The E-Channel Currency

Looking for funding? Get ready for some new realities. Organic growth doesn't matter the way it used to; same for longevity. Even profits, which have always been the yardstick by which success is measured, matter less in some financial corridors today. The new significant metric: revenue potential, especially if your business is focused on the Internet, and doubly so if you excel in e-business integration or solutions delivery.

As evidenced by the success of several channel companies, it's a new financial world. It's one in which earnings before interest, taxes, depreciation and amortization play an important role, and one where net losses must be looked at in a larger context, says Toby Corey, co-founder and president of USWeb/CKS (VARBusiness 500 rank: 141), Santa Clara, Calif.

Despite losing $188.3 million in fiscal 1998 on sales of $228.6 million, USWeb/CKS has emerged as a standard bearer for the new Internet services market segment. "This type of company does take some new education to understand. But 16 top analysts on Wall Street, numerous institutional investors and others in the financial community get what USWeb is all about," says Corey, who points out that leaders in other fields such as radio grew their businesses similarly before posting huge profits. Already, USWeb/CKS is posting huge sales gains. It jumped to No. 141 from No. 424 in the 1999 VARBusiness 500 ranking of the largest VAR organizations in the country. The jump was one of the largest on the entire list.

iXL Enterprises Inc. is another company that understands the new money powering growth in the channel. Like USWeb/CKS, iXL made an impressive leap in the VARBusiness 500. The company debuted all the way up at No. 244. Earlier this month, the Atlanta-based company completed its IPO, just three years after founder, chairman and CEO Bert Ellis started the company.

iXL's June 3 IPO raised $72 million on the sale of 6 million shares of stock. Its operating history is indicative of organizations emerging as new channel powerhouses. iXL's 1998 sales, for example, totaled $64.8 million, a whopping increase of 241.1 percent from the previous year. The company's losses, however, amounted to $54.6 million.

In past years, red ink like that would have put a company on the sidelines, as far as Wall Street is concerned. It would also have meant greater scrutiny at the local level and among venture capitalists. No more. Like USWeb/CKS, iXL is what many call an "Internet roll-up",an Internet-focused company whose principal instrument of growth has been strategic acquisitions rather than organic expansion. In this case, iXL provides e-commerce systems, interactive multimedia services, digital media services and Web site development and hosting to a roster of blue chip customers. These customers range from media giant Time Warner to networking powerhouse Lucent Technologies Inc. to worldwide drug maker Eli Lilly & Co., among others. In three years, iXL has completed 34 acquisitions. Those deals helped iXL amass a wealth of talent and a pool of top customers quickly,two characteristics Wall Street values greatly. Those assets helped the company stand out among hundreds of like-minded channel organizations that vie for attention from the financial community.

Proxicom Inc. (VARBusiness 500 rank: 328) is another example of a fast-growing, Internet-focused company that recently completed a successful IPO. Its 1998 sales were an impressive $42.4 million, but 1998 losses totaled $20.6 million. Nonetheless, the company successfully raised $58.5 million from its April IPO.

How are those and other companies doing it? How are they raising huge sums of money to grow their businesses while so many other service companies struggle to raise capital of their own? By gravitating toward the most compelling opportunity to hit the IT services market in more than a decade. In light of the recent IPOs of several high-profile VARBusiness 500 companies, many in the channel have come to the realization that the most successful companies in the IT solutions market, measured by their ability to attract financing, will be Internet-focused companies that devise ways to harness the worldwide network for maximum financial gain.

Finance Options

There are many ways to finance a VAR company today. VARs have the same external options for financing growth as other companies, among them private sources such as banks, which supply debt, and equity sources such as venture capital firms and angels, and the public stock market. Some rely on more than one, while others avail themselves of none.

The private sources lie along a risk-expected return continuum, with banks bearing the least risk and expecting the lowest return (the VAR's cost), and venture capitalists shouldering the most risk and expecting the highest returns. Meanwhile, going to the stock market with a public offering is everyone's dream, but, unfortunately for most, remains just that.

Only you can determine which source of funding is right for your company. Below are some insights that could help you decide how to fund your business in the new era of financing. Be forewarned, however: The new rules of financing focus on specific metrics for valuating companies, says Coleman Barney, vice president of marketing at SolutionBank Inc. (VARBusiness 500 rank: 455), a Salt Lake City provider of enterprise resource planning solutions.

"Two things are key: what kind of relationships you have with customers, and what kind of focus you have on high-growth opportunities," says Barney.

