Venture funding gets less venturesome: it's become very difficult to get capital for start-up enterprises, no matter how promising their ideas. Venture firms are directing their money toward more proven entities. (Venture Capital).

Venture capital isn't what it used to be. The once-lush supply of VC funding that propelled biotech, high-tech and telecommunications firms to prominence in the late 1990s has dried up on a worldwide scale. Venture capitalists have become increasingly selective as they now face longer investment cycles, declines in company valuations and limited exit opportunities. With few exceptions, companies have found that obtaining venture capital funding is not as easy -- or even as likely -- as it was a few short years ago.

According to the Ernst & Young/ VentureOne Venture Capital Survey, the amount of new venture capital invested skidded 62 percent in 2002. All major industries have experienced declines, including the once-red hot software, telecommunications, networking and life sciences industries.

"2002 has been a milestone year for the venture capital industry," says Gil Forer, Global Leader of the Venture Capital Advisory Group at Ernst & Young. "The industry has faced several significant challenges, such as a potential decrease in the number of VC firms, the LP-GP [limited partner-general partner] expectations and relationships, difficult fund-raising environment [and] significantly fewer liquidity opportunities."

With that, returns have slumped sharply. Venture capital funds suffered an average loss of 22.3 percent in last year's third quarter, according to a study by Venture Economics and the National Venture Capital Association. That extended a series of losses dating back two years. Still, as of last Sept. 30, the 20-year record for VC funds stood at a glowing 16.7 percent annualized return.

To Those That Have, More Is Given

Seed money, in particular, has virtually dried up. The number of companies receiving first-round venture capital has dropped to six-year lows, and VentureOne reported that first- and venture capital second-round investments in venture-backed firms slumped from $8.1 billion in the second quarter of 2000 to just over $1 billion in each of the last four quarters ending last September.

There is one category of recipient that is doing relatively well, however: companies that have established themselves to some degree in their marketplace. Because liquidity opportunities -- through initial public offerings (IPOs), mergers and acquisitions -- have grown progressively scarce, these enterprises have had better luck finding "follow-on" capital.

"The only financing we've done over the 18 to 24 months has been with companies that were previously funded," says Steven Block, managing principal of the corporate and securities practice group for Fish & Richardson. "As far as making investments in new companies, it's almost non-existent, especially companies with little more than a business plan."

"Two thirds of current venture financing is being invested in current portfolio holdings," says Martin Alter, managing director for Media & Entertainment at ITF Global Partners. "The remaining third tends to go in large blocks, in the $25 million range. In many fields, capital and resources are concentrated on a select group of 'stars' with exceptional management, R&D and sales channels."

Moreover, investors are now seeking companies that can demonstrate achievement of core milestones. "Investors want to know if you have a product, does it work and whether you can you ship it tomorrow," says Alter. "It may seem obvious that investors would demand answers to such questions -- but these fundamentals were largely forgotten in recent years."

"Entrepreneurs must recognize the fact that only the most fundamentally sound deals get done," says Tracy Lefteroff, global managing partner of the venture capital practice at PricewaterhouseCoopers, which facilitated three IPOs in 2002 that were "real businesses generating real revenues."

Brett Sharenow, founder of Broad-scope Consulting, agrees that venture money is available for companies that have developed traction in their market. "Over the past month, I've accompanied clients to over 10 venture capital firms in Silicon Valley and Denver," says Sharenow. "There is definitely money available, but you better have the answers to get it. If investors don't see a compelling case for customers in the first two or three paragraphs of a business plan, they lose interest," he says.

Revenue Is King

Venture firms are increasingly seeking companies with products that are generating revenues or, at the very least, have substantial contracts with creditworthy customers. "Today, cash flow is king," says David Washburn, a partner in the Dallas law firm of Arter & Hadden. "Funding for start-ups and early stage companies has virtually stopped in many industries."

A company in a pre-earnings phase must demonstrate how it will become cash-positive within a period consistent with the venture firm's investment horizon, says Washburn. "VCs are looking for companies that have an immediate path to profitability, such as certain segments of the biotech industry and certain manufacturing and service companies."

One successful funding story is SafeHarbor Technology Corp., a creator of Internet-based, self-service support environments for the technology, software and financial services sectors. It leveraged its track record to obtain recent rounds of funding, securing its fourth round of venture financing in March 2002 worth $7.5 million and bringing its total financing to $40.5 million.

"SafeHarbor was successful attaining financing in large part due to our impressive client list," says Bo Wandell, a company co-founder. "Our investors also liked our business model and the fact that we've been able to establish ourselves in our marketplace in spite of the economic downturn."

The company's client list includes large, well-known firms, including Adobe Systems Inc. and Washington Mutual Inc., as well as others picked up within the last year. "Our client contracts made the case that we could weather economic storms and continue to grow," says Wandell. "Our investors saw us as a safe, long-term investment."

Mimeo Inc., a company specializing in digital printing technology, is another example of an outfit with the necessary ingredients to secure venture financing in 2002. The company closed its third round of venture funding in last year's second quarter, for a total of $40 million.

