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perspectives on venture capital in greater washington

shaking the money tree

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the valuation game

Mr. Grant: In the fourth quarter of 1999, the average deal in the Greater Washington region was a little over $11 million. Of those local companies funded, 48.3% received their first round of financing, with the average startup getting $10.7 million in that first round.

Please shed some light on a topic that the survey does not reflect, but which I know is near and dear to the hearts of many of the people sitting in the audience today—valuation. What have you seen in valuation trends over the past year and what do you think is driving it, Roger?

Mr. Novak: Well, there is more money in the region. From a seed perspective, if you are an established entrepreneur coming back to the market, you can generally command a pretty good valuation. In a lot of instances, however, being in a seed situation is binary—either you are going to get funded, or you aren't. While there has been some upward creep, you don't see as much valuation creep at that stage as you do in the second round. Candidly, we are seeing our second rounds getting done at five to twenty times what the first round was, and that appears to be where the greatest valuation creep is. You do have a lot of large initial rounds, although we are usually not part of that because our average first round is probably $2-$3 million

Mr. Khoury: It goes back to the diversity of the deal flow. We find a lot situations where it's a $2 million first round. We invested in Riverbed Technologies (recently acquired by Aether Systems for $800 million) which involved FBR Technology Venture Partners as well, and that was a very successful investment for both of us. It was a small first-round investment. On the other hand, Broadslate Networks, a regional next-generation DSL provider, was a $35 million round in which we invested $20 million and three partners invested $5 million each. If you look at the average DC deal, you have to consider the fact that the average contains the service providers, in which some of us will do a first round of $40 million between four players, and initial seed stage deals where someone like Novak Biddle and Columbia Capital may only do $1 million apiece. I think it's pretty balanced.

Mr. Grant: Kevin, how do you see justifying $20 million valuations for some of these startups?

Mr. Burns: I think what's happened is that the whole investment cycle has been compressed into Internet time. The traditional model is to do a Series A during which you build your product and go beta; a Series B to roll out to your market; then a Series C to mezzanine, etc. That cycle may have run over a five-, six- or seven-year period in the 1980s. Now, it's all's gotten scrunched. The time has been cut in half, and steps have been surgically removed so that you do an A round, maybe a B and a strategic round, then go public. In many respects, the public markets for these companies are doing what we would have thought of as mezzanine financing.

You really have to look at the overall amount of capital you are going to put to work in the project. You might be mindful that there won't be these nice increments in which to double down your bets, so you may go in with a little more capital at a valuation that's maybe an average between an A and a B round, then provide enough capital to execute. The winners and losers are vetted out more quickly. With these Internet models, you don't get a second chance. You are either there or everybody kind of moves on, so Version 1.5 of the product has to be right. I think that's one factor working.

The other factor, if I put on my entrepreneur's hat instead of my VC hat, is that with fund size growing very rapidly, there is a lot of capital being pushed into this segment. Unfortunately, there is a shortage of good VCs who know what to do with the capital, and those dynamics push up average investment size. There are so many VCs who have to put the money to work in a certain amount of time that they have to put more money into each round. As an entrepreneur, you want to manage dilution, so you don't want to take mega rounds at low or moderate valuations. You want to play seven card stud—raise capital across a series of defensible milestones that investors can understand. A "smart person with no business plan" is worth a certain amount; "smart person with a business plan" is worth a little bit more. Smart person, business plan, team, beta, prototype, and so on, the value keeps going up. What I didn't know back in the '80s is that your points of value creation and inflection go up as you can take the risk out of the venture, and as the VC needs less vision to see that your venture is going to work.

I meet with entrepreneurs all the time who say they want to raise $30 million. No, you are not. You may need $30 million when the smoke clears, but you might raise $5 or $10 million, then go on up. That way you will wind up owning 25% of your company at IPO instead of waking up and owning only 8% of your company. Always raise money in about 12-15-month increments because, if you run out in between while island-hopping across these valuation inflection points, you will get crammed down on value.

I think that entrepreneurs spend way too much time worrying about control and dilution. The VCs probably spend way too much time worrying about the end value because our job is to make the pie bigger. If it's a good idea, we are going to blow out the pie. Our IPO of MCK Communications in which our $4 million turned into $184 million is an example. Nobody cared what our in value was because the pie was so large. You need to spend more time on the pie and not on the amount of valuation or capital.