Sources of Money

Banks are a natural first stop for borrowers, who pay the interest rate prevailing on the particular term of the loan. There are two compelling advantages: Debt is cheaper than the alternatives, and the VAR does not give up any equity, therefore retaining full control. Banks, however, will not lend to companies that lack an established, predictable cash flow, eliminating many businesses that operate on the cutting edge. Moreover, borrowers must accept financial covenants and also supply collateral, which limits the available amount of the loan. Above all, the VAR must make personal guarantees, the No. 1 disadvantage of this option. If the VAR-borrower misses the numbers specified in the covenants, the lender has the legal right to call the loan and seize assets should the VAR be unable to tap another source.

Half a notch up the continuum are mezzanine lenders, which issue subordinated debt consisting of both a debt and an equity component. VARs face fewer restrictions with this flavor of lender, but pay higher interest rates as part of the deal and must give up some equity.

Venture capital (VC) firms are the next stop. They supply private equity, which is defined as equity in a privately negotiated transaction, for a defined period; the stock market provides public equity through a non-negotiated transaction for an indefinite period. On the plus side, VC sources have large pools of capital and will work with companies that lack an established record. But the VAR pays dearly for the privilege because those typically institutional investors require an equity share that may exceed 80 percent, and expect average annual returns ranging from 25 percent to 40 percent. iXL's investors, for example, include affiliates of Kelso & Co. and CB Capital Investors. They own 25 percent and nearly 13 percent of the company, respectively.

The exact terms on individual deals depend on the perceived value and risk of the company, and the amount of cash it seeks to raise; the more value the VAR brings to the table, the smaller the ownership share relinquished and the expected rate of return. VC providers may also insist on board membership,which may be a pro or a con,and have a specific exit target of four to seven years.

In past years, the VC community has demonstrated an increased interest in service companies, which have been an enigma to lenders. That's because service companies typically have little in the way of collateral to offer venture companies. Because most of the assets in a service company are people whose sudden departure could materially affect an organization, venture capitalists assume great risk when lending money to these channel companies. The projected growth of those organizations and the proven stability of their model, however, have made them attractive. For example, Kleiner Perkins Caufield & Byers helped fund Viant Corp. (VARBusiness 500 rank: 479), formerly Silicon Valley Internet Partners, one of the first service companies ever funded by the Silicon Valley venture group. The investment will pay off when Viant goes public this month.

Angels are a type of venture capitalist most suited for early-stage enterprises needing relatively small amounts of capital, up to $2 million or so. Unlike their institutional brethren, they invest their own money and therefore have no external constraints. (VC firms are obligated to the investors in the pool.) Consequently, they usually have a longer time horizon. The downside is that angels are difficult to find; friends and family are a popular but limited source.

Finally, IPOs represent the crown jewel among funding sources. The pros include recognition, large amounts of available capital, a public security that can be used as currency for transactions and lower costs than the private equity alternatives. The latter is because publicly traded stock is more liquid than the ownership shares transferred in private equity deals. The big disadvantages are that VARs cede control and must clear a high hurdle in terms of company size and history, with dot com enterprises being a notable exception.

Whether the IPO route turns out to be the most prudent course for many types of channel companies remains to be seen. Certainly, many of the new Internet channel companies prize the new currency that an IPO can provide. But many also struggle with the unwieldy burden of trying to balance short-term concerns with long-term interests. There's also the ongoing concern over share price. Since its IPO, Proxicom's shares have hovered between $17 to $27.75. Not bad for a stock that debuted in the midteens, but it's certainly no eBay or Amazon.com.

For its part, iXL has fared slightly better, though its stock is too new to make any meaningful comparisons. Its proposed offer price was $10 to $12 per share. The company debuted at the high end, and then jumped above $20 before closing at $17.88. Where it goes from here is anyone's guess. One thing is for sure, however: You can bet that kind of uncertainty will dissuade very few from pursuing what many believe is the pinnacle in funding,the IPO. Even those who have once been rebuffed now eye the IPO as an ideal funding source. Tom Velez, founder and president of Computer Technology Associates Inc. (VARBusiness 500 rank: 154), a Bethesda, Md., VAR, says he is seriously considering an IPO, three years after ditching plans for a previous IPO. "The market is right, and my company is completely repositioned and in stride with prevailing conditions," he says. (See "CTA May Go For IPO")

Conditions may indeed be right, although that, of course, can change on a whim. Regardless, analysts who follow service companies and track their businesses believe this is indeed a special time in the industry. At this early stage of the Internet's development, it is more important to establish a brand, a capability and a market position than a short-term profit stream. At some point, however, even the new finances have to add up to long-term viability, says Bill Martorelli, vice president and analyst at the Hurwitz Group Inc., a Boston research company.

"Over time, the 'gee whiz' factor is going to become less valuable," says Martorelli, adding that companies that emerge today are going to have to prove their net worth at some point. He, for one, has no doubt that several will. Martorelli expects several new service giants to emerge from the pack, just as several companies did shortly after the birth of the mainframe services market and again after the creation of the client-server business.