The cost to get an internet startup off the ground is dramatically cheaper than five years ago, changing relations between investor and entrepreneurs. According to Clifford Carlsen in an article titled “Early risers” from the Deal magazine.

In recent years VCs have raised billions of dollars in capital and are under pressure to put it to work. For these large funds it doesn’t make sense to make a one million dollar investment to get a 20X return. These larger funds are looking for capital intensive deals such as alternative energy.

A number of factors contributing the landscape include:

• Falling startup costs
• Free open-source programming
• Growth of outsourcing/offshoring
• Ease of scaling up services for large markets
• Speed of online distribution
• Wide availability of broad-band
• Spread of on-demand computing and Web services
• Development of “angel” investing
• Emergence of capital intensive sectors like cleantech

Developers are taking ideas and converting it to code very cheaply, without heavy costs in infrastructure and in-house talent. Using cheap offshore programmers or using free open-sourced Web services tools such as Ruby on Rails.

As a result, a capital gap for internet start-ups is being filled by angels and early-stage VCs. The more traditional VCs are going in and pressuring companies to put their money to work faster than entrepreneurs would like. VCs are sitting out the early stage development and investing only at the stage when companies are prepared to spend aggressively on expansion.

Sean Johnston

Using the five indicators used by the National Bureau of Economic Research, the group that calls a recession, key data still suggests recession. 1. Jobs: No net non-farm job increases in 9 months. 2. GDP is barely growing. A GDP index shows that GDP has actually fallen .2% since January. 3. Personal income peaked in December of last year and was down .1% through April. 4. Manufacturing has fallen 1.4% since its peak in January. 5. Sales were down 3% in March (latest data) from its peak in October of last year. (Data Source: C1 of the Money & Investing section of the WSJ)

-James Winder

In Europe, despite the credit crunch private equity funds invested a record amount last year. However venture capital investments fell, according to the Wall Street Journal (Europe edition).

The European Private Equity and Venture Capital Association (EVCA) reported that its members invested €73.8 billion ($114.62) in 8,166 companies last year, up from €71 billion and 7,536 companies in 2006. In 2007, buyouts rose to €58.3 billion from €50.3 billion the previous year. Venture deals dropped to €12 billion from €17.3 billion previously.

Some people are concerned that this trend may damage the innovation in Europe. Neil Cross first chairmen of the EVCA and former executive of U.K. listed buyout firm 3i Group PLC said “Since then (1983 when the EVCA was formed) many larger firms have stopped doing small deals. I do have a concern that this is to the detriment of innovation in Europe.”

Another major issue that came out at the EVCA symposium is the increased skepticism from Europe’s governments, which are looking toward regulating the private equity industry. Jonathan Russell the new EVCA chairman said, “The private equity industry needs to demonstrate that it is committed to self-regulation on corporate governance, reporting, valuation and transparency if we are to avoid having the scope of the industry’s operations substantially affected.”

That said PE and VC turmoil in Europe we probable have some affect on the US. There have already been rumblings about tighter regulations on PE and VC for the US. You know what they say about dominos.

Sean Johnston – Intern

Ken Krull, a principle at Mercato Partners, developed these questions for his VC class at the University of Utah. I thought this would be a great exercise for entrepreneurs in understanding why and how funds function the way they do.

1. If a company has a first round valuation of $2M and a new investor invests $1M in a $3M second round with a pre-money valuation of $5M, what is the new investor’s ownership?

2. A venture Firm invests $1.5M in a $5M first round at $5M pre-money valuation. In a second round a year later the company invests pro-rata in a $2M round with an $8M pre-money round B. Three years later the company sold for $100M

3. What is the venture firms fully diluted ownership ($ and % of round) after the first round?

• 2. Is the second round an up or a down round?

  3. How much does the venture firm invest in the second round?

  4. What is the venture fund fully diluted ownership ($ and %) in the second round?

  5. How much does the venture firm receive at the sale of the company?

  6. What is the venture firms return multiple?

3. A venture fund has 20% ownership in a company it expects to have the following performance..

• 1. If comparable companies are selling for 20x earnings, what is the first year that the firm’s ownership in the company is expected to be above $10M?

  2. If comparable companies are selling for 5x revenues, when is the company expected to value $20M? What is the venture funds ownership?

4. A company has a new round with three investors. If a new investor A needs to have a 20% fully diluted company ownership and investor B needs to put $3M into the round, and investor C puts $1M in the round to maintain his 10% share, what is the round size and what is each investor’s participation % in the round?

We met with a major hedge fund a couple of times this week regarding our financing. Remarkably they were much quicker to understand our program and the value of the tax credits. In addition the hedge fund saw the value in the Ufof fund I portfolio. The group was able to address all of our concerns, providing us with much needed flexibility. As expected however, they required a significantly greater annualized return than most banks. The trip down the path was an interesting experience it seems like there is much less red tape to cut though with hedge funds. So with the great flexibility, industry specific expertise the trade off is the much greater cost of capital.

