When Vestas, the world’s largest wind-turbine manufacturer, announced plans for a new U.S. research center, 42 states lined up to make sales pitches. The winning location would be rewarded with hundreds of jobs, millions in tax revenue, and green-business cachet. Finn Strøm Madsen, president of the Danish firm’s tech division, wanted a site near big-name universities, so Massachusetts (MIT) and California (Caltech, Berkeley) seemed obvious choices. Portland, Oregon, was already home to Vestas Americas’ headquarters. But in June, Vestas picked Houston.

There are two kinds of companies in the Valley: those that make money, and those that don’t have to. As the economy worsens, the former group behaves like firms in other sectors, making cuts and revising earnings expectations. For the latter group, living in a VC-backed candyland, it’s as good a time as any to spend half a billion dollars on something fun.

So it was this week with two contrasting companies: Adobe [ADBE [1]] and Facebook. Adobe announced Thursday that it will miss its earnings targets for its fourth quarter ending November 28th, 2008, and will implement a restructuring program that will eliminate 600 full time jobs worldwide. Facebook, meanwhile, tried to buy Twitter for $500 million, despite the fact that it doesn’t make any money, and seems to need increasingly more capital to function.

Adobe’s misfortunes are yet another indication that technology companies, usually insulated from larger economic fluctuations, cannot remain buoyant amidst the global economic crisis. The company had projected revenues of between $925 million and $955 million, but said Thursday that it would only achieve $912 to $915 million.

The gap in revenue Adobe attributes to weak sales of its new Creative Suite 4 software, which was released in October. To make up the difference, the company will eliminate 600 full-time positions, which an Adobe spokesperson says will affect “Everyone across the board, all regions, and all business areas.” The cuts should should save Adobe tens of millions of dollars, much of which can be recorded in the fourth quarter of 2008. The spokesperson declined to say whether Adobe will re-hire any of those positions should the economy show signs of recovery.

Facebook’s profligacy seems irrational by comparison. The company is predicted to earn revenues of only about $300 million this year, which is about the same as the overhead it takes to keep the office running, according to Michael Arrington [2]. But that hasn’t stopped the social network from reportedly trying to buy Twitter with a combination of cash and stock options. Twitter’s CEO, Evan Williams, declined the offer.

Twitter doesn’t make any money either; its revenues are close to zero. Both companies are well capitalized, but reports of Facebook’s CFO flying around the world talking to sovereign wealth funds suggest that Facebook is growing too fast for its own good, and reaching a hunger for capital that US firms simply can’t — or won’t — surfeit. Twitter too is reportedly [3] putting revenue at the top of its list of things to do, in anticipation of a weakening fundraising landscape. The company had previously said it would wait until 2010 to worry about making money.

While I don’t doubt that juggernaut Facebook has its telescopes pointed in the right direction, it’s hard not to second guess the company’s prospects. If it is to ever become profitable, it will need to learn how to monetize a tool that gleans 3 out of 4 of its users from overseas, and sells famously ineffectual advertising space. Owning and managing another unprofitable Web entity would only exacerbate the problem. Had the buyout succeeded, 2009 might have been the year that Facebook was forced to come back down to earth.

[via Fast Company] by Chris Dannen

As venture capital funds face a cash crunch driven by the financial downturn, they are taking extreme measures to ensure they can fund their investments.

Some venture capitalists are selling their equity stakes in start-up companies at fire-sale valuations so they don’t have to keep funding those businesses, allowing them to husband their remaining cash for other investments.

Others are considering so-called annex funds, which are side funds that can provide an extra pool of money. And some are scaling back on new investments to increase the cash reserves in their funds.

“It’s all about cash flow right now,” says Terry Opdendyk, a general partner at venture-capital firm Onset Ventures in Menlo Park, Calif. “If you don’t have cash, companies die and we can’t resurrect them for our investors.”

Venture capitalists typically raise money from institutional investors to form a 10-year fund, using it to invest in private companies with the hopes of profiting later when the start-ups go public or are sold. The funds collect the capital their investors have promised over time, providing a steady stream of cash to nurture start-up companies.

In normal times, the funds can stop spending on the start-up when it has an initial public offering or is sold, allowing them to put remaining cash toward other investments.

Now, few venture capitalists can sell their companies or take them public amid frozen deal markets. Many older venture funds that have collected most of their capital now have to continue spending on multiple companies, spreading their cash thin.

