BUSINESS NOTHING VENTURED…

Can hi-tech hopefuls find cash in Dallas?

AN EXPLOSION of hi-tech entrepreneur-ship during the past year or so has illuminated a somewhat embarrassing shortcoming in Dallas-a city that prides itself on being one of the nation’s high-technology havens. Dallas, it seems, is still the place that breeds or beckons hi-tech enterprises and enterprisers, particularly if their fledgling companies feature “computers” or “communications” in their names or games. Here in the town of Sunbelt charm and brainpower, the creative entrepreneur can still find everything he needs to make a start. Everything that is, except money. For that, he goes to San Francisco or Boston or New York.

“We would not be alive as a company today if I had not been a native of San Francisco,” says O. Woodward Buckner Jr., chairman of Mastercare Pharmacy Systems, a young Dallas company with proprietary health-care software and systems already in production. It took Buckner and entrepreneur partner/Mastercare president Arthur Loughry about a year and $2.5 million worth of what Buckner calls “mosaic” financing to get the company ready for second-stage financing. After knocking on some Dallas doors, they found their second-stage money on the West Coast, where a consortium of specialists in health-care computer-related investments offered financial support.

“Then, suddenly, a company we had been talking to in Dallas got interested in us, and that was the result of the other four specialists being interested,” says Loughry, a retired Marine colonel from the Dallas area. “It seems that these Dallas groups want to be thought of as go-getters,” he says.

“That’s not to put down the Dallas venture capital industry,” Buckner says. “All venture capitalists like to invest in industries they know something about. If you were doing something in electronics, you could find some help here.” Ditto for oil and gas-at least in the past, says Buckner. But for a computer-based software concept…good luck.

Is that an unfair indictment of a city and its admittedly well-resourced financiers? No, it’s merely a way to highlight what has been a critical Dallas business illness. Despite this city’s claim to financial prowess and banks that claim to back an entrepreneur all the way, very few financial institutions here are interested in backing him in the beginning-particularly if he’s speaking a micro-babble of “bits” and “bytes” while they’re thinking cash flow and pay back.

It’s not really a bank’s function to offer startup capital, of course. Regardless of what one may have seen in TV commercials, banks require more than good ideas to produce collateral for loans. And entrepreneurs require more than pure debt financing to get their ideas off the ground. They need “equity” money-financial backing that is willing to wait out the start and early growth of a company because it has a stake in the company’s ownership. That kind of money-if it doesn’t come from an Aunt Mildred or a second mortagage on the entrepreneur’s house-is usually found with people called “venture capitalists.” Compared to some cities. Dallas has few of them.

So, basically, if you want to talk to someone knowledgeable about the current top five industries that are most attractive to venture capitalists, you’d best venture out of town- indeed, out of state-to do it. (Those five industries are data communications; computer software and peripherals; health-care delivery and medical-instrumentation products; prod-ucts and systems serving the “office of the future”; and robotics.) The Dallas-based venture capitalists we spoke to agreed with Buckner that the industry in this city is “immature” and “lacks sophistication”

Dallas officially has 11 of 33 venture capital firms in Texas, according to the seventh edition of the Guide to Venture Capital Sources, published earlier this year and considered the bible of the venture capital community. The guide omits at least another dozen qualified Dallas groups aiming for anonymity. It certainly excludes many venturesome family-based funders such as the Murchisons, Wylys or Jonssons -famous names with moneyed mox-ie and the professional managers to deliver it to selected recipients.

But the guide requires only four pages to name those venturesome Dallas institutions and partnerships that agreed to be named. Twelve pages cover the entirety of Texas venture capital. This compares to 23 pages required to list Massachusetts firms (mostly in the Boston area) and 53 pages required to list California firms (mostly in San Francisco). We cite these particular states because Texas- primarily Dallas-is trying to establish a presence as the “Silicon Prairie,” the equal or better of the hi-tech concentrations in California’s Silicon Valley and Boston’s Route 128. Few would argue that Dallas is attaining that status, but it’s not doing so by putting money where its minds are.

According to the guide, more than eight in 10 venture capital sources in Boston, New York and San Francisco say that they are prepared to provide an entrepreneur with start-up capital. This implies a willingness to finance a business that has been organized but has not yet completed product development.

