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Taking the Plunge.

What You Need to Know About Working With Internet Startups

DOT-COM SUCCESS IS not just about huge venture-capital backed companies, but encompasses millions of startup enterprises, which are developing new infrastructure, "enabling" technologies, and changing the way we live our lives. These new-economy enterprises need CPAs to assist them not only with their compliance requirements, but with their corporate finance, planning and implementation activities. However, if you don't have corporate finance and valuation experience, don't attempt to practice in this area; rather, make a corporate financial consultant part of your outside adviser team. The new economy offers great opportunity for CPAs, but before taking the plunge, you need to understand the playing field.


Know this: The days of easy money are gone. Prior to April 2000, venture capitalists and investment bankers drove the Internet economy. The rush to initial public offering (IPO) was simple: you get a good team together, fund a business model, have an IPO and shift the risk of your flawed business model onto the unsuspecting public investor. This greed-driven process made fortunes for those lucky enough to get out before the bubble burst.

Many thought the recent market correction would cull dot-coms with flawed business models and only companies with sound business models would survive. However, others believe this market correction is in fact a market crash--part of the natural evolutionary process of the Internet economy. Whatever theory you choose, the entire Internet sector has been painted with the same brush, and many Internet blue chip companies are getting slammed at the same time. Companies like AOL, Yahoo!, eBay and Amazon with sound business models and experienced management have seen their stock values plummet.

As a result, this market adjustment has had an adverse impact on capital markets and their appetite for funding Internet startups. Today, the bottom line is this: Unless your Internet startup falls into broadband, infrastructure, wireless, or optical networking plays, your ability to raise private equity or venture capital is negligible.


All is not lost, there is still opportunity to build a profitable Internet company now that the Internet economy has become more traditional. Knowing which Internet segments are currently in favor is key to a startup's success. The darlings of the business-to-consumer (B2C) segment have become the villains of the new economy. B2C companies such as, and have either closed their doors, or are on the brink of closing.

On the other hand, traditional companies are "dot-coming" themselves and finding success. Doing well are those Internet technologies that create efficiencies, assist in bringing customers back to commerce sites, or develop psychographics. Unlike demographics that track information such as age, gender or income, psychographics focus on what interests people, their hobbies, personal beliefs and preferences. Psychographics distinguish the BMW buyer from the VW buyer. Another segment that is active and developing quickly is people-to-people, which includes sites like and chat areas found on many major portals.


A new startup needs a precise and well-defined focus. Startups targeting the B2C or business-to-business segments are going to find it very difficult, if not impossible, to succeed unless their play is unique. Concepts must build value by exploiting Internet efficiencies in new ways.

Stay away from the retail, content and financial services sectors--the established Internet players and off-line industry giants will smash you like a bug. Don't assume that e-business is more efficient and profitable than off-line businesses with long-standing infrastructures; WebVan and Amazon are learning this hard lesson.

Technologies that speed up connectivity and enable existing Internet companies to conduct business more efficiently are in demand. The Industry Standard reported 39 venture capital investments from Nov. 1-10, 2000. The largest of these deals focused on broadband and enabling technologies. Success depends on knowing where your technology fits, being able to protect it and reaching the market before your competition.

Your startup's plans to generate income are critical. If a startup's business plan calls for relying upon banner ads as a primary revenue source, it will be difficult to succeed. But if you target opt-in e-mail, which directly correlates with advertisers' demographics, you may find the going much easier. Know and target the appropriate revenue sources.


Quality startups are comprised of a team of internal and external advisers with entrepreneurial and technical experience. Many Internet startups have struggled because they have been lead by technological experts who are unskilled in the entrepreneurial process. For example, when Yahoo! was a startup, before venture capitalists would provide funding, they insisted that Tim Koogle be brought on as the company's president and CEO to provide the business acumen that is essential for success.

Startup teams will differ, depending upon your market segment, and may change as the company ramps up its operations. However, critical elements that your team members should possess are an understanding of your technology and target market, as well as the fund-raising process, valuation issues, and networking with venture capital and private equity firms. Often startups leverage their expertise and finances by using outside consultants and advisers.


Engaging a law firm with Internet experience is critical. An experienced law firm can assist with properly issuing the founders' stock, drafting stock-option plans, and protecting the startup's intellectual property. The law firm should be experienced in dealing with venture capitalists and private equity firms, as well as drafting private placement memorandums.

CPAS, either as part of the internal or external team, can help Internet startups by assisting with business plan preparation and financial projections. The planning process establishes a road map for management to follow, and its criteria can he used to judge progress.

Conservative financial projections are an essential element of the planning process. An experienced adviser can become an asset by grounding management's overly optimistic revenue projections and bringing some conservative, rational and objective thought to the planning process.

While revenues for Internet companies can grow exponentially, operating costs tend to grow linearly. Therefore, projecting revenues accurately becomes the financial projection's most difficult component. Financial projections will be used to estimate the startup's funding requirements as well as assist in valuing the company during its early-stage funding rounds. The projections also will be used to produce the company's operating budgets and track the startup's actual performance. Internet startups are very dynamic and may morph several times before they precisely define their technology or their Internet commerce play, so expect to modify the financial projections to reflect these changes.


