about the state of the economy.... the principle of squeezing common stock in a down round, or washing it out all together may not be a bad idea. Maybe if original investors/management/employees would have orginally delivered, the company wouldnt have to make a new investment at a lower valuation.

The "new" stock also gives the new investors an opportunity to identify critical positions within the company and reward those employees with new stock options according to the employees (perceived) value.
blakkkat21 12/4/2012 | 11:01:30 PM
re: Washed Out in the Valley i would concur seeing that they are using an X 86 processor...
Titanic Optics 12/4/2012 | 11:01:29 PM
re: Washed Out in the Valley "Holy", please be more specific--

>>many exercise when hired and get locked in. >What if they didn't exercise? From what I am >seeing with the fallout, maybe it would have
>been smarter NOT to have exercised. Many >employees who did exercise have loans granted to >them in their names. If the options become >worthless, they still owe interest on the loans
>(over 2-4 yrs this can really add up).

Employees excercise options in a pre-public company? What would be the point of that? Why pay money to get stock that you can't sell? "Holy", are you referring to people exercising options in company like Cisco or Agere, which is already public?

Also, please describe these loans to employees based on their holdings that you refer to. Do you mean where they have excercised options and have stock in a public company, and have pledged the stock as collateral? Was the loan a margin loan? Or was it a collaterallized loan?

openmind 12/4/2012 | 11:01:28 PM
re: Washed Out in the Valley It is a common practice to get the pre-ipo company to give you a loan to exercise your options at the set price, some times within days of your joining them. This means that the 2 year clock for IRS starts on the day you bought the share even if they are not vested yet thus helping you with taxes (Capital gains vs. ordinary income) if the company was bought or IPO'ed. If you left before the complete vesting, you have to give the stocks back of course. Oh yes! The loan has some nomal interest rate (not too low unless you are an executive that the company desperately needed..but you could be taxed on that too!)and is paid back in installments from your paycheck if you so desire.

The disdvantage is that if the company folded, you have to return the $$ company loaned you basically leaving you with a worthless stock. If you had not taken that step of buying the stock, you would be that much ahead, i.e. you would not loose money.

Hope that helps.
BadgerAlum 12/4/2012 | 11:01:28 PM
re: Washed Out in the Valley Employees excercise options in a pre-public company? What would be the point of that? Why pay money to get stock that you can't sell? "Holy", are you referring to people exercising options in company like Cisco or Agere, which is already public?

-----

If you exercise your options when they are granted, you avoid possible AMT penalties (you're buying your stock at it's current value). For example, if I were granted 10,000 shares at $0.10 apiece, I could exercise them all for $1000 and not have to pay AMT. If I wait until the company goes public and those shares are now worth $10, I can exercise for $1000, but will have to pay AMT on the difference in value, or $100,000 - $1000. It's a risk to exercise as the company may fold, but hey, for $1000 (in this example) you can avoid a whole mess of tax problems.

BA
optical_man 12/4/2012 | 11:01:27 PM
re: Washed Out in the Valley "Employees excercise options in a pre-public company? What would be the point of that? Why pay money to get stock that you can't sell? "Holy", are you referring to people exercising options in company like Cisco or Agere, which is already public? "

Nope, here's how it works:
You get a job at a preIPO company. Your vesting schedule starts day one. The shares could be say $1.00. It's really up to the BOD, there's no SEC oversight at this point. Ok, now there's a couple of 'internal' splits, now your strike price is 33 cents.
Dean Witter/Payne Webber/Morgan Stanley will gladly loan you the 20-50K to buy the options. 2 reasons, 1) after 12 months, you pay normal capital gains of 20%. 2) Everyone knows that the stock will IPO at $5.00 up to $16.00. You've got it at .33. Even if the sucker collapses to 2 bucks, you make out great!!!
Now, if the company never makes it to IPO, well then, your sorta stuck (unless you can get Morgan to loan it to you at a little higher rate, risk free........if they are underwriting the launch, then they will)
ARBoy 12/4/2012 | 11:01:26 PM
re: Washed Out in the Valley So the Caspian PR people say that the deal is in flux eh? That means that they absolutely need $50M to keep the lights on and they have no idea how they're going to get it given the market they're going after, the present economic state and their associated valuation. Anyone know how many people work at Caspian? VCs are very hot on burn rate and that is a direct reflection on how many souls are drawing a paycheck each week.
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