Funds that haven’t gathered all their capital also face cash difficulties, since some cash-strapped institutions are reluctant to honor their commitments. It is also difficult for venture investors to borrow money, as many banks are currently disinclined to lend.

At Onset Ventures, Mr. Opdendyk says his firm’s $280 million fund raised in 2000 has collected most of its commitments from institutional investors and doesn’t have much cash left. At the same time, the fund has to keep spending to nurture numerous companies because there have been so few IPOs and sales. “We’re squeezing every dime” and may consider selling some company stakes, he says.

Onset’s $200 million venture fund that was raised in 2005 and a new fund raised this year are in better shape because they haven’t invested all their capital and still have money in hand. Mr. Opdendyk says those funds are getting an offer a week from other cash-strapped venture investors who want to sell out of their companies at a discount, often “for 10 cents to 60 cents on the dollar.” He says Onset is considering purchasing one or two such stakes.

Tom Crotty, a venture capitalist at Battery Ventures in Waltham, Mass., says the situation is reminiscent of the technology bust earlier this decade, when many venture funds faced a similar cash crunch. With few sales and IPOs at the time, venture investors were left spending money on too many companies. Ultimately, venture capitalists had to cut many start-ups loose.

This time, Mr. Crotty says, Battery is closely monitoring its $850 million fund that was raised in 2000 and which already has collected on all the capital pledged by institutional investors. If Battery uses the fund’s remaining cash too quickly, “we could end up having a shortage in the fund in mid- to late-2009,” he says. To prevent a crunch, he says the firm is now pruning the fund’s portfolio, a process that will leave more cash for the start-ups that make the cut.

For some venture investors, the cash crunch is an opportunity to buy into start-ups at a big discount. Bryan Roberts, a managing general partner at venture-capital firm Venrock in Palo Alto, Calif., says he recently purchased a stake in a health-care-related start-up for just 40 cents on the dollar, based on the company’s last round of financing, from a cash-strapped investor he declined to name.

“The dislocations in the markets have created such losses and constraints in liquidity that investors lacking sufficient cash are being forced into uneconomic decisions to satisfy short-term problems,” Mr. Roberts says.

Other venture investors are considering raising annex funds, which also happened during the tech bust. Bryon Sheets, a general partner in the San Francisco office of private-equity firm Paul Capital, says several venture capitalists have recently approached him about providing capital to establish such funds.

The venture capitalists didn’t set aside enough money to keep funding their start-ups and now need new capital to do follow-on financings for their companies, Mr. Sheets says. He adds that his firm hasn’t yet decided whether to participate in any annex funds.

John Steuart, a venture capitalist at Claremont Creek Ventures in Oakland, Calif., says his firm is trying to avoid a cash crunch by increasing cash reserves for existing investments. In its $130 million fund that was raised in 2005, Claremont Creek originally planned to invest in about 20 start-ups, meaning the firm would have about $6 million to put into each company over time.

But, since the downturn hit, Mr. Steuart says Claremont Creek has decided to make just 16 to 17 investments, leaving more cash to put toward each company. “Our portfolio will be smaller and more concentrated,” he says. “It’s all about cash economics.”

[via SmartMoney SmallBiz] by Pui-Wing Tam

Silicon Valley technology startups are adopting a new business plan: deferral.

MerchantCircle Inc., a Los Altos, Calif., Internet startup, typifies the trend. Last month, company founder Ben Smith was in New York talking to media companies about raising $50 million, with which he planned to make acquisitions to fuel MerchantCircle’s growth. But as the financial markets tumbled this month, Mr. Smith canceled two trips to New York and a roadshow to Europe to raise the capital. For now, the fundraising is on the backburner.

“When we started the year we were pushing really hard for growth,” says Mr. Smith, who in 2005 founded MerchantCircle, which provides online advertising services for small businesses. “That’s just not as important anymore. Now it’s all about cash flow.”

The shift is being echoed across Silicon Valley, where executives at startups—which form the foundation of the tech economy—are now deferring expansion projects, taking voluntary pay cuts, delaying hiring plans and slashing expenses. The shift is a turnabout for the region’s young companies, which have traditionally focused on go-go growth by grabbing customers early and being first to market with new technologies.

The change is being spurred by the souring economy and market gyrations, which have hit startups’ main source of funding: venture capital. Prominent Silicon Valley venture capital firms Sequoia Capital and Benchmark Capital recently sounded the alarm, saying a downturn would be protracted. Venture capitalists are now slowing their investments, doing just 583 deals totaling $7.37 billion in the third quarter, down from 673 deals totaling $7.94 billion a year ago, according to research firm VentureSource. VentureSource is owned by News Corp., which also publishes The Wall Street Journal.

