Navigating the new funding landscape: The money's still there, but you have to look a little harder to find it. Enterprising start-ups share where they got the capital they need to thrive. (Dollars & Sense).

The initial shock of the dot-com crash may be over, but these are still difficult times for a start-up seeking capital. Having watched more than 500 Internet companies shut down or declare bankruptcy last year, venture capital firms are not only wary of funding new businesses, they're still nursing their existing investments. For example, VCs invested just $7.7 billion in the third quarter of 2001 -- down 31 percent from the previous quarter -- and a whopping 81 percent of that money went to follow-on investments.

This presents a real problem for the start-up that would normally be ready for a first or second round of VC financing. James Arkebauer, president of Denver-based consulting firm Venture Associates, notes that it's difficult to get money from VC firms, corporate VC programs, even angels. What's a dotCEO to do?

It's still possible for a start-up to raise capital. But times have changed. Says Arkebauer: "The entrepreneur has to use his imagination."

Consider some alternative means of financing: credit lines and bridge loans; conducting an online offering directly to individual investors; going back to the well of angel investors, who are still willing to take on more risks than many VCs are; and finding an established corporation that can serve as a strategic investor, willing to contribute equipment and services as well as cash.

Many start-ups are still focused on raising equity investments, but borrowing money is often a good way to secure capital. Although Xytrans, a maker of wireless transceivers in Orlando, Fla., had raised $4.5 million in early 2001, the company opened a $1 million line of credit this January from Silicon Valley Bank, headquartered in Santa Clara, Calif. The money paid for Xytrans to build its first factory, which is expected to manufacture up to 10,000 transceivers a month.

Now, Xytrans doesn't have to race the clock in raising another round of investment. "This gives us everything we need for the foreseeable future," says CEO Rob Strandberg. These days, he says, CEOs are worried not only about raising VC money, but also about how VCs will value their companies. The credit Xytrans secured allows it to hold out for a higher valuation.

The "venture lending" business is a big one for certain banks, such as Silicon Valley Bank, and can be a source of cash for start-ups that have raised their first few million dollars but have yet to start generating revenue. CEOs should know that banks providing such credit will monitor them as closely as VC firms.

Another short-term lending measure is bridge financing, which is a loan from $100,000 to several million dollars for a set amount of time, often 60 to 120 days. These special loans are useful when a company needs a cash cushion to reach a milestone, such as finalizing a Web site or signing a major customer.

Although some banks are in the bridge financing business, bridge loans are more often provided by early investors to help a company manage until the next round of investment. So, while they're technically loans, bridge loans are best viewed as another form of investment because they're almost always convertible into equity down the line. CEOs are most concerned with the terms of that conversion, because bridge financiers, whether they're investors or banks, usually look to convert their debt to equity at a discount to the terms of the next equity round.

Those terms are critical -- a lesson learned by AGEA Corp., a start-up in Austin, Texas, that makes software to connect employees to enterprise systems. AGEA raised $4 million in bridge financing in 2000, but when the market went south, the terms of the bridge loan gave its providers extremely attractive terms for taking a stake in the company. "We ended up getting punished from a [shareholder] dilution standpoint," says Russell Glass, vice president of strategy and a co-founder.

Bridge financing has become more important these days because even when equity funding is available, it takes longer to raise it, "Companies are in this continuous funding model," says Bill Reichert, president of Garage Technology Ventures, a start-up-oriented investment bank in Palo Alto, Calif.

The Direct Approach

If venture capitalists aren't willing to put up the money, perhaps individual investors will be. Since the mid-1990s, there has been an increase in the use of direct public offerings (DPOs), which eschew the investment bank/IPO model and offer shares via the Internet directly to the person on the street. There are several types of direct offerings under various regulations, including offerings within one state that allow a company to raise up to $1 million, and nationwide offerings that allow a company to raise up to $10 million.

Not surprisingly, there has been a surge of interest in DPOs in the past year or two, according to Gwendolyn Field, co-owner of Drew Field Direct Public Offerings, a DPO advisory firm in San Francisco. "DPOs are a terrific mechanism for specific kinds of companies," she says. Those with a built-in retail audience are best suited for DPOs, because those customers are the likely foundation of any investor base. A company needs lots of individual investors because each one will typically buy $2,500 to $5,000 worth of stock in a DPO, Field says.

A good example is Real Goods Trading Corp., a Broomfield, Colo.-based retailer of environmentally related products. Real Goods had a catalog business and a Web site that gave it a customer list of 250,000, which it contacted for a DPO in 1997. Many of those customers ended up investing, and the company raised more than $2 million. "It worked really well," says Real Goods CEO John Schaeffer. "You could buy our stock on the Internet, enter your credit card and even print out a dummy stock certificate until real certificates arrived by mail."

