If the number of phone calls I have received over the past few months is any indicator of the shifting focus of venture capitalists' interests, then bootstrapped companies are the new darlings of the financial markets.
But taking my word for it is probably not sufficient. According to the latest venture capital report by Venture One and Ernst & Young, since the first quarter of 2002 more than 70 percent of all venture deals raised either second or later rounds of funding. With an average U.S. deal size of $6 million, 80 percent of new venture financing in the first half of 2003 went to "B" or later rounds. Clearly, the economic challenges of the past year or so have dramatically reduced investors' appetites for startup funding.
But now we have a new and interesting dilemma. Why would a company that has been able to grow organically, funding growth through profits (the old fashioned way!) now want to seek venture financing? That is a question worth exploring -- both from the funders' and founders' perspective.
"ProfitLine was founded in 1992 and had bootstrapped its way to success -- building the company one client at a time and pioneering the telecom administrative outsourcing concept," said Rick Valencia, chief executive officer and founder of ProfitLine. "This success caught the eye of several venture capital firms, who all approached me -- not the other way around -- to ask if I was interested in their help. It was the hard work of the entire ProfitLine team during those first 10 years that made it possible to secure venture backing in these tough economic times. In many ways it's quite easy to see why the capital providers are now looking for resourceful, seasoned and mature companies ready to take a major leap. Their management teams are tested, their markets are validated and the kinks are worked out of their technologies."
Bootstrapping is no small accomplishment when building a technology company, which is generally cash intensive in the early years. Founders must be extraordinarily resourceful in funding R&D and product development. At the RTA, we have seen an increased interest in the use of grants, for example, and entrepreneurs are more attentive than ever to considering alliance models for both R&D funding and product distribution. Bootstrappers are using strategic partnerships to leverage innovative new technologies and gain access to the resources and deeper pockets of corporate partners -- and are receiving support. But that support does not include investor interest at the early stage.
Indeed, bootstrapped companies have weathered the downturn and somehow been resourceful enough to find clever niches or value-added benefits in order to remain competitive and profitable. Perhaps they weren't sexy enough for the VCs in the late 1990s, or possibly they were independent enough to just go it alone. But for the most part, the companies that have grown through a bootstrapped model have experienced hard knocks and proven themselves. That's what investors seem to be looking for these days.
Leo Spiegel, a partner at Mission Ventures, agreed. "Although we are still looking at very early companies, the 'sweet spot' for early-stage investment has evolved. Investors are looking for more developed plans -- and for entrepreneurs to carry the ball down the field a bit farther."
Spiegel underscored Valencia's assessment, and commented that "by funding real businesses in real markets, both the technology and market risks are somewhat reduced. This allows the investment capital to be put the best use -- to really accelerate company growth."
With all due respect to the investment community, it wasn't very long ago that their collective mantra was 'disruptive technologies,' and at most they were seeking a 'defined path to profitability.' Pro forma financials were standard for a first investment pitch. But much has changed -- or returned to normal -- in this post-Enron environment.
Without question, growth companies of late have become masters of cash flow. One successful bootstrapper, Fernando Corona, chief executive officer of V-Enable Inc., put it this way: "There are two types of expenses, those that fall into the commodity expense bucket and those that fall into the value-added expense bucket. The key is to accurately identify which are which and to make sure that you seek out the lowest cost approaching free for those that are commodity items for running the business." V-Enable, a company that makes wireless applications easier to use and navigate, recently leveraged its ability to manage costs while building value, closing a $3.75 million private placement in September -- a "B round" financing.
The challenge is that the characteristics of these companies, their independence, resilience and strategic value propositions are also the reasons why they are not seeking equity investors. In some cases they were brushed off in their early efforts to secure funding and so learned how to go it alone. In other cases, they weren't looking to build fast growth enterprises but grew by virtue of having found a ready market or solved a pressing problem for their customers.
"Innovation in software continues, despite the turmoil in capital markets," said Bob Slapin, executive director of the San Diego Software Industry Council (SDSIC). "But," he added, "for the most part, it moves forward inconspicuously. Innovators are working quietly, crafting products to meet the needs of the market. These are the companies that will grow our economy."
We have heard it said of businesses that "money makes you stupid." Although I'm not convinced that this is always the case, surely the corollary rings true -- limited money can make you clever. ProfitLine's experience underscores this. According to Rick Valencia, "we were in the driver's seat because we had already overcome the obstacles every new company faces, and were doing business with Fortune 500 clients. We'd proven that companies would buy our services, so we were able to take the outside capital and use it to build the company, not pay off outstanding debts."
But do these entrepreneurs really want to give away a good percentage of their firm and add a capital provider to their board? Do they want to reposition around a more sophisticated business model? Are they ready to step aside and secure "professional management" to take their business to the next level? Well, I'll tell you, there are more VCs than founders beating a path to my door these days.
So what does this really mean? I'm convinced the pendulum is still in motion. Slapin is optimistic. "This evolution will continue. So long as creative people believe there is a way to make things work better, they will respond to the needs of the market. Despite the incredible progress our industry has made, there is plenty of room for improved technology."
I suspect that we will eventually find a healthy balance. The investors' pain of 2001 will become tomorrow's history lessons, and skittish entrepreneurs who weren't sexy enough for the high times will be ready for real growth capital. Some subset of the fund-worthy companies are out there growing quietly, under the radar. Now we find ourselves in the new "funding divide," and help is needed to connect the bootstrappers to the capital providers -- an interesting turn of events, to be sure.
Orion is president and CEO of the San Diego Regional Technology Alliance. He can be reached at firstname.lastname@example.org.