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science, art or sorcery?
clues to .com valuations

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the audience: q&a

Mr. Hooke: We'll start with an email question. What is a down round?

Mr. Frederick: A down round is any round of financing that you have to raise at a lower price per share than the round before. Watch out for these because there is an odd disconnect between the private and public markets in this regard. In the public market, stocks go up and down all the time. Cisco was down yesterday. You don't feel that it's a weaker company because of that, but, in the private market, people expect the exponential growth curve to go in only one direction. It can taint your company if you are pushed into a down round scenario, so I urge you to think about that when you establish your valuation expectations.

Mr. Hooke: Please give your advice on the following scenario: an Internet startup with no capital and no experience would like to bring in five experts. Contribution and dollars invested in time is valued at $10,000 each. Since the company's growth is a complete unknown, how can a percentage of future profits or a vested ownership be looked at fairly, and what are some scenarios?

Ms. Kim: Early on, especially when we were trying to preserve cash, we thought of some of these issues, whether it was with strategic advisors, outside agencies, development firms or others. We gave some of them convertible notes and said, "You are giving us $10,000 worth of services. Here is a note that converts at the first VC round,"ómaybe with some slight discount to itó"Thanks for letting us use your money. You get to invest along with some pretty smart VCs who have done pretty well, so you should do very well." Those are the arguments we used and it seemed to work out.

Mr. Frederick: That's the best way to do it. Unfortunately, we see people with broken capitalization tables because they gave too much of their company away too early, or they tried to get fancy and ended up with things like revenue overhangs. I can't think of any subject matter expert who is worth some sort of revenue share going forward. The best way by far is these convertible deals where it converts as the same price at the next round of financing. If the subject matter experts are going to play an important role in securing that financing or creating value at the time of that financing, give them a discount. We have absolutely no problem with that. If it's just a little bit of value that they created, give a 10% discount; if it's a lot, 20%.


Audience Member: Scott, you said that a "sure thing" with 2x return on your money wasn't worth looking at. Would you be willing to look at a company coming to you with less risk but much less return and help them develop a more exponential growth model and a larger market possibility?

Mr. Frederick: By all means. If the seed of the idea is compelling enough, and it sounds as though there is the opportunity for much greater than the 2x return, then I'm not worried about that limited return opportunity. That's what we do. We view ourselves as roll-up-our-sleeves types of investors and are certainly willing to help a company develop a strategic model that can give us the returns we are looking for.


Mr. Hooke: The question I often get from people when I travel around the country is, "How much longer is the Internet valuation craze going to last? How much longer are you going see these huge multiples of sales?" Jeff, does your firm have any standard response to this question?

Mr. Anderson: I don't think I can predict how long it's going to last, but one interesting way of looking at it, perhaps, is that a lot of times we get the question, "Is the market overvalued?" The market is what it is. It's twice as big for these companies driven by the capital markets at this time, and the values are tremendously high. As I mentioned before, it's very difficult to justify these markets using an income approach, but you still have to try to do it. One way of using the income approach to determine whether the values are reasonable or not is to back into it. For example, I was looking at recently. Earlier this week, they had an enterprise value of $275-$300 million. I wanted to see what kind of assumptions it would take to justify that market value in today's dollars; what kind of targets they would have to hit. Using a simple DCF model over a 10-year period with a discount rate of 18%, the company would have to grow annual revenues in excess of 150% for 10 years, achieve an operating profit margin in year three and grow to 50% in year six. I assumed an exit multiple of about 20x. This is not's business plan. It gives you a sense of the magnitude, the hyper rate at which these companies have to grow in order to justify current values.


Mr. Finn: My name is Michael Finn with Powersim. Our revenues are skewed more towards services than products, but we want our investors to view us as a product company. What kind of things do you look for in a business plan that help you categorize a company as a product versus services firm?

Mr. Frederick: The distinction is important because service companies are often viewed as difficult to scale. A lot of entrepreneurs we talk to don't quite realize that just because we make that distinction, it doesn't mean that service businesses are not good businesses. We did very well on our investment in Proxicom, but the danger of a service company is that all your assets go home and sleep in their own beds every night, which is a pretty scary position as an investor. The reason why the product company gets a higher multiple and tends to get higher valuations is that it's eminently scalable. Once you make the product, you can enjoy repeat sales. With services, in order to grow you need to get your body count up, and that's going to be a function of the rate at which you hire and retain people.

We see a lot of companies trying to make that transition from being a services company to becoming a product company. One of my biggest fears is that a services company that wants to "productize" will never be able to firmly delineate what the product is. It sounds simple, but it's tough because you are going to be tempted in a lot of situations to do anything to close a deal. Big customers will say, "I really like the product. If you could just do this to it, then I'd buy it." You are going to want that customer as a reference, but you have to be careful not to become a one-off consulting shop that has to layer on tons of services every time you sell a product. We wrestled with that with webMethods, and they were very successful. They said, "Hey, this is our product." After a while, you need a "take it or leave it" aspect to hope that it sells.


Mr. Grosvenor: I'm Edwin Grosvenor, CEO of KnowledgeMax. Scott, I assume that most of the deals you are doing are $5-$15 million. Most of the New York investment banks won't act as placement agents for raises that are much under $20 million. How often do you work with placement agents for the size rounds that you do? On the whole, do you find them to be helpful in the process or would you rather see that percentage of your money going into the operations?

