VC financing: Cold realities

Looking for financing? Good luck in this market.

Joshua Geist thought he had started the pitch to a hometown venture capitalist pretty well. Geminare, his small 17-person software company based in Toronto, was quickly going global after signing a deal in November with CA Inc., one of the world’s largest software makers. CA would resell Geminare’s hosted business-continuity software as its own to an initial target group of 300,000 small and medium-sized businesses (SMBs). Geminare had some 30 other channel partners signed on, too, and a year from now, Geist predicted, it would have sales channels infiltrating dozens of countries. That is, if it gets $5 million to support the growth.

But just four slides into a 30-slide presentation, the well-respected VC interrupted him with a question that took Geist aback. “Why couldn’t CA figure this out and you did? They’re a huge company, they would have access to more resources than you.”

Geist, a congenial and straight-up guy, fumbled for just a moment. He explained that CA has 13,700 employees, with multiple large departments dispersed in several locations and a wide array of products. By the very nature of its size and structure, CA is less nimble than Geminare. But what he really wanted to say was: Why does it seem so unlikely to you that a small Canadian company did figure it out?

Less than an hour later, the never-more-than-cordial meeting was over. Geist and his CFO were back on the frigid Toronto streets, making the 10-minute walk to Geminare’s offices in a converted downtown rowhouse. As they hustled past Danger Falling Ice signs, he mulled over the odd question. Perhaps it was irrelevant, considering how strangely quiet the VC’s office had been — not another soul was in sight save the receptionist — but it nevertheless had struck a nerve.

Geist thought back to the several meetings he’d already had in previous weeks with VCs in the Boston and Silicon Valley areas. Not one had asked a question like that. Instead, the underlying tone in the United States was congratulatory, and intrinsically trustful of an entrepreneur’s ability to disrupt a market with new technology. In addition to being more knowledgeable about the software-as-a-service business model Geminare was pursuing, as well as its strategy of using value-added reseller sales channels, American venture capitalists seemed to place more interest in Geist’s own vision and abilities, and the company’s technology and market potential.

Canadian VCs? They only wanted metrics: revenue, deal pipeline, number of employees. Either a company’s business plan populated its spreadsheet models with the right data, or it was too risky for investment. “I did a couple of double-takes with Canadian VCs that said, ‘We want to see you have x-million in revenue, and then we’ll talk about investment,’” says Geist, who has now met more than a dozen each of Canadian and U.S. venture capital firms since the fall. “If we were hitting those gates, we wouldn’t be going for VC dollars, because the company would be self-sustaining,” Geist points out. “I wouldn’t go to a VC, I’d go to a bank and get a line of credit.”

Not prone to entrepreneurial bombast, Geist is matter-of-fact in his pessimistic assessment of the current environment for growth capital in Canada: “We would not have a problem getting a deal done in Canada,” he says, “but the deal would be so poor, and there would be so little value out of it for the company that I already know this isn’t for us.” Instead, Geist, like many before him, is focused on attracting U.S. dollars.

Geist’s gloom is shared by many in the venture capital industry. For most of this decade, the size, number and total amount of investments by Canadian VCs have been slumping, and it’s only worsened since the roiling financial crises started last fall. According to Canada’s Venture Capital and Private Equity Association (CVCA), the total value of venture cap deals slumped 36% last year, to $1.3 billion. Financings averaged $3.6 million, down from $5 million in 2007, and 10% fewer companies received money. Not surprisingly, a large hit came in the last three months of the year, when the average value of a deal dropped 43% from the same period in 2007.

But the biggest problem was that American VCs turned their attention away from Canada. Investment deals by U.S. firms dropped 56% in 2008, accounting for 28% of disbursements in Canada — well off its 41% share in 2007. Venture capital investment hasn’t been this low since 1996. And no one is predicting a turnaround soon.

For many early-stage companies, 2009 is shaping up to be a year of basic survival. Preserving cash is of the highest priority. Unpredictable conditions in the technology market make it difficult to forecast anything beyond 60 days, according to some entrepreneurs, and raising new capital comes at a heavy cost: high interest rates, 12.75% on venture debt, if companies can get it, or low valuations for equity stakes. In short, only those companies that absolutely require capital are raising it. Even then, many VCs are turning them away, choosing to keep their powder dry to help support existing members of their portfolios that could need injections — and not even those companies may get it.

