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Paul, Hastings, Janofsky & Walker partner Richard M. Asbill opened a conference on venture funding with these words: “What a difference a year makes.” His point: The heady, almost free-money days of early 2000 are over, and the rules for companies seeking venture funding have changed. Last Wednesday morning, about 100 lawyers, accountants, venture capitalists and business types from companies in need of capital gathered in Atlanta’s Bank of America Plaza conference center to discuss and debate ways to raise money and construct exit strategies in the brave new world of a down economy. The event was sponsored by Paul Hastings; Deloitte & Touche; Deutsche Banc Alex.Brown; and Croft & Bender. One of the panelists, Steven Nussrallah, chairman of Noro-Moseley Partners, told the audience that despite appearances, investment money is out there. “If you look at the investments … we are still substantially above the investment levels of just two to three years ago,” he said. The difference between now and early 2000, he explained, is that today’s investors are making a “flight to quality.” That means the sales and marketing hype that fueled the dot-com craze has been replaced by more traditional values such as experience, strong management and profitability. In this new environment, “gray hair and older, mature people are back in vogue,” according to panelist Brad R. Swanson, a vice president in the technology investment banking group of Deutsche Banc Alex.Brown. And instead of a focus on B2B (business to business) and its progeny, Swanson says the new watchword is P2P: the path to profitability. Investors are demanding profitability by year’s end for software companies, he says, though optical networking and communications companies have a slightly longer grace period. That means capital-seeking companies must show potential investors historical performance records — even three months’ worth — because venture capitalists are no longer basing their current valuation of a business on that company’s prior round of funding. Chris Hunter, a vice president at Croft & Bender, an investment bank for small and midsize companies, outlined several steps to getting venture capital. Among them: � Structure the transaction by meeting with your company’s management team to figure out capital requirements, start due diligence, create a detailed memorandum on your place in the market and analyze risk; � Do a hard analysis of similar deals in your industry and locale, then set up meetings with venture capitalists. This step can take four to six months for young companies. THE SCENARIO Once a venture firm is interested, negotiations begin. Paul Hastings partner Walter E. Jospin, one of the event’s moderators, presented this scenario: A client calls, elated, saying she’s received a term sheet from a venture capital firm. The VC tells the client, ” ‘It’s a standard term sheet,’ ” Jospin says, and the audience erupts in laughter. There is no such thing as a standard term sheet, says Paul Hastings partner Elizabeth H. Noe. Companies poised for funding need to ask the following questions, she advised: � What kind of security does the VC want? � Is that security permitted by the company’s articles of incorporation? � What restrictions would the agreement place on founder’s stock? � What board composition is the VC requesting? Who will they put in those seats and what value will they bring? � Are there limits on the company’s ability to grant stock options to workers? � What has the VC done to protect its investment, and how will those actions affect the company’s management? Two common ways of protecting an investment are the ratchet and the hurdle. A full ratchet basically guarantees that if a company’s share price drops in later rounds of investments, investors from earlier rounds will be given additional shares to make up the difference. This arrangement protects investors, but means the company takes a hit. As Noe points out, if a company goes through enough down rounds, a VC that invested with a 25 percent ownership position may end up with a controlling stake. A less onerous plan for the company is to use a weighted average ratchet, which employs a mathematical formula to provide extra shares to early investors if later investors buy in for less. Sometimes a VC will protect itself by using a hurdle. This happens if a VC firm’s valuation of a company is less than the company’s valuation of itself. The VC firm might agree to go with the higher valuation as long as the company meets a hurdle — producing a certain amount of revenue by a certain date, for example. If the company can’t meet the hurdle, the VC’s ownership stake rises. Once a company has obtained its venture funding and is mature enough for its owners to consider an exit strategy, it’s time to look at mergers and acquisitions and initial public offerings. Unfortunately, the current economy is anything but rosy for those ventures. As an example of how the market has changed for mergers and acquisitions, panelist Ronald Goldman, vice president at Croft & Bender, says that in 2000, 60 percent of spending on acquisitions occurred in the first quarter. The average deal size was about $200 million. By the fourth quarter, the average deal size was $5 million. “You’re seeing a lot of fire sales, and it’s just a very, very different environment all around,” he says. But Goldman says acquisitions still are occurring everywhere, and the important question to ask is why. Some likely answers: to increase market share, to enhance product lines or service offerings, and to buy talent. Talent is so valuable these days that some companies are being valued as a multiple of their engineers, he says. Paul Hastings New York partner Leigh P. Ryan offered a checklist for companies preparing to be acquired: � Do your own due diligence, because acquirers will do it to your company and you’d better be prepared; � Articulate the reasons for your sale or merger early on, because you’ll have to convince a buyer or merger partner to go forward; � Consider what would be an acceptable valuation and talk with investors to gauge their level of cooperation; � Examine your company’s organizational structure — is it an LLC or a “C,” or regularly constituted corporation, for example — and consider tax implications and whether there’s a need to convert structures; � Get finances in order and perform any necessary audits; � Look at existing contracts and make sure they’re in writing, complete and in force; � Identify what consents you need from other parties to move forward — such as lease provisions with a landlord; � Examine employee benefits plans, options, vesting and golden parachutes that might be triggered by a change in control; � Develop a plan to retain key employees; and � If your potential buyers are competitors, consider how much information to provide and what confidentiality agreements to construct. Though mergers and acquisitions aren’t the only exit strategies, panelist Pierre Williams, a vice president at Deutsche Banc Alex.Brown, says that from an investment bank perspective, equity markets are viewed as closed. He says his bank and others now are focused on early 2002 for the next round of IPO activity. Panelist Avery Munnings, a partner at Deloitte & Touche, says, “IPOs really just are not going to happen and that’s not good. … When the companies don’t do work, we don’t do work, and we feel that.” But he says the IPO market will come back. When it does, companies with strong management and profits — old economy traits once eschewed by the market — likely will be the hot deals of the next IPO generation.

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