At first glance, New Jersey-based security firm NetForensics appears to be the kind of company that investors would flock to during rough economic times. Unlike the dot-coms of recent past, the company has a product, a substantial customer base and is generating revenue. In addition, NetForensics counts among its initial investors Cisco Systems, a strategic partner with a 1,000-person sales force pushing its product. And yet the company’s most recent fund-raising experience was anything but a slam-dunk.

Over a five-month period in 2001, NetForensics met with dozens of venture capital firms in an attempt to get the financing terms it desired. In the end, the company was able to raise a total of $13.8 million from lead investor SoundView Ventures, along with participation from two other new investors and its existing investors. Given the current economic climate in the technology sector, raising $13.8 million is nothing to turn your nose up at. But the company was forced to settle for a down round and faced a number of obstacles along the way.

Setting the Table

After raising $7 million in its first round in late 2000, NetForensics spent the first quarter of 2001 preparing to begin pitching investors in May. Working closely with Cisco and its other previous investor, Storm Ventures, the company outlined the total amount it wanted to raise and the valuation it was looking for. According to CEO Rajeev Khanolkar, NetForensics hoped to raise around $10 million, which he figured to be enough to last the company well into 2003. And where the money would come from was as important as the size of the round. The company wanted investors that could provide senior-level industry contacts that would help it generate new business.

Much of the early preparation focused on honing the company’s pitch to investors. A two-minute summary essentially outlines what the company does, why it’s important to customers and why its product is superior to other products on the market. Khanolkar says he was confident that NetForensics had a compelling story to tell investors. The company makes a product that pools security devices from multiple vendors, allowing a company to manage all its security information from a central location through a Web browser. He explains that by centralizing security information, businesses can get real-time insight into their security system and identify potential problems before they occur.

Testing the Waters

From May through August, NetForensics met with between 15 and 25 venture capital firms, averaging about three pitches a month. Many of the meetings came via referrals from the company’s existing investors, while others were more serendipitous. In the case of SoundView, the venture firm actually contacted NetForensics cold after coming across it in a trade magazine.

Early in the process it became obvious that NetForensics might have trouble getting the valuation it wanted. CFO Joe Rooney admits that after a few meetings he realized that stating the figure the company was looking for up front might be turn off potential investors before they had a chance to sell them on the company’s value proposition. “Discussing actual figures, that’s just negotiation; that should happen after you decide if you like the idea and want to be involved,” he says.

Khanolkar and Rooney were also quickly realizing that firms just weren’t investing in that many new companies. “One question I would always ask in meetings is what percentage of deals are now going towards existing portfolio companies,” says Rooney. “The numbers coming back were 80 percent towards existing portfolio companies and just 20 percent for new business. A year ago, better than 50 percent was going towards new business.”

Doing Your Homework
In addition to being preoccupied with their existing portfolio companies, many investors were gun-shy after getting burned by the technology sector’s recent meltdown. “During the bubble, with so much competition between venture capital firms, the pace was quicker and many VCs didn’t have the luxury of spending time with management to understand the business and the market,” says Ed Sim, a Managing Director at SoundView and now a NetForensics board member.

A sellers market had turned into a buyers market, and it meant many VCs were in no hurry to find places to invest their money. In particular, NetForensics found that firms were skittish about being the lead investor in a deal. “A lot of VCs we met with were sold on the whole concept and ready to invest; however, they didn’t want to be the lead investor,” says Rooney. He attributes this reluctance to the fact that a lot of funds just don’t have the resources at the moment to do the necessary due diligence on deals. Indeed, once SoundView came aboard as the lead investor in early September, NetForensics received substantial interest from other firms wanting to get in on the round.

For the venture firms that did show interest after the initial pitch, several months of rigorous due diligence followed. It is this aspect of the fund-raising process that is perhaps the biggest change from the go-go days of the dot-com boom. The due diligence process today resembles more of a 1950s-type courtship rather than the shotgun wedding atmosphere of the late ‘90s. Investors take months to check references, talk to customers and industry analysts, and make hardcore assessments of a firm’s technical and financial performance. For startups, such intense scrutiny of their business means understanding your market segment — and having solid references is essential.

One way NetForensics found to assist in the due diligence process was to be brutally honest when describing the current state of the company. “If you’re not doing a thorough self-analysis, it looks like management is just ignorant,” says Rooney. For NetForensics, that meant admitting the company’s strengths and, more importantly, its weaknesses. As SoundView and other potential investors pointed out, the company lacked the resources to go after its international sales market and it needed a new vice president of marketing. Sim says that by being receptive and open to such feedback, NetForensics accelerated the process and avoided the dance of “making everyone happy.”

Closing the Deal
By the end of the summer, NetForensics had narrowed the list of potential investors to a handful of candidates. While the company received term sheets from a number of firms, it went with SoundView for several reasons. Most importantly, SoundView’s opening bid was close to what the company had hoped to raise. While the deal would still end up being a down round, the SoundView terms were substantially better than what others were offering. NetForensics also liked the fact that SoundView had invested in several other security companies and was based on the East Coast.

The company signed the term sheet two days after the tragedies of September 11. As further evidence of just how much the due diligence process has changed, the term sheet was subject to successful completion of yet another round of review involving further accounting and legal analysis, along with a thorough inspection by a technology consultant.
With the initial $10.8 million raised, the company then decided to pursue an additional $2 million from a strategic partner. After meeting with the likes of Computer Associates, Oracle, IBM and EDS the company settled on Philadelphia-based cable giant Comcast. The entire $13.8 million round was finally completed in early January 2002.

“I think it should not have taken this long, given the company has a product and revenue, and the fact that it ended up being a down round. But I’m glad we got it done,” admits Sanjay Subhedar, general partner at Storm Ventures. Subhedar attributes NetForensics difficulties to a combination of a rough economy and the fact that it’s easier to raise money for very early- or later-stage companies, given the current difficulty in making accurate revenue forecasts. He also notes that security is a nascent and complex market that often requires an extensive education period for those not familiar with it.

Hitting the Pain Points
Clearly, the days of companies raising money based on a light bulb over a CEO’s head are over. Today, perfecting your pitch, knowing your market and having solid connections in the VC community are essential to a successful road show. “There’s a ton of VC money on the sidelines right now,” says Sim. “The difference is investors aren’t looking for the next Big Thing anymore. They are focused on solving customers problems.”

Overall, Khanolkar is happy with what NetForensics was able to accomplish and believes the company got a fair valuation. “The major problem is showing maturity. You must be able to present your story, the market you’re in and what sets you apart,” he says. “As we went along, our presentations got better.” With this challenge behind it, the company is already looking ahead to its next milestone: reaching profitability in three to four quarters.
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