One attraction of the DPO was that it cost the company a 7 percent commission, rather than the 15 to 20 percent commission on initial public offerings. Real Goods used the money to expand its business to the point where it was able to merge last year with a larger retailer, Gaiam.

Companies without profits or a recognizable name can have a hard time conducting a DPO, Field says. And, because of the public scrutiny involved, it can take several months to whip a company into the necessary shape for a DPO.

Down-to-Earth Angels

If a company likes the idea of going to individuals for cash, a better bet is often angel investors. These wealthy individuals became crucial parts of the private-equity game in the late 1990s, investing more than $20 billion per year, by some estimates. But while VC firms have pulled back dramatically from fund-raising, angels -- usually working in networks or clubs -- have only pulled back a bit.

Indeed, the typical experience is that of the Southern California group Tech Coast Angels, which is funding just as many start-ups these days but at only half the valuation of two years ago. "Also, companies are further along in their development when they're pitching to us than they were a year or so ago," says Luis Villalobos, founder of the group.

Where a start-up might once have raised $1 million from angels and then sought out $5 million or more from VC firms, it might now find that its second step is to go back to angels for another million or two. Why? For one thing, VC firms sitting on cash are more likely to fund previous investments and are looking for places to put $5 million or $10 million. And angels, because they fund riskier, earlier-stage companies, still have an appetite for risk.

Slingshot, a Seattle-based company that offers prepaid internet access, has been almost entirely financed by angels, having raised $8 million from them over the past two years. "We couldn't raise the VC money," says CEO Keith Kegley. Slingshot has instead been in a process of continuous fund-raising. For example, Kegley raised $300,000 from angels in December, another $400,000 in January. His secret? "I do a lot of networking," he says, noting that he talked with 232 angels to attract 27 investors.

Of course, angels are just as concerned as venture capitalists about eventually getting a return on their money. So executives raising several rounds from angels have to show progress, and a clear path to future profits. Keeping those angels in the loop is crucial -- Kegley sends out monthly updates to Slingshot's investors.

Corporate Ties

While VCs and angels are more concerned with financial returns, some corporations with venture arms are equally concerned with strategic fit -- in other words, furthering their technology, helping their customers and expanding their markets. As a result, they can make attractive investors under the right circumstances. And there are still a number of corporations actively investing in start-ups, such as Sun Microsystems, Novell and Intel.

For example, AGEA recovered from its bridge financing experience when it landed $8.5 million in equity investments last September, and one of the investors was Sun Microsystems. Sun, whose operating systems fit with AGEA's strategy, bought a 10 percent stake in the company. "Strategic investors are a little less concerned with valuation. One way to mitigate the dilutive effect of the downturn is to have a strategic partner," says Glass.

Sun provide non-cash benefits, as well. Besides giving AGEA a shot of credibility, it's providing customer introductions and even office space. "We're using Sun furniture," Glass chuckles.

While the endorsement of a major corporation can boost a start-up's credibility -- and that's a key consideration these days -- entrepreneurs must be careful. "A start-up needs to make sure it understands what each company is looking for," says Garage's Reichert. "You don't want the appearance of bias, so that it seems your company will only work with, say, Oracle's software." He notes that some start-ups also spend too much time pursuing corporations' "strategic alliance programs," which provide helpful technology and advice to startups but rarely hand over hard cash.

To be sure, there are no exact replacements for the cash that can come from venture capital firms. But there are alternatives to VC funding out there, even if some are stopgap measures. The time has passed -- probably forever -- when three guys with a Web site could get a $10 million investment from a Silicon Valley venture capitalist. Start-ups just have to work harder and be more creative to raise money -- even if that means an amalgam of angel capital, corporate investments and loans. As Reichert says, "It's a lot more complicated these days."

Contact

AGEA Corp. www.agea.com

Alliance of Angels www.allianceofangels.com

Drew Field Direct Public Offerings www.dfdpo.com

Garage Technology Ventures www.garage.com

Real Goads Trading Corp. www.realgoods.com

Silicon Valley Bank www.svb.com

Slingshot www.slingshotprepaid.com

Tech Coast Angels www.techcoastangels.org

Venture Associates www.ventura.com

Xytrans www.xytrans.com

Loren Fox. ("Navigating the New Funding Landscape")

Loren Fox is a writer in New York. A business journalist for nearly a decade, he has worked as the finance editor at Upside magazine and as a senior editor at Business 2.0. His freelance writing has appeared in The Wall Street Journal, Barrons, Salon.cam, and other publications.