The pullback recalls the tech slump earlier this decade, when venture capital also froze up and numerous startups flopped. That downturn, which started in 2000 and lasted till 2004, helped weed out weak companies and taught surviving firms better fiscal discipline.

But it also led to the disappearance of one in five jobs in Silicon Valley. And it crimped innovation, as companies put off new projects. In several quarters in 2000 and 2001 as the tech bust took hold, there was a dip in economic productivity, according to Forrester Research.

The coming shake-out will “weed out the weak” but there are risks that some innovation will be stifled, says Eric O’Brien, a venture capitalist at Lightspeed Venture Partners. Earlier this decade, the tech bust made telecom firms wary of buying unproven communications technology, forcing an end to even promising tech start-ups, he notes. “My fear is that some of these companies may die when they shouldn’t,” Mr. O’Brien says.

Many startups are already suspending development projects this time, which could affect innovation. Ruckus Wireless Inc., a Sunnyvale, Calif., startup that makes wireless equipment, this month shut down research and development around potential new wireless products. While those projects were “nice,” they weren’t “material,” says Selina Lo, Ruckus’s chief executive, who adds that killing the projects would save the company $150,000.

Ruckus is partly funded by Sequoia Capital, which held a presentation for entrepreneurs earlier this month warning of the dire economy. Ms. Lo says the event “freaked people out,” leading to her decision to eliminate new development. In addition, Ruckus’s executives took a voluntary 10% pay cut mid-month “to demonstrate that everyone must share the pain for a more secure future,” she says.

Such moves have implications for Silicon Valley’s economy, which until recently was holding up. Silicon Valley’s unemployment rate in September was 6.5%, for instance, far below California’s overall unemployment rate of 7.5%, according to the state’s Employment Development Department. Companies had continued to fight to recruit strong technical talent, over whom price wars had regularly broken out.

Now such employment-package inflation is likely over. Bill Nguyen, founder of music Web site Lala.com, says he had planned to grow his Palo Alto, Calif., company to 70 employees from 35 in September. But this month, he put hiring on hold. He now expects Lala to top out at about 40 employees by the end of the year.

“We have internal arguments daily about hiring,” says Mr. Nguyen, who is trimming Lala’s burn rate—Silicon Valley lingo for how much cash a young company with little revenues and no profits goes through each month—to $500,000 a month from more than $650,000 a month. “It’s a choice between accelerating growth or taking a more conservative approach and lasting another three years.”

Silicon Valley commercial real estate, which had been in the doldrums for much of this decade because of the tech slump, is also likely to take a fresh hit. Lala’s Mr. Nguyen says he this month deferred taking on a new office lease that Lala had signed earlier this year. Meanwhile, Ruckus CEO Ms. Lo says that she has postponed adding 5,000 to 10,000 square feet in new construction to the company’s offices.

Not all tech startups are deferring their plans. Internet chat startup Meebo Inc. raised $25 million in April, before the funding environment soured. Seth Sternberg, CEO of the Mountain View, Calif., company, says he remains on track to develop new services to grow revenue. The 45-person company is also still hiring and plans to get to 55 staffers by the end of the year.

But he is still making some cutbacks. Meebo was aiming to open a new datacenter—a facility that houses back-office computers and networking gear—this year, but has now decided to wait six to 12 months. “Just because we’re already operating lean doesn’t mean we’re operating as lean as we could possibly be,” Mr. Sternberg says.

[via WSJ Small Business] by Pui-Wing Tam and Bobby White

Venture capitalists are reining in spending amid the financial downturn, a shift that has implications for entrepreneurial activity.

According to two sets of data pegged for release Saturday, venture capitalists did fewer new financing of companies and spent less money in the third quarter than they did a year earlier. Venture capitalists typically put money into young companies, with the aim of profiting later when those start-ups go public or are acquired.

Venture capitalists arranged 571 financings totaling $7.2 billion for the third quarter, down from 651 deals totaling $7.8 billion a year earlier, according to research firm VentureSource. VentureSource is owned by News Corp., which also publishes The Wall Street Journal.

The National Venture Capital Association, a trade group, and PricewaterhouseCoopers found a similar trend, noting that venture investors put $7.1 billion into companies in the third quarter, down from $7.8 billion a year earlier.