Funding an Internet startup can take several directions and become the most difficult hurdle to clear. Internet entrepreneurs are well-advised to move cautiously until they have secured their initial financing, i.e., don't quit your day job and mortgage the family home. Most startups follow a common path to raise capital. The initial funding usually comes from the team members themselves (founders) and allows the startup to formalize its plans, engage its external advisers and develop the offering materials for its first round of financing.

Traditionally, first-round financing is the "friends and family" round, during which the founders seek financing from relatives, friends and almost anyone who is willing to invest. During this period, the founders need to work closely with their lawyers to develop the startup's private placement memorandum and to be absolutely certain that they comply with both federal and state securities laws.

Initial funding documentation must be in compliance with applicable securities laws because it is the foundation upon which follow-on funding rounds will be built. You'll need to make all necessary disclosures to potential investors and determine their qualification to invest in a high-risk venture. All too often, startups fail to follow proper procedures when raising their initial round of financing. A critical question at this phase is, "How much money do you need to raise and at what valuation?" This is where an outside adviser with experience in both corporate finance and business valuation can help the company.

The friends and family round usually results in the issuance of common stock, so there is no liquidation preference for these shareholders. Shareholder litigation can be the poison pill that kills a company's ability to raise subsequent financing, so make sure the friends and family round is done correctly.

The second round of funding is usually more formal since the targeted investors are high-net-worth entrepreneurs, institutions or venture capital firms. This round is usually structured as a Series A Preferred Stock with conversion rights, and will raise enough capital to get the startup to IPO, a liquidity event or its next funding round. A significant amount of thought needs to go into determining the magnitude of this funding round and its valuation. At each funding point, the founders and previous-round investors give up a portion of their equity interest in the company (a process known as dilution). The logic is. that each funding round results in a valuation increase that more than offsets the decrease in ownership interest.

This step begs the question, should you raise only enough money to get the company to a higher valuation, or should you raise as much as you possibly can and suffer the dilution at a lower valuation? By tiering or staggering your fund-raising activities, you expose the company to the capital markets' whims, which can turn cold overnight. You must weigh the exposure of changes in the capital markets against the company's current valuation and dilution.

Many startups envision receiving venture funding at their second round of financing that, in reality, is very difficult to obtain. In those cases in which venture capital or private equity is obtained, it is usually at a very high cost/low valuation and significant dilution. Given the current condition of the Internet IPO market, venture capitalists are reluctant to invest in privately held Internet companies that will be difficult to take public. Venture capitalists form a tight community, and everyone knows who is investing in what. Therefore, at any given time they tend to invest within a narrow band of criteria.

Most leading venture capitalists won't fund a deal that is submitted without a formal introduction. These people are very busy, and sending your business plan to them (over the transom) without an introduction from a respected deal source is fruitless. If a startup wants venture funding, it will need an adviser who can get its plan introduced. Very few startups fit the venture capital model, so you'll need to explore alternative funding sources.

Many large U.S. and foreign corporations have investment funds which they essentially use to further their products' sale, or to fund new technologies for possible future acquisition. Other industry constituents may be funding sources if your technology or Internet commerce play is of interest to them. Whatever the source of your second round of funding, it will be an ongoing baffle to keep the machine fueled with funds. The more quickly you break even, the better your chances of survival.


How do you harvest the fruit of Internet success? Currently it is very difficult to successfully take an Internet company public. Underwriters won't touch them, analysts won't track them and institutional investors won't buy their stock. What are the alternatives for funding the exit strategy of your client's Internet investment? Selling or being acquired by another company in their niche, or one that can leverage upon their activity is probably the most logical means of monetizing their investment Unfortunately, most public Internet companies are not flush with cash and those that are, don't use their cash to acquire companies. Therefore, your client can expect to receive stock and not cash when they implement their exit strategy.

Given the Internet sector's current status, your client can expect to receive a much lower valuation than if they had sold in 1999. On the upside, they may receive publicly traded stock, which will provide the liquidity they didn't have when they were privately held. Today's stock valuations are very low, and the possibility of further significant market contraction appears remote.

With the IPO door shut, your exit strategies have become somewhat limited. This means that entrepreneurs should be prepared to build and hold their companies for an extended period of time while the market corrects. Sound business models will survive and eventually the capital markets will become more favorable.


There is more to advising an Internet startup than first meets the eye, particularly in today's "corrected" market. Understanding the dynamics of the new economy and the startup's technology is as crucial as understanding the

capital markets. A startup's survival is tenuous at best as it succumbs to the market's changing whims. However, as a CPA, your understanding of accounting, tax, corporate finance, business valuation and organizational structures, make you well suited to the task of advising and assisting new economy clients.

Lloyd Chartrand, CPA, is a partner with Santa Rosa-based Andersen d Co. LLP The firm provides compliance, corporate finance and valuation services to emerging technology companies, including Internet startups. Chartrand's practice emphasizes corporate finance, business valuation and mergers and acquisitions.
COPYRIGHT 2001 California Society of Certified Public Accountants
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 2001, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Publication:California CPA
Date:Jan 1, 2001
Next Article:The H-1B Controversy.

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