No Mercy Are VCs sucking the life out of your business? Maybe you're better off without them.

Remember when the entrepreneurs who couldn't get venturecapital funding were the unfortunates, the wallflowers, forced tosit on the sidelines and envy those with VC partners? Well, if youwere one of those wallflowers, now might be your time to gloat.

Playing with VCs is not the fun it used to be. The once enviabledeals have increasingly devolved into ugly wars over tougher termsand lower valuations, with entrepreneurs caught between priorinvestors and opportunistic new "vulture capital"partners. On one side are the VCs who have already investedsubstantial cash in a given company; they had expected to exit thedeal many months ago, but, because of the nonexistent IPO marketand the sluggish M&A environment, they have no immediate hopesfor liquidity. Now they are either unwilling or unable to sink morecash into the venture, which likely needs another capital infusionto survive the dismal economic climate.

Consequently, companies are forced to seek funds from other VCs.But the new investors are drastically reducing old valuations anddemanding exceedingly harsh terms. "It's a buyer'smarket right now," says Dan Primack, editor-at-large forVenture Economics, a Thompson Financial subsidiary that monitorsthe venture capital industry. "The VCs completely control thisthing."

They're insisting on returns of two to three times theamount they put in-or more-before management and other shareholderssee a personal return on the investment. "That [puts]management and common owners down the line," says ScottUngerer, founder and managing director of VC firm Enertech Capitalin Wayne, Pennsylvania.

One way to remedy the situation is by arranging "sidebaragreements" between management and the investors, which saythe management team will start getting bonuses after the firstliquidation preferences are paid out. It's to the VC'sbenefit to make sure those running the firm are rewarded. "Ifmanagement isn't motivated, who is?" Ungerer says.

But, logic notwithstanding, VCs are adding perks for themselvesthat make deals less attractive for founders. One is the"participating preferred" agreement-previously notuncommon but fast becoming standard-which gives the VC an ownershipstake in the company, plus priority in recovering their originalinvestment. In some cases, VCs are also winning more control overmanagement, capping salaries and predetermining whether the companycan seek additional funding at a later stage.

For small companies, the drop in valuation is the hardest pillto swallow. Where once upon a time it was only those companies withno product revenue, little expense history and an incompletemanagement team that had to worry about lower valuations, thesedays, even companies with established products and revenue areseeing values drop by 50 to 60 percent. That's bad news forthose who already have a stake in the company.

And not all investors will take that lying down. When onlinewine retailer Wine.com (formerly eVineyard Inc.) was facingbankruptcy and seeking more capital earlier this year, tensions ranhigh between Chris Kitze, a serial entrepreneur and major investorin Wine.com who had begun personally bankrolling the company whenits funds were depleted, and many of the company's 60 or soinvestors. The VCs who had plunked down cash in the 2000 round werefurious over the prospect of a new round of funding and a newvaluation of $2 million. But they also refused to cough up moremoney to protect their investment and threatened to sue the companyif it didn't go bankrupt. "They were waiting to the lastsecond to see if we would agree to these ridiculous terms,"says CEO Peter Ekman, 40. "It was the ultimate vulturebehavior." Eventually, Kitze convinced them that his offer of5 cents on the dollar was better than the zero they would havegotten in bankruptcy.

But the experience was grueling-and convinced Kitze the companywas better off without VC involvement. None of the investors in theJuly round of financing, which raised $9 million for Wine.com, wereVCs. "If you are an entrepreneur and had the misfortune oftaking their money, you're an expendable piece ofKleenex," he says.

Avoiding new VC investment may not be a bad idea, at least untilthe IPO market returns to full health and offers VCs moreliquidity. For now, in the current harsh environment, entrepreneursin search of VCs will still have to do their due diligence whetherthe price of capital is worth the sacrifice.

C.J. Prince is executive editor of CEO Magazine. Shecan be reached at jprince@chiefexecutive.net.

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• Venture Economics
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