It’s one of the warmest winters in North Carolina, but the funding climate bears more resemblance to the Ice Age. With first-round investments accounting for just 15.1 percent of deals in the third quarter, down from a high of 34.8 percent in the second quarter of 2000, and seed funding down 74.4 percent from a quarter earlier, entrepreneurs have been forced into hibernation. While new investments have come to a standstill, venture capitalists have never been busier and quicker on their feet in keeping existing portfolio companies alive. “VCs are allocating a much higher percentage of their portfolio and almost 100 percent of their time to managing those existing investments instead of looking for new ones,” said angel investor Fred Fink.
LocalTechWire caught up with Fred Fink and Lodestar Capital’s Reid Leggett, both of Charlotte, on their cell phones to talk about the effects of the economic downturn on angel investors, entrepreneurs and the future of North Carolina’s technology startup market. In a separate call, LTW talked with Ben Brooks of Raleigh-based Southern Capitol Ventures about the same issues.
LTW: How would you characterize the funding climate we’re in right now?
FF: It’s about as bad as it could be. It’s very difficult for any startups to obtain funding right now unless they’ve got, at the minimum, a proven management team. Even with that, there are a lot of funding sources that are saying, “We want to see established revenue in the existing business models. We’re not interested in doing startups or early-stage funding.”
Everyone is more interested in protecting the interests they already have, and VCs are allocating a much higher percentage of their portfolio and almost 100 percent of their time to managing those existing investments instead of looking for new ones, since there’s no IPO market and less of a strategic market.
RL: I think Fred’s right. I’d say the market is in a state of paralysis right now, because there were so many deals that didn’t work well. The amount of money companies need to raise to get to cash flow breakeven is higher than they can raise, and since investors aren’t willing to fund into a round A that they know is going to need a round B right behind it, it’s almost come to a standstill.
BB: It’s extremely challenging, but also a tremendous opportunity. I’m spending a lot of time educating angels and trying to convince folks they should be investing when valuations are low. We’ve been raising money straight through this.
LTW: Given that climate, what kind of advice would you give to up-and-coming entrepreneurs seeking seed and early-stage investments, and established entrepreneurs seeking A or B rounds?
FF: Don’t be surprised that, if you can even get funding, you’re going to see valuations that a year or six months ago you wouldn’t have considered. It’s now an environment where if you can get money at any cost, you darn well better take it. If there are ways to modify business models to survive without needing outside funding-whether it’s relying on family and friends or using internal resources, and keeping burn rates down-you really have to explore all those avenues.
RL: I haven’t talked to anyone in the last three months who wants to put more money into early-stage venture investments. The scrutiny around timing to cash flow breakeven is more intense now than it was 18 months ago and focused on how you’d adjust your business model to achieve cash flow breakeven as opposed to achieve substantial revenue growth. That dynamic has changed significantly.
The companies I’ve seen that are somewhat noteworthy are ones with really interesting technologies or models that are truly different and have a plan that keeps their burn rate at a minimum for a long time. They’re just trying to keep things moving forward until the funding environment gets better. I think when this market turns around they’ll be the first to get funding.
BB: Develop a business model that achieves profitability within 12 months. If you’re two to three years out, it’s going to be very difficult to get any funding at any level. To A round companies, I’d say look at alternative sources of revenue. If they’re a one-product company, maybe look at diverging and bringing in some sort of consulting service to create a revenue stream.
LTW: What should and shouldn’t entrepreneurs expect from angels and other early-stage investors?
FF: The local angel community is getting much more rigorous in its due diligence and more demanding in its terms. Some of my co-investors and I have been developing a special term sheet we’re going to using that clarifies to entrepreneurs that we’re not willing to do rolling closes or step into situations where we don’t have some type of preferred stock position with liquidity preferences and some control triggers in it. We’re not going to be a passive investor anymore.
RL: My sense of it is that the good old days of buying common and writing a check after a couple meetings are over. The people who are left standing are doing what Fred’s doing, a more professional approach to the early stage, and that’s working its way through the system.
BB: They shouldn’t expect a quick answer if they’re looking for dollars and they should expect a lot of questions, a thorough analysis of their business model and detailed questions that wouldn’t have been asked two years ago, such as “On the margin, how much does your product cost and what is your profit per unit?
LTW: How do you see the North Carolina tech startup market changing over the next 12 to 18 months, especially in light of what’s happened in the last 12 months?
RL: There were a lot of companies that got created in that space over the last three or four years-some of which are going to survive and prosper, though it’s not clear yet which ones and when. But when that happens, that’ll create another pool of capital to get the next rounds of companies done. In this market there’s not much wealth and capital being created in those sectors, so people are waiting for the market to get better.
BB: The real change is going to take place when the public markets create confidence again. I think we probably saw the bottom of the stock market right after the terrorist attacks [of Sept. 11], unless there are more things to come. The venture and angel market will lag the public market three to six months. There will probably be a few venture funds that will take an active role in helping in the early stages, and we’re going to have to create more dollars in that arena in order to stimulate the growth in our area.
Since we’re an immature market, our future and growth is very much ahead of us. I’ve always looked at this as a five to ten year proposition for the Research Triangle to get where it needs to be. Was there a setback? Maybe a reality check, but if we can raise money in this environment–which we’re doing–I can only imagine what we can accomplish when the markets turn.
FF: I’ve been in businesses and investing for 25 years or so and been through a couple cycles or so, but whether or not it’ll reach the e-commerce craze again is anyone’s guess.
About the VCs
Ben Brooks is director of wealth management for Capital Investment Companies and managing partner of Southern Capitol Ventures, an early-stage venture capital firm in Raleigh. Previously he was CEO of Marion Bass Securities.
Fred Fink is an active Charlotte-based angel investor focused on emerging medical technologies and the health care industry. Most recently, he was founder, president, CEO and a board member of Optical Resources Group, Inc., a consolidator in the wholesale optical laboratory field that was sold in 2000 to a foreign lens manufacturer for greater than 10 times cash flow.
Reid Leggett operates Charlotte-based Lodestar Capital LLC, which invests in very early-stage tech companies in the Triangle. He also serves on the venture capital committee for NCTDA’s first Flight Venture Fund. Previously, Leggett was general partner and managing director of Carousel Capital.
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