Mr. Khoury: One additional point. I have seen two trends an awful lot in the last six months that terrify me. One is when an entrepreneur walks in the door and, after a half-hour presentation, says he wants $20 million "to plant the flag." I have heard the statement, "plant the flag," more times in the last six months than I can shake a stick at.

The second is that our number one reason for passing right now is because entrepreneurs are saying, "I want more money at a higher valuation." When investors are willing to give the entrepreneur more money at a higher valuation hoping that they will make the return anyway or because the public market is making 10X returns, it drives a lot of the valuation statistics. We see a lot of that. Our number one reason for passing is, "I want more money at a higher valuation."

Mr. Novak: But it's a wonderful time to be a Series A investor and entrepreneur with all of these people with large amounts of money. If you get your business model right and have a good management team, you can command incredible step-ups and create feeding frenzies.

Mr. Grant: Just don't tell them you want "more money at a higher valuation."

Mr. Khoury: Or that you want to "plant the flag."

inside the deals and outside the exits

Mr. Grant: Let's take a look at some deals each of you did this quarter. Roger, your firm invested in Para-Protect Services, a company in a sector that's receiving a great deal of media attention lately. Will you to tell us a little bit about this deal?

Mr. Novak: Kevin said earlier that he tends to be a theme investor. We are also theme investors, and one of the themes I got interested in back in the mid-1980s is large scale networking. I felt that, ultimately, it would work its way to the commercial sector, but I decided that security would be an issue, so I made a string of investments in encryption and secure computing, then smart card security. I became convinced that, as the world is moving to B2B and E-commerce, we will need more robust security. What was out there was pretty weak.

Para-Protect came to us via referral from a former Deputy Director of Information Security at the National Security Agency (NSA). He said that the guys at Para-Protect are the best guys in the world at what they do, and what they do is operational security. They have a database of attack signatures that goes back a long way. They will run a penetration test, look at all the holes and fix them. One of the other founders was a founder of Carnegie Mellon's CERT Coordination Center, so they can probe a Web site or an E-commerce site once or on a periodic basis. If you are attacked and go down, they can probably bring you back up within a few hours because they know how your site is mapped.

We put some seed money into Para-Protect, which is largely in four vertical markets. In finance, they are working with some of the major banks and brokerage houses. In technology they are working with domain registrars—whoever they touch, Para-Protect protects them. In entertainment they work with large, respected brands; and in health care, again, their customers are household names. We look at it as an infrastructure play and they are growing like a weed. We think they can probably go public within a year, but, more probably, somebody is going to make an offer for them.

Mr. Grant: Kevin, you did a deal that many talented VCs tried to do and failed. Please tell us how you were able to get the deal done.

Mr. Burns: I talked earlier about our B2B focus and the appeal of vertical markets that are ripe for disintermediation. The telecom space is very ripe for that. We applied our 15 criteria for what makes a good vertical, such as where you can build a community and the like. I think telecom is a 10 on that scale. If you have ever gone to a telecom trade show, you know that by the third booth you are saying, "Didn't I just talk to you?" and, "Why is that router different from that other router?" If you are at home in your home office, go try to order a DSL line and see what happens to you.

If you look at Cisco, they channel a large amount of their orders through their E-business site on the Internet. Of their $11 billion in sales—I looked at it—$9 billion is flowing through their E-commerce site. Mostly that's at the high end of the marketplace where you have a Cisco router and you need five more, so you don't need to talk to a smiling salesperson and hear a joke in order to say, "I need four more of what I already have confirmed." You can go to school on that, but, if you look down the pyramid into the mid- and lower markets, the vocabulary, the numbers— well, I thought software was bad, but telecom is worse—the acronyms, the buzzwords and all of that.

The core of's business idea was very appealing to us. They said that they were going to suck in all these complex telecom devices, terms and so forth, and normalize it so that a buyer can compare apples to apples. A lot of telecom people quote speeds, feeds and things like that; all using different levels of metrics. The buyer can't look at the products using a side-by-side technical comparison. pulled together these complicated things with crazy terms and different quotes into a database so that if you are in the mid-market, you can call them up and ask, "What do you have available that will fulfill these kinds of business requirements?" Up come the solutions prepackaged, configured and the like.

We found the business idea compelling. To invest as a VC, you have to "get it." If you are confused or you don't understand why an idea could change the state of play, you usually don't invest. At the time you write a check, you should say, "Man, this is exciting!" You may not feel that way after the first board meeting, but when you write the check, you should think, "We are going to change the world."