Some in the entrepreneurial community call it scary; others, merely depressing.

But Geist knows that Geminare is in a fortunate position, for several reasons. One is that its product — business continuity software that replicates a company’s servers and simultaneously hosts a copy off-site to offer virtually zero downtime or loss of data should an outage occur — targets an under-served need in the SMB market, even in a recession. Another is that the product is sold as a service, so end customers can roll it into an operating budget at a time when large one-time capital expenditures are unfeasible. Finally, Geminare’s sales strategy is based on using multiple sales partners, which has the potential to rocket-fuel its growth, especially because its software service is a high-margin revenue stream for its resellers.

The challenge is that Geminare now needs to support all those partners, especially the 13,000 or so in CA’s network. Geist flew to Las Vegas in mid-November to attend CA World, the company’s annual trade conference for customers and partners, and witness the public launch of CA Instant Recovery On Demand (Geminare’s product rebranded). H was deluged with meeting requests by representatives from all over the globe.

While Geist was pleasantly surprised by the high demand, it quickly became clear that Geminare didn’t have the staff to offer full training and sales help to everyone interested in taking the product to existing customers, and talks are already underway with European and U.S. ISPs, as well as numerous data centres. “They’re now calling us,” says Geist. In all, it now has some 50 sales partners. The company is watching the number of installed servers increase by 20% each month; a year from now, Geist predicts, it will be hundreds of percent higher. It’s a great problem to have, but Geminare needs investment to seize the opportunities — and it couldn’t have come at a worse time.

Venture capital has been tightening in Canada since 2005. VCs have found it increasingly difficult to raise capital for new funds, because the country’s largest institutional investors — primarily the big pension funds — have turned away from venture capital in favour of what they perceive as better, or at least less risky, private equity buyout funds. In turn, VCs are forced to invest less and in fewer companies. When the capital markets began to unravel last September, even highly respected players such as Ventures West and Edgestone Capital Partners were unable to raise new funds.

A related problem is that venture capital firms are finding it difficult to successfully exit their existing investments. Only one VC-backed IPO listed on stock markets in 2008, and acquisitions at good valuations are scarce. (A key driver of M&A valuations are those deals that pre-empt a company’s IPO — when there’s an IPO market, that is.) And all of this was before the financial crisis rocked the stock markets. Since then, valuations have only plunged further.

The tumult in financial markets has even impinged on the one remaining bastion of capital for early-stage companies: angel investors. “It turned very quickly,” says Mike Middleton, founder and managing director of Q1 Capital Partners in Toronto, which provides M&A services, capital fundraising and financial advisory services to private Canadian tech companies. For instance, he had been actively speaking to a number of angels about a possible investment, before they suddenly backed out in September, choosing instead to wait on the sidelines until their net worths bottomed out.

And now, says Middleton, “The whole system is like a deer in the headlights.”

A few VCs remain active — GrowthWorks and JL Albright Venture Partners are two of the biggest — but financing is harder to come by, and deals are taking longer to put together. “I think long and hard about taking on a client right now to raise money,” says Middleton. Instead, he’s focused on M&As, but notes that most entrepreneurs are dismayed at the prices being offered. “We are running into a lot of bottom feeders,” says Middleton. “Valuations have dropped so significantly. It’s a bit of sticker shock for guys thinking that six months ago they were worth twice the amount they are now.”

Providers of venture debt financing — firms such as Wellington Financial and MMV Financial — are open for business, as are some banks for lending, but in both cases money is predicated on solid cash flows. Given the spasms of the economy, it carries a high risk.

If they can, companies delay seeking out large amounts of capital by using creative accounting techniques. Bruce Chin, deputy leader, technology, media and telecommunications, at Deloitte Canada, watched demand for its services rise even before last fall, as entrepreneurs sought ways to bootstrap their early-stage firms. “It’s all about getting cash in the door,” says Chin. Tax strategies to generate cash such as loss utilization and accelerating deductions to reduce tax are popular. In one situation, Chin devised a strategy to accelerate the filing of a claim for a Scientific Research & Experimental Development (SR&ED) tax credit. He then secured a loan against that claim, essentially shortening by as much as eight months the time it would have otherwise taken to get cash back. In some cases, that might be enough to keep the wheels greased.