In Dallas, however, only two of the 11 firms listed indicate a willingness to supply “seed” or start-up capital to young companies, meaning that the other nine won’t talk to an entrepreneur until he either has a prototype product ready to enter production (first-stage financing) or is producing and shipping a product and needs expansionary working capital (second-stage financing).

“Traditional venture capital means institutional investors with very explicit parameters concerning a company’s projected growth rates, the investors’ points of entry and exit and a desire to avoid anything resembling a crapshoot,” says Dallas attorney Mike McCollum, former associate of SMU’s Caruth Institute of Owner-Managed Business. “Entrepreneurial investing is what I’d call the precursor to traditional venture capital, but the question is, how many truly entrepreneurial investors are there in Dallas?

Not many, McCollum implies, because the venture capitalists themselves are in an entrepreneurial state. Of the 11 Dallas firms listed in the guide, only six were founded earlier than 1980; five of those didn’t become more than peripherally active until after 1980. Besides being categorized as “conservative,” Dallas’ venture capital business might also have to be ranked as “green.” But the situation is turning around, even if a certain amount of imported sophistication is required to do it. Buckner predicts that “Within a year, you’ll see a half dozen or more of the top names in the [venture capital] business either opening their offices here or participating in a Dallas-based venture capital fund.”

His reasoning is that a number of outsiders have already funded hi-tech start-ups that have elected to grow in Dallas. “And the tendency is,” he says, “once you’ve made an investment in Dallas-to look for another investment opportunity in the area.” If nothing else, the additional investment saves the time and money necessary to visit one’s capital recipients in this area. Why not visit two or more companies for the price of one? As Buckner sees it, the next logical step in economizing is to open an office here.

While an invasion of expertise from Silicon Valley, New York City or Route 128 is likely, the current method of overseeing investment in Dallas entrepreneurs is to work through a trusted local venture capitalist. Oddly enough, one of the most trusted is also one of Dallas’ youngest. Sevin Rosen Management Co., whose principals Buckner says he wishes he had met when he was in the throes of second-stage capital thirst, has come on like venture capital gangbusters in just two short years of existence. Dr. Truman Blocker (who has a doctorate in physics from the University of Pennsylvania) says he’s glad Sevin Rosen was around when he and Dr. Mark Miller (who has a doctorate in computer science from MIT) decided to start a Piano-based software company.

“I had been at Texas Instruments for 15 years, and when I came there in 1966, L.J. Sevin was then an engineer who had a dream of building semiconductor memory for computers,” Blocker says. “He left in 1968 [to co-found Mostek Corp.] and wound up developing the first 4K RAM [random access memory] in the world. It was that that is responsible for developing what we have in computer power now.”

Sevin, a former Mostek chairman, departed the company about 14 months after its 1979 takeover by United Technologies. With Benjamin M. Rosen, a top-ranked New York-based electronics industry analyst, he then founded a private venture capital fund that managed to raise $25 million from 20 institutional investors, despite the founders’ warning that they had absolutely no experience managing such a fund. That fund has since helped start or financially assist 17 new hi-tech companies-including five in Texas and, ironically, seven in Silicon Valley-during the past two years. But Blocker says that with respect to his own company, Computer*Thought Corp., that’s only half the story.

“Mark [Miller] and I had in mind starting an educational systems company, and L.J. Sevin really started us off,” Blocker says. “We raised about $1 million on the initial offering, and L.J. brought in the original investor, American Research and Development [ARD].” (Boston-based ARD is widely credited with beginning the institutionalized venture capital industry in 1946.)

Subsequently, eight other venture capital investors, including General Electric Venture Capital Fund, Harvard University Trust, First National Bank of Boston and, of course, Sevin Rosen, entered Computer*Thought’s financing picture to the tune of almost $2.5 million. For that kind of money, Blocker says, he and Miller traded up to 55 percent of their company’s equity.

“That’s kind of hard to accept when you’re thinking, ’This is my company,’ ” Blocker says, “but venture capitalists put a lot of their time and energy-in addition to their money-into making a company succeed. Venture capitalists try to make you succeed, and most people don’t realize this. As a result, our success is much more guaranteed than that of some others.