The amount invested was the lowest quarterly number since late 2006.

The slowdown has repercussions for entrepreneurs in sectors such as technology and life sciences, many of whom rely on venture funding to kick off and grow their companies.

“Entrepreneurs are seeing lots of their traditional avenues of finance getting whittled away,” says Mark Heesen, president of the National Venture Capital Association. He adds that he has a “high level of concern” for the overall health of the venture industry.

The pullback comes as venture capitalists have been hurt by a gyrating stock market, which has put a crimp in the market for initial public offerings, which the industry depends on to generate returns.

Merger-and-acquisition activity — another route to returns — has also tanked. And many venture capitalists are also facing difficulty raising funds as their investors grapple with hard-hit portfolios.

The information-technology sector took a particular hit in the quarter. According to VentureSource, 270 financings totaling $2.7 billion took place, down from 342 deals totaling $3.4 billion a year earlier.

Other sectors, such as health care, were relatively stable.

[via WSJ Small Business] by Pui-Wing Tam

After a string of rough years and falling values for private companies, here’s some good news: Now just might be the best time to sell a business that we’ve seen in quite some time.

Why? Jay C. Jester, marketing director of Audax Group, a Boston-based private equity and mezzanine firm, explains that many private equity companies and venture capital firms raised money for investment funds with capital-deployment time limits several years ago, and now the clock is ticking ever closer to midnight. “There’s a ton of private equity with a fuse on it,” Jester says. “You’ve got pent-up supply and pent-up demand coming together. There’s activity in just about any sector you can think of.” Of course, some sectors are hotter than others. Right now, telecommunications equipment and semiconductor companies are starting to fetch good prices again as those industries bounce back after having been down for years. For obvious reasons, companies involved with various aspects of security are hot — home security systems, devices that control access to buildings, retinal identification. Many companies dominate various niches of the medical instrument sector, and as the population continues to age they’ll command premium prices.

During the past several years, as the market stagnated, buyers eased their demands that acquisition candidates have at least $20 million in annual revenue — in part because fewer companies qualified. More and more buyers are now willing to consider $10 million or even $5 million. Andrew Cagnetta, CEO of Transworld Business Brokers in Fort Lauderdale, Fla., reports that in the past five years individual buyers from around the world have started to check out businesses advertised by his firm on the Internet. They arrange to come here, and if they like what they see, they apply for a visa on that first trip, buy the business, and move here. Cagnetta cites Venezuela, Colombia, Canada, and Great Britain as some of the most common homelands of these new immigrants. In addition, says Phil Steckler, a principal with business brokerage Country Business in Brattleboro, Vt., a tight job market means that lots of downsized-out-of-a-job executives are looking for businesses to buy and run. Given the way private equity firms and their funds have multiplied, however, the odds are much better than they were five years ago that a buyer will be a company rather than an individual.

Even if you’re not interested in selling your business right now, it’s a good idea to put your company through a valuation process regularly (see “Judgment Day,” page 69). You can even do a self-valuation; that’s what Kelly Flatley and Brendan Synnott, owners of Bear Naked Granola, do quarterly (see “Maximizing a Company’s Value,” below). They would eventually like to sell a majority stake in their business, but because they’re in no hurry, they can afford to wait for the perfect fit and the right price. Meanwhile they can hone their strategic plan and continue to grow.

“There’s a ton of private equity with a fuse on it. You’ve got pent-up supply and pent-up demand coming together.”

Right now, service seems to be the hottest sector. If you turn to the “Trends by Industry Group” charts on page 78, you’ll see that multiples for service businesses jumped in 2003 — meaning sellers at service businesses got a higher price per, say, net income or cash flow than they had in recent years. An example from Stanley Feldman, chairman of independent valuation firm Axiom Valuation Solutions and associate professor of finance at Bentley College in Waltham, Mass., shows how some service businesses are making the most of the improving economy. Medical practices, Feldman says, might sell for a lower multiple than dental practices (our data shows the opposite, see page 81). The difference, he says, is that dentists have the greater ability to go after discretionary spending by encouraging, say, whitening, straightening, or cleanings four times a year. Doctors are much more dependent on insurance and on the political pressure to keep health care costs down. “They’re trying to pay doctors less and less money,” says Cagnetta of Transworld Business Brokers. “So as doctors are bringing in less and less money, people aren’t buying doctor practices the way they used to.”

