Show Me the Money

Even in the Internet services space, few companies have funding histories as short and sweet and well-timed as the financial life of Web integrator Breakaway Solutions Inc. At the end of 1998, Gordon Brooks cashed in his stock options and walked out of Cambridge Technology Partners Inc. with a vision of an Internet services company that would provide a complete range of services to the middle market--from application services to creative Web design. Usually, you can't put dreams in a bank, but less than a year later, Brooks' vision had a cash value of $48.3 million: Breakaway completed its IPO with 3.45 million shares of common stock at $14 per share, three times its offering price.

Breakaway, Boston, had in abundance one of the most important ingredients of fast-track success: good timing. Brooks, president and CEO, launched his quick march from idea to IPO just when the public and private markets were falling all over themselves for ideas like his. His only hiccup so far was in April, when he decided to withdraw a secondary offering in the face of market turbulence. But even that move showed good timing: Breakaway withdrew the offering on April 13, and on April 14, the Nasdaq suffered its biggest point loss in history.

Although Breakaway's gestation cycle--from fertilization of the idea to birth as a public company--wasn't much longer than nine months, the company's short history offers some instructive lessons about how Web integrators are getting their money, who's funding them and what the investors are getting in return.

Beyond Cash
As Brooks realizes, one of the most important steps in successful financing is finding the right partners. Breakaway has had a single major investment partner since the beginning--Internet Capital Group Inc. (ICG), Wayne, Pa., which calls itself a "holding company" but acts in many ways like a venture capital firm. ICG invests in young enterprises in exchange for a piece of the action. An investor should be more than just a source of cash--a good partner such as ICG should specialize in an industry and bring management expertise, industry knowledge and a wealth of contacts to the table.

When he left Cambridge Technology Partners, Brooks wanted to build a company that would capitalize on four trends: the growth of B2B e-commerce, the growth in Internet professional services, the growth of hosting and what Brooks calls the "emergence of the midmarket as a huge buyer of hosting and commerce integration services."

Brooks didn't have time to build the company from scratch. Mindshare is as critical in the Internet services space as it is in the B2C e-commerce world, he believes, and he wanted to quickly become the biggest provider anywhere of Internet services to the midmarket. So he started looking for "foundational companies"--companies he could acquire that would give him a step up into the market in a hurry.

Brooks turned to Chris Greendale, managing director of operations at ICG, with his idea. Greendale helped him find an acquisition target: The Counsel Group, an 80-person Boston-based company specializing in CRM and commerce implementations for midmarket companies. "It was a small company that was technically excellent but did not have the ability to create a new market or go out and market itself and do the things it needed to do to be a national player," Brooks says. "They had good middle management, really good project management and very little executive management."

With ICG backing, Brooks also acquired Applica, a New York ASP, and WPL Labs, which Brooks describes as "a really high-tech commerce implementation company out of Philadelphia." He funded the acquisitions with the promise of ICG capitalization, a promise realized when ICG pumped $8.3 million into the infant company in January 1999.

Brooks hit the height of the seller's market for venture capitalization last summer. When he needed to raise $14 million for a secondary round of financing, he could dictate the terms to potential investors.

"It sounds arrogant in hindsight, but it made sense at the time and worked great," he says. "We talked to nine institutions and said, 'We're going to raise $14 million; we're only going to allow two of you in, and it's going to be the two that offer the most value beyond capital. The meeting is on this date in Boston; you're all going to come together, and you have to sign the terms sheet before you come. The price is already set.'"

Brooks wound up raising $5 million more than the $14 million he wanted, and he took on four, rather than two, new investors,Crosslink Capital Inc., GE Equity, Intel Corp. and Morgan Stanley Dean Witter & Co. joined ICG as Breakaway's investment partners. "We took more than we planned because there was so much demand, but they were people who could really add value," Brooks says. Having a company such as Intel on board, for example, lends automatic credibility to a young company like Brooks'.

With plenty in the bank, Brooks can wait until the market turns favorable again before he launches his secondary stock offering, but he has every intention of continuing Breakaway's explosive growth (484 percent from the first quarter 1999 to the first quarter of this year). Breakaway has already added a London office to its 10 U.S. offices as it moves toward market dominance.

Tougher Times
Last year was golden for Internet services companies. AppNet Inc., iXL Inc., Modem Media, Proxicom Inc., Razorfish Inc., Scient Corp., US Interactive Inc. and Viant Corp. were among the companies joining Breakaway on the Nasdaq. But not every company enjoyed as quick and easy a path from idea to IPO as Breakaway. When Jonathan Nelson and three partners launched Organic Inc. in San Francisco in 1993 with a mere $5,000 in seed money, Nelson went to a venture capitalist on Palo Alto's Sand Hill Road for backing. "We were probably one of the first business models based on the Internet he had ever seen. We couldn't even get ourselves arrested," he laughs.

The result was three years of hand-to-mouth existence. "We were forced to really bootstrap ourselves," he recalls. But when the Internet began to take off, Nelson finally got backing for expansion of his company, which he had grown slowly to more than 60 employees. "We looked at venture financing, strategic partnering and bank loans," he says. But he chose Omnicom Group Inc., a New York communications holding company, "because Omnicom wasn't pushing us toward an IPO the way a venture capitalist would. They didn't care about an exit and tended to have more of a hands-off management policy."

Nelson sold a 19.9 percent stake in Organic at that point, diluted the stock as low as 15 percent with a series of stock option plans, then raised a second round in capital from Omnicom, bringing the holding company's stake back up to 19.9 percent in 1999. Then he did one last round of financing--"just a credit facility to backstop us"--before the IPO, which saw the company raise $125 million by Feb. 10 this year, opening at $20 per share and hitting almost $40 at the close of its first day of trading.