“L.J. spent four hours with us one afternoon helping us rewrite our business plan,” Blocker says. “That help-from a multimillionaire in his own right-is what gives us a high probability of success.”

Blocker says that Sevin also arranged a telephone conversation that opened doors for his fledgling company: “L.J. got me on the phone with a key executive of Intel Corp. to discuss ideas, and the next thing I knew. I was talking to a variety of decision-makers. It’s that kind of help that you buy when you go with venture capital.”

But Sevin Rosen probably devotes more time to its invested “charges” than most venture capitalists are willing to commit, and it differs from “traditional” venture capitalists in other ways as well. The vast majority of venture capitalists, for example, expect the handout-hunting entrepreneur to submit a detailed business plan and a five-year earnings forecast, typically requiring 150 to 300 hours of preparation and no small amount of market study. Sevin Rosen, on the other hand, has “incubated” four companies in which the entrepreneurial founders had little more than good ideas to begin with. Sevin, in fact, prefers to bet on certain individuals without plans than on those who submit extravagantly prepared “dream” sheets.

“Most business plans are written with a view toward attracting capital, not with…a real perception of what the company will do,” Sevin says. In other words, most plans are far too optimistic.

“I don’t like to read that kind of a plan, and I won’t. But we are available to make consultation [with someone whose plan is incom-plete].”

A more traditional operation in screening and culling business plans is the young Dallas venture capital partnership, Sunwestern Investment Fund, which earlier this year committed to fund eight new or growing companies from a capital pool of more than $11 million. However, to arrive at those eight, Sunwestern Managing Partner James F. Leary says the four general partners looked carefully at 100 of the more than 300 deals or “situations” presented to them directly by entrepreneurs or through referrals. Of those, he says, about 65 received “serious consideration” because of good business-plan preparation and because they were compatible with the expertise and goals of the general partners, all of whom have started and/or managed major business enterprises.

That only eight of the deals would catch the brass ring is consistent with what happens nationally in the venture capital industry. Industry surveys indicate that venture capitalists reject 60 percent of the deals brought to them after a 30-minute scan. Another 25 percent are discarded after a few hours of examination. Of the remaining 15 percent, two-thirds are dropped because serious flaws in the proposed management team, business plan or both are detected.

With five out of 100 qualified entrepreneurs remaining, two are likely to remain unfunded because they will find the venture capitalist’s terms unpalatable-namely, demand for a 20 to 60 percent stake in the company’s equity, depending on how much capital is needed and at what stage of financing. Generally, the newer and hungrier the company, the more control the venture capitalist seeks in case something goes wrong. If it does, the entrepreneur could find himself out on his ear.

Generally, however, this doesn’t happen. “We’re interested mainly in the people. There are lots of good ideas but fewer people who can carry them off,” says Sunwestern General Partner Dan M. Krausse, formerly founder and president of Earth Resources Co. Adds Leary: “We want to see these people succeed. You want to see your [entrepreneur] partners reach such a success that someone will want to buy them or they can be brought public.”

The bottom line of a venture capitalist’s expectations for supplying the entrepreneur with start-up and subsequent capital and sitting on that investment for seven to 10 years is typically to get out of the business with stock or warrants worth fivefold or better in a public offering.

Sometimes they hit home runs. Dallas Business Capital Corp. (now called DASBIC Inc.), one of the city’s oldest venture capital-type financiers with a 13-year history, recently sold a 7.1 percent stock position in Richardson-based Electrospace Systems that returned it $14 million, or more than 700 times DBC’s historical carried cost of those shares. On the other hand, says former DBC officer Elroy Roelke (now president of an affiliate company), DBC also has walked a few of its charges through Chapter 11 bankruptcy proceedings and into new managements.

However, Buckner of Mastercare indicatesthat a company’s chances of successfully obtaining money from a source are greater whenit has gone through the drill necessary to impress a venture capitalist: “The venturecapitalist wants to come in when he can seepeople, markets and technologies, in thatorder. If you don’t have the people, he’s not going to look at your markets. If you don’t havethe markets, he’s not going to examine yourtechnologies. The management team and marketing plan must be complete before you see aventure capitalist. But if you can show him excellent people, you’ll win the day even with anaverage product.”

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