Mr. Frederick: Great question. We have very rarely invested in deals that were brought to us by placement agents. This is going to be a huge generalization, but deals that come through placement agents tend to be higher priced because a lot of the places they are going to are not "smart money." I don't mean that in a detrimental sense, but they are going to high net worth individuals who are going to be a little bit less valuation-sensitive. That being said, private placement agents can be very, very valuable, and we have used them in some of our portfolio companies for follow-on financing. At that point, we are already in the company and we are trying to get as high a valuation as possible. There is a second reason as well. We want the management team building a business, not on the street raising money. Agents can be very, very valuable, and there are some people locally who will do smaller rounds. Just make sure you ask for a list of companies they successfully raised capital for.

Mr. Hooke: I would add that a placement agent can be helpful in drafting a story for you that is appealing to institutions, and they can give investors a reality check that they are in the market zone.

Mr. Frederick: Sometimes they can oversell. They will want to get your business and they will say, "We can raise money for you at such-and-such a valuation." They will go out on the street, then come back and say, "Well, the market is actually telling us it's lower."

Mr. Hooke: The common problem is that they try to bid as high as they can to get the business. Six months later they say, "The market changed. Sorry, I can't give you that valuation."

Mr. Frederick: That's incredibly frustrating. In a deal we are trying to close now, there was a private placement agent who was offering to raise money at two to three times the valuation we gave, and we had to explain to the entrepreneur that the placement agent's money wasn't guaranteed. I would wire by Christmas.


Audience Member: Regarding B2B transition, we are moving into industries that are not commonly known to those who invest in Internet startups. What is your best advice for trying to convey to the VC both the opportunity on the Internet and in the industry itself without losing them or putting them to sleep? In other words, how can we best explain a complex business model in a short time?

Ms. Kim: We have seen great receptivity to B2B. It's so hot right now. We got started in May, when it was still not sexy, which was one of the reasons why we entered the space. Now, it is so red hot that when we were doing the fundraising, all it seemed we had to say was, "We are focused on B2B in a really boring industry," and people would be all over us. Getting the suppliers in the market to listen to you is something of a different story, however, and we have used some public relations things to say to people, "This is real. It is going to happen to your market. Don't let what happened to some of the old consumer companies happen to you."

Mr. Frederick: Boring is good. I'd rather be rich and boring than famous and poor. Especially in the B2B space, boring is hot.

Ms. Kim: Right now, because it's so hot, you can be famous and rich. Maybe.


Mr. Shin: I'm John Shin with Web-On-Site. We are involved in a second round of financing and getting a lot of interest from individual and institutional investors. How much money should you take at various stages, especially as you start thinking about public offerings later? Additionally, at what point do you want to introduce strategic investors, and how important is that to you?

Mr. Hooke: Are you giving the same valuation numbers to the individuals and institutions?

Mr. Simon: We were trying to get some money in to shore up things. We are going to true up the individuals if it winds up that the institutional money comes in at different valuations.

Mr. Anderson: Scott recommended, at least in earlier rounds, not to worry too much about dilution, but, instead, to obtain a large amount of money up front in order to get to a certain level. An alternative strategy is to take a look at the minimum amount of money that you need to get to a certain level, then revalue the company at that time once you have a better track record for financial revenues, customers and so forth. It might give you a little bit more flexibility and higher valuation and dilution at that time if you are in a different stage.

Mr. Hooke: Individual investors are nice because they are less sophisticated than VC firms and you can get more dilution out of them. You can get more hand holding as the company grows.


Audience Member: I have been told by a lot of VCs that the window of opportunity for these valuations is closing to a certain extent, even to where some securities lawyers have suggested that we have six months left to get out. That just seems ridiculous to me, and I wondered about your thoughts.

Mr. Hooke: Well, if everybody promises to keep their answers to under 20 seconds, I think we should all answer that. I thought it was going to end 20 months ago. I think this thing could keep going for a year, two years easily until there is some severe downturn in the general market as a whole. Jeffrey, what do you think, particularly about the non-earning space metrics?

Mr. Anderson: I personally think this may last a couple of years. It's really going to be dependent upon how the funding continues for these companies to be able to market and develop their enterprises before they start generating revenues. As we mentioned before, these measures such as subscribers and site visitors are just potential value. You have to convert those measures into revenues, and, hopefully, one day, operating profits. There is so much money going into these companies now, and a lot is being spent on marketing promotion, so I think that in a couple of years, if you are not turning things around pretty quickly, that funding could dry up and you'll face real problems.

Mr. Frederick: First of all, I want to say I'm a raging bull; otherwise I wouldn't be in my profession, but I do think that in the end all markets have to return to some sort of fundamental analysis. What you are speaking of are proxies, and you use proxies such as eyeball counts when you don't have earnings. My fear is that the Internet success will, to some extent, actually take its own air out of the balloon. I don't think it's a bubble that will burst; I think it will deflate a little bit, but not burst. Let me give you some examples. People say these extreme valuation multiples have never happened before, but that isn't the case. I'll tell you a funny story about biotechs. There literally were biotech companies whose stocks fell when the FDA announced approval of their products. A Wall Street analyst explained that it was because the companies could no longer garner biotech multiples because they were now real drug companies.


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