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Why venture money is harder to find.

WHY VENTURE MONEY IS HARDER TO FIND When the software industry was young and feisty, venture capitalists seemed willing to throw cash at every software startup that passed the hat, no matter how unlikely the product or inexperienced the management. Today, many of the same venture groups have grown much fatter--TA Associates, for instance, now manages a fund worth more than $300 million-yet the flow of venture money to new companies has been reduced to a modest trickle. So what's going on here?

Andy Updegrove, a Boston-based attorney who specializes in software financing, argues that there's a reason for the current shortfall in startup funds: Venture funds have literally priced themselves out of the market.

"The venture capital industry has become choked by its own success," Updegrove argued recently in Technology Law Bulletin, a quarterly newsletter his firm circulates to clients. "Pension plans now pour huge amounts of capital into these investments [and] the result is that the average size of new funds continues to grow, with $200 million and larger funds becoming commonplace rather than exceptional." The managers of these mega-funds, he adds, now prefer to put large chunks of money into "leveraged buyouts, turn around situations, and even into public stocks" rather than provide seed money for startups.

"As a result, an excess of capital is now courting a diminishing number of companies that fit an increasingly rigid profile," Updegrove says. "The managers of large venture capital funds feel that they cannot economically invest in startups even if they want to."

One consequence of the large fund syndrome, Updegrove told us recently, is that software entrepreneurs now have a much harder time raising the kind of money that's typically required for creating new products. "It's comparatively easy to raise $50,000 to $250,000 from private sources, and it's not too hard to get venture funds to invest in million-dollar deals," he said. "But it's sheer agony for companies that need financing in the $250,000 to $1 million range."

Ironically, Updegrove adds, by focusing exclusively on mega-deals the big funds have cut themselves off from some of the most lucrative software opportunities, particularly those that are based on developing stand-alone products rather than building entire marketing organizations. "We have routinely reprsented companies which, with less than a hundred thousand dollars in financing (usually derived from consulting revenue or marketing partners) have developed and marketed a product and sold that product for $2 to $5 million dollars within four to five years," says Updegrove.

Updegrove is convinced that the venture community eventually will invent new methods for financing startups, if only to insure a healthy crop of new companies that will be big enough in a few years to need larger second-stage investments. (He recommends "a commitment by large funds to invest 10% of their assets in smaller funds purely for the purpose of pollinating the entrepreneurial fields.")

But until the ventuire funds come back, Updegrove argues that most startups will do much better if they simply ignore traditional venture capital and rely on private investors and customer financing. "Total independence from venture capital is becoming more and more feasible," he says. "We have an increasing number of software company clients who have received all the funding they need from strategic partners who demanded no stock, and asked only for non-exclusive rights in the products which were developed."

Andrew Updegrove, partner, Lucash, Gesmer & Updegrove, One McKinley Square, Boston, Mass. 02109; 617/723-2770; "Technology Law Bulletin," 10/89).
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Title Annotation:software financing
Date:Nov 27, 1989
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