Retail and wholesale businesses also saw healthy increases in multiples last year. In particular, several business brokers and private equity executives report that food distribution is hot — especially small ethnic and natural food distributors, which are being snatched up by larger companies as their fare continues to grow in popularity.

By contrast, manufacturing has drifted, with multiples of earnings neither rising nor falling much. But buyers are paying much less for book value. “There’s tremendous discomfort with domestic manufacturing because of outsourcing overseas,” says Bill Landman, chief investment officer at CMS, a Philadelphia investment firm. “A lot of people that used to concentrate on domestic manufacturers are trying to buy them for less.” Buyers don’t want to pay a lot for costly production facilities in the U.S. When they do make a purchase, there’s a good chance they’ll move the plants overseas.

Current owners of manufacturing concerns are doing the same. “Companies that can move quickly and adopt new market economics will receive higher multiples,” says Linn A. Crader, president of Crader & Associates, a mergers and acquisitions boutique in Lake Oswego, Oreg. “And companies who don’t move or stay with the old economic ways of doing business will decrease in value.” This may well mean outsourcing production to someplace like China. It could mean “componentizing” — having other, most likely foreign, manufacturers make your components, assembling the components at your own offshore facility, and selling the completed product here at a price below what it would have cost to manufacture it here. Companies with annual sales of as low as $20 million now need to consider these measures, says Crader. And this doesn’t apply just to manufacturing. If services are your thing — processing health or benefits records, for example — you can batch them here, send them to India overnight, and have them back in the morning at 20% of the cost of doing it all here.

A word of caution when it comes to comparing business valuations: Many participants in private markets say obsession with multiples is unwise. “Value is in the eye of the beholder,” says David Malizia, managing director at Florida Capital Partners, a Tampa-based private equity firm. Malizia believes that many valuation experts take an overly technical approach to their craft that’s inappropriate for private businesses, the most illiquid of all the markets. Malizia compares selling a business to selling a house. “If you sold your house at $200 a square foot, and your neighbor wants to sell his house, he might want $200 to $205 a square foot. But the houses are not the same. It’s not the same floor plan; it’s not the same decoration; it’s not the same landscape. Too many business owners think that if that business over there sold at that multiple, I should get the same multiple. But there are different management teams; there are different product lines; there are different profit margins; and there’s a different emphasis on strategies and tactics.”

“I’m a three- to five-times cash flow valuation man.”

On the other hand, if you’re looking to sell a business, you’ve got to watch out for people who tell you not to pay attention to multiples. “Sellers should recognize that buyers are obviously trying to come in and get it at the lowest possible valuation,” says Steven Rogers, clinical professor of management and finance at Northwestern’s Kellogg School of Management. Rogers recommends that sellers use the discounted cash flow model, which forecasts the amount of cash a company will be able to throw off in future years, then derives a present value from that prediction. Interestingly, Rogers likes the technique precisely because of the uncertainties involved in making future projections and the flexibility those uncertainties provide. Unlike Malizia, Rogers is a believer in multiples as eternal verities. “I’m a three- to five-times cash flow valuation man,” he says. As he explains in his book, The Entrepreneur’s Guide to Finance and Business, in a typical deal, in which a buyer finances 75% of the purchase with debt, he expects to be able to pay off that debt in five to seven years. That means he shouldn’t be willing to pay more than five times cash flow for a business.

Another important part of the value equation is you, the owner. How long are you willing to stay on as a manager and a minority owner so you can transmit your unique feel for the business? Crader says an ideal seller is an owner in his mid-fifties who is willing to stay on as a manager with an equity stake for three to five years. But Jester tells those owners really interested in getting out not to worry, that he’s got plenty of people ready to take over “if somebody says it’s time to ride off into the sunset.”

In any case, now is a good time to consider selling, and now is always a good time to value your business. The process means considering multiple variables and running multiple scenarios. Potential buyers may emphasize the more pessimistic assumptions and outcomes, but they may also be able to create grander strategic plans than you ever could imagine with resources and connections you didn’t know existed. Good business brokers or independent appraisers should be able to do the same.

[via Inc Magazine] by Jim Melloan

They are the true believers in the world of start-ups. Inc Magazine presents a guide on searching for and courting these diamonds in the rough.

Inc Magazine Angel Investors Guide

Also, check out Jason Nazar’s Guide to Raising Money for a Startup Company. Jason is the CEO of Docstoc.com, an online community for document sharing.