We are also big on the people. I once took my INTERSOLV business plan from 1982 and blew the dust off. We were still in the same space, but the differences were laughable—or cry-able. Of Lazard's 19 portfolio companies, I would say that at least 15 have morphed at least 90 degrees. They don't morph out of their space—their target audience is the still the same or similar—but a lot of times the first idea is not quite right. What's going to take you through the morph to the big idea is the quality of your people, their creativity, how committed they are and the passion they have for doing it. Some other VCs who had met the Telezoo team were put off by their wild and crazy approach to business, their funny titles and such. We found it to be an endearing quality. They were also willing to bring in other people on the management team who could bring the skill sets required to build a big business rapidly. The space is right and growing fast, competition is not too thick, the people dynamic is right and we think that it's part of our job to help management create the dynamic and to succeed in that space. It's a very exciting $1.3 trillion market.

I believe that the platform is not the PC, it is the Net, and the Net rides on telecom infrastructure. I think there is going to be a lot of growth in that space. If Telezoo works hard and we can help them, we should be a big winner there.

Mr. Grant: Karl, Columbia Capital has participated in some very capital-intensive deals in this region, which you may wish to touch on, and the exit can be just as exciting as getting the deal done. Please talk a little bit about some of your recent liquidity events.

Mr. Khoury: On the investment side, I'll give a brief synopsis of one company, Broadslate Networks, which is a region-wide DSL carrier that's going to focus on the next generation of DSL.

Covad, Rhythms and some of the nationwide carriers participated in something that is very typical in any industry, a land grab where you throw as many D-slams and cover as many cities as you can. It happened in cellular, in long distance and in local, as well. Now, we are in the next generation. All of these companies need to fill in their markets and start to create some breadth and depth, so that when someone orders a DSL line from Bell Atlantic it doesn't take six months to provision the line.

We founded Broadslate with $35 million in the seed stage, along with Bessemer Venture Partners, Charles River Ventures and J.P. Morgan Capital. The same management team who had built out a previous business for us said that they could build a direct sales force for DSL services instead of using the ISPs. So, Broadslate was a $35 million seed stage investment that already had a business plan since Rhythms, Covad and others had proven the business model; they just focused on penetrating the market with a direct sales approach, rather than using the indirect channel that frustrates all of us who are waiting for a DSL line.

On the exit side, we have all seen a lot of really attractive times to exit, and there is no better time to exit than right now. It doesn't matter whether it's the public market for LifeMinders or MCK Communications, or whether it's a sale transaction, as in the case of Riverbed Technologies.

Riverbed is a fabulous story and congratulations to the entire management team. These folks spun out of an IT service company named Noblestar, and were seeded with $2 million in the spring of last year. Their business model is basically the extraction and synchronization of data from the enterprise to a mobile or hand-held device. At the time, a lot of people told them, "We would rather use a laptop. You can't really get that much data off the PalmPilot." However Riverbed plugged ahead and they were able to secure an exclusive license with 3Com, maker of the PalmPilot, to use Riverbed's technology. As is so typical in our lives when we get involved with a company, that one event changed everything. Suddenly Aether Systems, a company that was more of a service provider, saw the value of taking the enterprise solution and dropping it into their service model. They acquired Riverbed. The timing was right, and none of us can predict these things. In some cases, you would rather be lucky than smart. In this case, the service provider needed the enterprise solution, so it worked out absolutely perfectly. It was a great blend and sold well on the street.

Mr. Grant: If any of you don't know, the acquisition went for north of $800 million.

Mr. Khoury: It definitely was an attractive purchase price.

the sources for deal flow

Mr. Grant: This quarter, PwC in cooperation with the Mid-Atlantic Venture Association (MAVA) began tracking companies that received funding as a result of the Mid-Atlantic Venture Fair—which will be called the Capital Connection this year. Kevin is one of the co-chairs of the Fair.

In only five weeks' time, between the Fair in November and the end of the fourth quarter of 1999, 20% of the companies that got funded had presented at the Fair, and we expect that to go up next quarter and the quarter after that.

Related to that, how do companies get your attention and how do you like to receive your deal flow?

