Traffic Station Restructures To Win its Venture Funding
By Edvard Petterson
Staff Reporter

IT took Traffic Station Inc. Chairman and Chief Executive Geoff Halstead a good two years before he could persuade a venture capital firm to invest in his company.

"We were unusual in that we were originally a joint venture between two established companies," said Halstead "Be cause of this ownership structure, we were going to require more heavy lifting from a venture capital firm than other companies might have."

Traffic Station provides real-time traffic information to commuters and businesses in 20 metropolitan areas in the United States. This information is available on the TrafficStation.com Web site, but users also can get customized traffic reports via their mobile phones, pagers and handheld computers.

In addition, partnerships have been established with so-called portal sites on the Internet, such as those run by Microsoft, AltaVista, and Infoseek/Go Network. These portals include Traffic Station's information on their web sites.

Although this arrangement provided the startup with the financial backing to start operations in fall 1997, it also proved to be a serious obstacle to attracting venture capital.

"We looked at the company about a year before Zone Ventures funded them', said Paul Nadel, president of East/West Capital Associates. "The unorthodox ownership structure was one of the main reasons we did not invest in them at the time. The business model was also still too much a business-to-consumer model back then, and the business was a little young anyway."

Under the old ownership structure, the management team at Traffic Station did not have enough equity. The owners were a group of six founders of Alpha Base and Diablo Productions, and Halstead, as one of the six, had a relatively small share in Traffic Station.

When Halstead connected with Zone Ventures last summer, the venture capital firm like the business plan and the management team, but would only agree to invest in Traffic Station if the ownership structure were overhauled.

"We wanted to transfer a large part of the original founder's share in the company to the CEO and the CTO (chief technology officer), said Darius Sankey, a partner with Zone Ventures. 'The basic assumption is that you want the management team to be committed to the company and to have a substantial financial investment in it. We look for at least a 10 percent share for the CBO at this stage, because it gets diluted over the next rounds of financing. Halstead had only a 2 or 3 percent share at the time, and that was not enough for us."

It required lengthy negotiations to persuade the original owners to make the financial sacrifices that were required to secure the investment by Zone Ventures. In the end, only three of the original investors stayed with Traffic Station, while the other three went back to Alpha Base and Diablo Productions.

"It was a difficult process," said Halstead. "The founders who left had earned their equity in the company and they needed to be convinced that this was the best thing for the company. Zone Ventures held a firm line on this issue, because they know how important it is for a startup to be structured properly."

Weeks after the company had finalized the reorganization and the deal with Zone Ventures was on track to be completed, Halstead went back to East/West Capital and secured additional financing.

"The company came back to us and said they had solved the issues that we had raised previously," said Nadel. They had dealt with the ownership situation, their business model was now a more business-to-business play, and the market was coming around for their product. Halstead had pulled this thing off."

In the end, Halstead landed $3.5 million in a first round of financing from Zone Ventures and East/West Capital.

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Only Most Tenacious Entrepreneurs Land Funding...

by Edvard Petterson
Staff Reporter

THE amount of venture capital pouring into Los Angeles may suggest that cutting a deal with a VC firm has become a snap for start-up companies but the process remains long and complex - and only the best prepared and most tenacious entrepreneurs wind up with a check.

From submitting a business plan to meeting face-to-face with a VC firm, to working out the terms of an investment, there are numerous pitfalls that can wreck a deal. The biggest hurdle for many startups is being heard above the noise.

Case in point: eCompanies Venture Group in Santa Monica has received no less than 7,500 business plan submissions through its Web site since it was launched last July. Just one of those has been funded.

"It hasn't got any easier to get financing from a top-tier Venture capital firm, and it definitely helps to be well connected," said Steve Ledger, eCompanies venture Group's managing general partner. "On the other hand, there is a much larger variety of options than there ever was for early-stage financing from angel investors to large financial institutions that have entered the field."

Many startups that are successful in securing a first round of financing received seed funding from an angel investor at an earlier stage, and are then referred to the VC firm by the angel investor.

A Solid Plan

While being well-connected helps, it's not enough without also having a strong business plan. Jonathan Funk, principal at Media Technology Ventures, reviews about 1,000 proposals every year, but only two or three of them get funded by his firm.

"We get a ton of stuff," said Funk. "It will typically take me 15 minutes or less to make a decision whether or not I'm interested in an idea."

When a VC firm believes that the idea looks promising the next step it to meet with the management team. This is a critical step because the business plan and management team are the only things a venture firm has to go by in deciding whether to invest.

"This tends to be a touchy-feely kind of a process," said Gary Freemen. a partner with venture investments group of BDO Seidman LLP "There are specific numbers and milestones they can look at and financial models they can run, but the bottom line for a venture capital firm is if they can work together with the management team."

At the initial meeting with the VC Firm, the management team of the startup has the opportunity to make their pitch and show that they and their business are for real. In most cases, this is the end of the story. Funk, for example, has two to three such meetings every week and the vast majority of them do not result in an investment.

On the other hand, if the first meeting goes well, arrangements might be made for the management team of the startup to meet with the other partner of the VC firm. Typically a VC firm will require a unanimous endorsement from its partners in order to cut a deal, but in some cases a majority decision will do.

Down To Brass Tacks

At this point, the VC firm and startup will look seriously at the nuts and bolts of the deal and begin hard negotiations. In the past, it was standard procedure for the venture firm to do its due diligence before discussing terms, but given the fast-moving marketplace, what had been a linear process has become a parallel one.

"It used to be that when you got to term sheet you were at the 25-yard line," said Ledger. "Now it means that you're only half way down the field. We have to start looking at the terms before we have decided whether our heart in really in the deal simply because of the competitive nature of the business."

The most contentious issue in working out terms tends to be the actual worth of the startup. In other words, how much will the VC firm invest in exchange for what equity stake.

"You want to have general discussions about the value of the company early on," said Funk. "Many deals fall through over this issue so we want to make sure we're not too far apart from the outset and that the company doesn't believe they're worth S50 million when we think they're worth $20 million,"

Given the super-high valuations of many high-tech companies, however, traditional ways of measuring the value of a startup have pretty much gone by the wayside.

"The valuation of a startup is pretty highly negotiable," said Freeman. "There are really no good benchmarks, and we can tell in entrepreneur only if something is very much out of whack. The rest really depends on their negotiation skills."

Other important issues that are discussed at this point are the composition of the board, the terms of ownership of the founders, the option pool, liquidation preferences, and other structural issues. None of these tend to be deal-breakers, though.

Simultaneous with these negotiations, the VC Firm will conduct its due diligence on the startup and conduct background checks on the management team, look into any intellectual property issues, and research the startup's market.

Once the due diligence process is completed and the term sheet is signed the startup is handed the check. The whole process, from beginning to end, may take eight to 10 weeks.

"Five years ago, it would be very rare to complete a deal this quickly," said Ledger. "But markets are changing so quickly now..."

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