However, even the SR&ED claim financing market (a specialty of lenders like Lawrence Capital and TCE Capital, but also offered by some banks), comes at a higher price these days. For instance, businesses might be forced to switch their entire banking relationship. And what used to be a prime-plus-2% loan to cover up to 80% of the claim, is now prime plus 4% or higher for less of the claim. “If it’s a one-off, it’s pretty hard to get it done these days without having to give up a lot,” says Chin.

Being financially prudent with a business is one thing, but at some stages companies simply need capital to expand. Kneebone Inc., an emerging Toronto company with a web-based software service for analyzing how money is spent on marketing initiatives, got by until last May on a couple of capital injections from its chairman, Duncan McEwan. That was when the former CEO of Sprint Canada recognized that Kneebone’s software had begun to gain traction, and the company would need further investment to the tune of between $1 million and $1.5 million. Meetings with venture capitalists were not fruitful, though. Canadian VCs offered unfavourable terms in his view, and his preferred American VCs, although they received Kneebone warmly, had minimum investment thresholds closer to US$10 million.

Kneebone found itself in an all-too-common position for Canadian companies: stuck in the large gap between venture capital supply and demand. For McEwan, like many entrepreneurs, the solution was to pursue wealthy individuals and raise a private round. While he’s confident he’ll be able to soon close a deal with the $300,000-per-share units that Kneebone is offering, it’s taken a lot of legwork through the last few months of 2008. “The only issue has been the time it’s been taking to get the cash in,” says McEwan, although it’s only delayed the company’s expansion plans, not put it in financial jeopardy. “We’ve added at least four months to the process.”

Angel investors are emerging as viable alternative sources to raise a couple million dollars in capital, says Albert Behr, who runs a consulting firm for startups in the IT and clean-tech industries. “There is an enormous amount of activity in the angel world,” he says. “Today, trying to raise between $5 million and $20 million for a little company is really hard on either side of the border. But if you need $1 million, $2 million or $3 million, then it’s doable.”

Behr says that Canadian entrepreneurs need to think about how to build businesses differently rather than complaining about the lack of financing. And those who spend their time trying to raise millions in venture capital only to fixate on reaching the next milestone are going at it the wrong way, too. “I’d argue that 80% to 90% of the companies that have taken that route are in big, friggin’ trouble here,” says Behr.

Entrepreneurs should focus on signing up strategic partners, principally in the U.S., that would rather sell someone else’s technology than build it themselves. As he sees it, Canadian companies are rarely able to successfully scale their businesses globally, and any technological advantage disapears within 18 months anyway. Better to strike while the iron is hot, keep as much of the equity as possible, and get into a position where another larger company might be interested in an acquisition rather than pay royalties.

Which brings us back to Joshua Geist and Geminare — who has worked with Behr in the past. Geist continues to speak regularly with American VCs. One large firm hosted him in Boston for a two-hour meeting with eight representatives, and another flew to New York just to sit down with Geist. For now, though, such meetings are nothing more than an ego boost for Geist. He says he’s looking for a single Tier 1 VC to invest US$5 million — as he puts it, he doesn’t need several cooks in the kitchen asking what’s for dinner. “It’s nice to talk to the right VC that’s able to write the whole cheque themselves and bring that expertise to the table, too,” he says. (In fact, he bumped up his asking price from $3 million because most American funds don’t invest less than $5 million.)

Despite the apparent interest in Geminare, it may take some time to get just the right deal, and it might help to let the company run a bit on its own to demonstrate the potential of its business model — before some VC tries to establish a valuation. Still, Geist is looking to nail down a private investor round of about $1.5 million in the next few weeks, with between 10 and 15 people buying in.

In early February, he fired off an e-mail with a few teaser slides to a group of friends in the industry who have expressed interest in investing. Soon after, he got a call from one of them, asking, “So, how did this small software startup in downtown Toronto do it, and not CA?”

Guess it’s a Canadian thing.