"Part of our success was in Mimeo's proven technology," says John Lyons, president and CEO. "We showed our investors that we had established a unique position in an enormous marketplace. We could also point to hundreds of loyal customers that were producing millions of dollars in revenues."

Strong Management

These days, companies aren't getting funded without having a capable management team. "My venture capitalist clients say a major challenge is finding promising businesses run by people with relevant track records," says Richard Smith, co-leader of Spencer Stuart/Venture Capital and Private Equity Practice. "Now, more than ever, we're investing in companies with a strong management team in place to mitigate our risks."

It's not enough for managers to have the capability to do the job, says Smith. Venture capitalists also expect to see leadership positions filled with people who've dealt with similar management situations in the past and can draw from that experience.

John Lyons of Mimeo, for example, recalls that investors were impressed with his more than 20 years of experience as an executive and business leader in Fortune 1000 companies. Prior to joining Mimeo, Lyons held senior executive and leadership positions with companies including IBM Corp., Entex Information Systems and Impact Venture Partners.

"It's both a business maturity issue and, more specifically, an experience issue," says Smith. "In the searches we're doing, we really try to highlight what are the likely challenges that are going to be most prevalent in the near term and show somebody who has overcome similar challenges in a similar environment."

Financial officers are also a key determinant when evaluating management teams. "Financial expertise has really come to the top of the organization, and CFOs are now more important when we evaluate prospective companies," says Smith. "A few years ago, financial management was done more in retrospect; now we want to see how CFOs can leverage scarce resources beyond classic operational finance."

Tough New Terms 

As losses, write-downs and business failures mount within portfolios, venture firms have taken to structuring new investments in a way that minimizes future problems. Whereas traditional convertible preferred stocks were once the norm, experts now say that entrepreneurs can no longer assume a funding scenario where all parties share the risk.

"VCs are focused on minimizing losses if things don't go well," says Scott Zajac, a manager at Advantage Capital Partners. "Some investors are funding companies at 'bargain' valuations, based on share prices that are lower than previous financing rounds. They are also moving toward debt investments, requiring security interest in company assets and, in some cases, liquidity preferences greater than the amount of the investment."

Zajac says these tough terms force "discipline" into business plans, but create obvious challenges for entrepreneurs, who face higher hurdles before they enjoy the fruits of any success. "Today, venture firms may invest in a new enterprise, but they expect a significant return on their investment; they expect to have priority over management when with regard to profits and over other creditors when businesses fail," he adds.

Venture capitalists are also doing more due diligence, including closely scrutinizing financial forecasts. "Venture firms expect to sit down with the person who put the numbers together," says Broadscope Consulting's Brett Sharenow. "They want to know where the facts came from and determine that financial projections are obtainable."

Joseph Tzeng, managing director and co-founder of Crystal Ventures, says many venture firms are calling customers of investment portfolio companies to confirm that they plan to continue using products of potential funding candidates and have allocated budgets for doing so.

"These calls have actually resulted in closing two deals for portfolio companies as the potential customers recognized Crystal's commitment to its investment," he says. "Conversely, we're receiving more calls -- from bankers, attomeys and other vendors -- seeking confirmation that their portfolio investments will be standing and are worthy candidates for engaging in business transactions."

Clearly, the game has changed for companies seeking venture capital. Many describe their search for funding as a long, arduous process that required a lot of preparation and advance planning.

"I like to say that in the old days, a financing round was an event, but now, it's a process," says says Chris Konda, vice president of finance for Azanda Network Devices, one of the few telecom companies able to raise money in a second round. Azanda received $10 million in its first funding round in 2000, and later secured another $33 million in its second round.

"We approached about 100 investors for our second round. We expected it to take six months, but it ended up being a nine-month process," Konda sighs. "Everything took longer than we anticipated."

For some companies, the new world of venture financing actually worked in their favor. Take CYA Technologies Inc., a company that produces data back-up, disaster recovery and business continuity software products. After waging an unsuccessful battle to raise funds throughout 2001, President and CEO Elaine Price abandoned her search to focus on sales and marketing.

After doubling company revenues, releasing new products and establishing itself in key industries, CYA sought funding again in 2002 and found a much better reception. "Investors embraced us, helping CYA quickly secure $6.8 million in Series A financing in May 2002," says Price.

"When we started the fund-raising process in 2000, our timing was off. But by 2002, the market had turned in our favor and several investors were now interested in our company," she adds. "Because CYA had continued to thrive regardless of market conditions, we went from fighting for attention among venture capitalists to being in the driver's seat."

Price attributes her success to developing brand recognition and a roster of clients that "paid their bills." CYA's management team was also an asset. And investors were impressed that the company's products were already proven in the marketplace. "After it was over, we had met with 26 potential investors and, once we selected a venture partner, closed the deal in 13 days."

That's a tale most capital seekers could only wish for these days.

RELATED ARTICLE: Keys to Follow-on Funding

1. Demonstrated marketplace success

2. Proven products and business model

3. Strong management

4. Good client list

5. Proven financial expertise

6. Real cash flow

Steven Van Yoder is a freelance business writer in San Francisco. He can be reached at [e-mail].