Another company that had a tough financial start before the VC market caught up with its ideas is Navidec Inc., a rebranded company based in Greenwood Village, Colo., that began as a VAR in 1993. In 1995, the company began working as an e-solutions developer, bringing some of its client base with it.

But at that point, "venture capitalists really weren't interested in e-solutions companies," recalls Pat Mawhinney, Navidec CFO. "We spent most of our time explaining what the Internet was and that it was actually going to be something." In 1996, Navidec finally managed to raise $1.5 million from individuals with the help of investment banking firm Joseph Charles and Associates, Boca Raton, Fla.

Navidec had a small IPO in February 1997 before Internet fever swept through the investment world, going out at $6 and then tripling that. The company launched a secondary offering last year at $9.25 and also received a strategic investment from Wells Fargo & Co. that brought in some $25 million.

With its 11 million shares trading recently at more than $8, Navidec now has a capitalization in the $90 million range, with 20 percent ownership by employees and management, 10 percent by Wells Fargo, 3 percent by Sun Microsystems Inc. and the rest by the public.

Navidec went public too soon to catch the height of the Internet market, according to Mawhinney.

"A few people were financing the Amazon.coms and Netscapes, but people really didn't understand e-solution providers. So we went out with a very small underwriter doing a very small public offering back in '97 and we weren't able to catch much attention from investment bankers until 1999. Even at that point, because we were doing a secondary offering rather than an IPO, it hampered us somewhat."

Going public early had one advantage, however: It forced Navidec to be business-oriented. "We developed an e-solutions [company] for approximately $6 million, where the rest of the world was doing it on $50 million to $100 million," Mawhinney explains.

Capital Gains
In the wake of the past few months of market uncertainty, venture capitalists and other potential investors have begun to ask tougher questions of Internet services companies, but a large pool of capital is still available.

The first quarter of 2000 saw a record $22.7 billion in VC investments, a 266 percent increase over the $6.2 billion invested in first quarter 1999, according to the National Venture Capital Association. At $12.4 billion, computer-related investments represented more than half of the quarter's VC investment, growing fivefold from the $2.5 billion in computer-related VC investment in the first quarter of 1999. Although the percentage of VC investment in services dropped from 35.93 percent to 23.29 percent, in absolute dollars it more than tripled, from $1.1 billion to $3.9 billion.

According to PricewaterhouseCoopers' "Money Tree" quarterly study of VC investments, the VC community poured $10.7 billion into Internet-related companies in first quarter 2000, "a pretty good indication we are still on a roll as far as funding Internet companies is concerned," says Tracy Lefteroff, U.S. managing partner of PricewaterhouseCoopers' Private Equity and Venture Capital Practice. "Some areas are probably having trouble, such as the business-to-consumer space, but in most other areas like Internet services, business services, Internet software tools and Internet access and infrastructure, the interest is still very vibrant and the funding is overflowing." Even in the wake of April's Nasdaq nosedive, VC interest in the Internet space is heated, Lefteroff says, especially in Internet infrastructure and telecommunications.

But Terrence Tierney, vice president and senior research analyst of technology at Minneapolis-based U.S. Bancorp Piper Jaffray, says the easy money should last through next month, and then begin to dry up.

The myth, for a while, was that an Internet entrepreneur could walk into a VC office with a slick PowerPoint presentation and walk out with millions in first-round funding. "I'm not sure that was ever true," Lefteroff says. "Most of the venture guys I deal with have always done a fair amount of due diligence. But certainly now it's not true. Because of what's going on in B2C, venture [capitalists] are taking a closer look at all their companies and asking what the revenue model is and how the company is going to make its money."

Criteria For Cash
Stephen Lane, senior analyst at Aberdeen Group Inc., Boston, agrees that VC firms are being much more careful now and taking a much closer look at business plans than they were in the recent past. "Even with rebranded firms, they're asking about their client base and their history in terms of repeat business. If you show a venture funding firm you have a track record and clients who are going to be your target market, you're going to get a lot more positive attention," he says.

The quality of the management team is one of the key issues VC companies and other investors examine before they stake their money, Lefteroff says.

One reason Breakaway had such an easy time in its second round of funding was the management team who had been there and done it before. "Six of my senior executives had been CEOs of their own companies," Brooks says.

"Top-tier clients are the primary thing integrators must show," adds Steve Harmon, principal of E-harmon Zero Gravity, San Francisco, an Internet holding company. "The proof in the pudding is if large corporations are buying their services."

Another key funding criterion is a clear business plan, one that demonstrates both a clear path toward profitability and a sharply defined business focus differentiated from the competition.

Aberdeen's Lane says he sees a lot of what he calls "Lake Woebegone syndrome," where all the young companies are above average (they say), and it becomes hard to distinguish one company from the next. "The clearer they are about what they do, the more I focus on them," he says. When a company tells him something it won't do, then Lane knows it's clear about what it does do. "Sometimes it boils down to how clear they are in terms of defining their value proposition," he adds.

For a while, even the potential of profit seemed like the last thought on the mind of any would-be investor in the Internet space, but today "venture companies are taking a closer look at all their companies, asking what the revenue model is and how the company is going to make its money," Lefteroff says.

"The profit can all be prospective, but the venture capitalist wants a business model that, first, shows someone will buy a product or service, and, second, that it will be priced in a manner that they can actually make money off it." n