Mr. Burns: We recently did a review of the 19 portfolio companies in our first fund to see where they came from. Of the 19, 18 were referred to us by somebody we knew. Only one came, as they say, "over the transom" at a show. As an entrepreneur, trace that back one level and understand that on an average to poor morning, there will be five unsolicited business plans in my email, sometimes 10. If I go into the office, there will have been another five or 10 delivered by mail, usually Federal Express, so just reading these things is a problem.

Do a little homework up front to make our jobs easier, such as reviewing our Web site, learning our investing themes and so forth. That plus a referral from somebody we know who can say, "This should meet your level one criteria," will stop it from going into the pile of 100 plans that have to get read in order to find out that they're about golf carts in Palm Springs with a GPS system. That way your plan comes in at level two of the screening process, and your probability of getting focus, air time and a meeting are probably enhanced about 10 times.

Just a quick plug on the Mid-Atlantic Venture Fair—it is huge. At the last Fair, we had 1,000 slots and actually turned people away at the door with their checks for $1,500. We had 72 very high-quality entrepreneurs presenting with their teams. They each had a booth, meeting rooms and 12 minutes of air time to tell their story. There were 375 checkbook-carrying VCs. It was just a wonderful event and we think the one on September 5 will be equally terrific. VCs like the forum because there, in one place, under one roof, over a day and a half, you can watch your competitors. What are they sniffing around? Who is meeting with whom? Where is the action? We'll bring two or three people. You can cover the two tracks, and there is a good chance that you can generate enough sparks to actually cut through the normal lobbying of your business plan and see if it gets any attention. These group meetings are places where VCs go to leverage their time. Essentially, all they have is their capital and their time, and time is scarce these days.

Mr. Grant: Karl, how do companies get your attention?

Mr. Khoury: We are having the same problem. Our team is pretty large. We have nine partners and five associates, and we are getting 15 business plans a day. The difficult thing for all of us is that we want to get back to the entrepreneur with a quality answer. We want to be able to help them out, but, unfortunately, Kevin is absolutely right. Of the 29 deals we have done in the 10 months since the fund closed, four were ideas we created ourselves and brought in a management team that we had worked with in a previous life; probably one-third may have come from service providers, either lawyers, accounting firms or consultants that we work with; another third were references from limited partners; and the remainder came from CEOs we worked with in the past.

What we are experiencing now is the recycling of management teams who are coming back for the second and third time. It makes the process so much easier because you know them, you trust them, you understand their strengths and their weaknesses. There is much less of the "getting to know one another" game that you had to go through the first time, so they are very easy deals to do.

It's pretty balanced, but coming in the door and sending an email is only effective if you know someone or if you have an in to make it more than an unsolicited email to Go to the Web site and find someone's name, then send the email to them personally. If you send it, it's sometimes a little difficult to distinguish it from the other five or six or seven that come in every morning.

Mr. Grant: Roger, your partner says he likes to look at everything. Is that true?

Mr. Novak: Well, it is true; one of us at least scans every deal. Since we are doing seed and startup deals, when we set up the fund we recruited roughly 60 IT entrepreneurs as investors. We felt that they would be a source of deal referral, potential co-investors and that they could be mentors to some of the existing portfolio companies—a reality check on our judgments. If you look at our portfolio, I would say 80% come through this limited partner network.

Since we are looking for the engineer with the great idea, we read at least a piece of every business plan that comes in, even unsolicited plans. We will take anything coming over the transom, and at least do a cut on market, technology and people very quickly.

Now, I will say that I hate to get emails. I will not open unsolicited files; I just won't do it. I did it one time and got a virus, so it was the last time I have done it. I personally prefer a hard copy.

We will not sign Non-Disclosure Agreements (NDA) and the reason is for exactly what was alluded to earlier by Kevin. Most companies, particularly seed startups, morph, and they may morph within 30 days after you start working with them. The business plan you see today is generally not operative in six months.

We also will work with entrepreneurs for four to six months, in many instances, with, say, $50,000 to work on the plan and get it into something that we think is focused with a real business model. We love to get vetted deals, but we will look at unvetted deals, too. That's the honest answer, but, like everybody right now, a vetted deal carries much more weight than an unvetted one. With an unvetted deal, you have to do a lot more work to make the investment than with a vetted deal. That's also true when a referral comes from another VC. If Kevin said, "Look, this deal is too early for me, they only need $150,000. If you do it and get it to the next stage, I'll invest in it," that's something we'll probably take a serious look at.

Mr. Grant: I'm sure that all the comments this morning have garnered a lot of questions from the audience, so let's open up the floor.

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