Sean Johnston - Intern

Reading this week I came across the line, ‘the single hardest transition in an early stage deal is moving from a technology development organization to a sales organization.‘As I have watched VC’s interact with entrepreneurs I would have to agree with this statement.

From my perspective, I see very few deals that receive funding pre-revenue. The ones that are already have beta customers using the service for free. VC’s want to know that companies have made the transition to a sales focused organization. The sales aspect is so important that there is a slew of phrases to describe it (let me know of others):

• Will the dog hunt?
• Does the deal have legs?
• How is the horse? How is the jockey?
• How are they doing out of the gates?

As an example - ‘Going Broke by Degree,’ a book about higher education in America. One of the overarching ideas is that education is is not adapting and evolving to market demands placed on it. Richard Vedder, the author, points out Major Universities have become so enamored in innovation/research that they are neglecting the educational aspect of the University. The transition from research/technology to sales focused organization is not happening thus we see increased tuition. Opinions aside it is an interesting read.

Looking introspectively at the Utah Fund of Funds, as I mentioned in my last post. The Utah Fund of Funds has a very unique financial vehicle behind us. Time will tell, for starters we have made our first 20 commitments and now need to let them mature. Already we have seen some early ‘hits out of the gates’ and have done a great job with economic development (almost 125% reinvested into Utah). I think we have a great portfolio with a lot of really great managers behind each and every fund. Peter Jarman and Fort Washington did an excellent job advising the UFOF Investment Committee. A lot of congratulations are in order.

Going forward the Utah legislature “doubled down” and now we need to build on our successes. With this new fund comes a new advisor, LP Capital Partners. The Fund is almost mentized and we are getting ready to make the transition from Financing (our version of Technology) and start selling Utah Talent and deal flow. As always our door is always open, let us know your ideas and feedback, help us make the program better.

Tim Hunt was the founder and Chairman of the Board of Lingotek, a software development company of a new technology called the Language Search Engine. Lingotek raised $3 million+ from venture capitalists and angel investors. While getting his MBA at the University of Utah, he won both state wide and international business plan competitions. He was awarded 2002 Utah Outstanding Student Entrepreneur of the Year and he also helped found the University Venture Fund. Prior to that he supervised scripture translation for the LDS Church where he supervised the translation of 85 of the 100+ languages in which the Church has produced scriptures.

The hardest part of my job is to let an entrepreneur know that their deal is not VC Material (a post detailing what is VC Material is forthcoming). Its just that simple venture capital is not for every start-up. When this happens I still try to offer help by supplying some alternative options and contacts – all the same I can still see disappointment in their eyes.

A little bit of history and I will bring this back to the opener; UFOF I has some very creative financial engineering behind it that allow UFOF to function in a manner that doesn’t cost the State of Utah. UFOF is in the process of building another instrument, UFOF II, and we want to push the envelope on financial engineering once again. Bankers do not like to push the envelope and lest we forget the credit market is not helping out either.

Returning back to my example of when I have to let Entrepreneurs down, we got a dose of my medicine this week. As UFOF II is coming together we wanted more (rather ‘lower’) rates than had been graciously offered to us and nobody was marching to our drum. Try as we might we could not bend the economics that traditional banks must meet. Much like the Entrepreneur, disappointment began to set in. Talking about my situation with a friend he thought I should try with a different entity, one with more understanding of our business. Long story short - UFOF is now talking with the ‘different entity’ and turns out that they know our business very well and have experience with all of the assets associated with our deal. They are interested in putting something together that has potential to be more innovative than UFOF I. If I had let my emotion run the moment I may have missed the opportunity. Jerry McGuire said it best:

“Help me, Help You!”

We may not have all the answers but, we will try to help you get appropriate financing. ‘Help me, Help You!’ Financial structuring is a game of options, the more options that are in place the better the terms are going to get. Get creative and work with people, what may have worked in the past or for others may not be the best option now. We all need to be open minded enough to accept alternatives, in the end they could be better for business.

Brett Derricott, founder and CEO of Agency Fusion, has been building websites and creating software since the mid-90s. With an atypical affinity for both technology and creative pursuits, the founding of a web-development company focused on serving designers and agencies was inevitable for him.

From large, national agencies like McCann-Erickson to small, local agencies around the country, Brett and his company are carving out a niche, providing web-development services and content management tools to creatives and their clients (Microsoft, Medtronic, and YESCO, among myriad others).

Brett and his team interact with creatives in a refreshingly down-to-earth manner—no geek-talk to translate, no design ‘advice’ from the programmers, and no botched projects that look nothing like the original design.

In addition to his role as CEO of Agency Fusion, Brett frequently speaks and blogs about design and advertising-related technology. His blog is found at www.AgencyByte.com.When he isn’t working, Brett enjoys SCUBA diving, photography, and music.

August 2007 - The Utah Fund of Funds presented our purpose and offering in front of:

Mountain West Capital Network

Utah Technology Council

Utah Valley Entrepreneurial Forum

Wayne Browne Institute