I finally got around to my quarterly comparison of deal terms published by our firm, Fenwick (a Valley based firm that reports on transactions in the Valley) and Cooley (a firm with many offices that reports on transactions handled by it).

And here of New York:  No one that I am aware of reports on New York transactions.  But, starting with Q1 o f 2012, we will, because we are doing increasing amounts of emerging company work there.

So here is part 1 of my thesis:  I expect that terms will be most favorable to entrepreneurs in the Valley, least favorable in New England and somewhere in between for the rest.  Of course, I think that the “somewhere in between” number will include Cooley’s New England transactions (which will have the effect of making them generally seem less favorable to entrepreneurs).  We should all note that Cooley feels compelled (at least in some instances) to report numbers for Northern California separately from the others.

So, without further fanfare, below is the table that compares certain of the deal terms reported on by the three firms for Q4 of 2011.

Fourth Quarter 2011 Transaction Terms

Of course I knew what the chart would say before I made the prediction, so no surprise that it supports my thesis.

Here, however, is part 2 of my thesis:  When we start reporting on New York separately (which we will be doing starting with a Q1, 2012 report – to come out soon), it will show that terms in New York are far closer to those in the Valley than to those in New England.  Now I don’t’ know the answer to that question, but we are doing the research now and will have an answer soon.

Keep in mind that New York has gone from nowhere just a few years ago to equaling (or passing by some measures) New England.  Could it be that NYC is just a friendlier place for entrepreneurs than New England?

Here is what my partner, Dave Pierson, had to say about Q1 activity, “The total number of New England Series A transactions dropped 46% from Q4 …. The total number of New Englsnd Series B and Later round transactions during Q1 decreased 21% from Q4…”

Fenwick had similar observations.  Fenwick had this to say, “Venture capitalists invested $6.4 billion in 661 deals in the U.S. in 1Q11, compared to $7.6 billion in 735 deals reported in January 2011 for 4Q10, according to Dow Jones VentureSource (“VentureSource”). Although this represents a 16% decline in dollars and a 10% decline in deal volume from 4Q10, the 1Q11 results were generally flat with the average of $6.6 billion raised per quarter in 2010.”

All I can say is that either Foley Hoag is lucky or the venture world took off in Q2.

Here is the open question, given the turmoil in the public markets, will I have written plenty of new posts and be lamenting the amount of time available for such pursuits?

Without further adieu, below is the same table I produce each quarter.  This is, of course, a table reflecting Q1 activity.

There is no surprise in these numbers.  They have followed a consistent pattern from quarter to quarter for as long as I have been tracking them.  Note the greater frequency of dividends and redemption provisions in New England deals.  Having wondered about why there is not convergence on terms, given that so many of the leading venture firms do deals on both coasts and having asked a number of people in the business about it, I have come to the conclusion that it the divergence in these terms reflects a basic cultural bias.  New England just has more of a lender mentality than the Valley.

As I have done each quarter for some time, this blog presents a comparison of the published statistics relating to venture deals from my firm, Foley Hoag LLP, and the west coast firm, Fenwick & West LLP.  This time I am not including Cooley LLP because their year end edition has not yet been published. 

Here are some general thoughts:

Foley Hoag, in our publication Venture Perspectives, reported on a total of 46 deals in New England.  Fenwick reported on 95 deals in the Valley.  This puts the New England market at about half the size of the Silicon Valley market  -- entirely consistent with historical norms (at least for so long as I have been observing the scene).  The new comer, of course, is New York, where, according to Crain’s New York business.com, there were 51 financings in Q4 in New York in the following industries 20 in software, 17 in media and 14 in IT (for sure there were other in other industries). 

On the one hand, this might suggest that New England is losing ground to NYC.  On the other hand, it suggests that the north east (New England plus New York) is now as big a market as the Valley and is probably growing faster given the velocity in NYC.  (I can hear the Valley folks saying you’ve gotta include Seattle and San Diego – whatever.  If that is where they take it, they have in effect conceded the point.)

Even more interesting, is that most of the New York deals are software, digital media and IT related.  Based on anecdotal evidence there were a significant number of digital media deals in New England (unfortunately, our survey lumps media in with software so I don’t have precise number).  According to Fenwick, the most active sectors in the Valley were software followed by cleantech and hardware then came internet and media followed last by biotech.

If I had to pick something hot today, it would be internet and digital media – and the epicenter is not in the Valley!  The reasons for this are almost certainly that the advertising industry is headquartered in New York, there are lots of digital and data infrastructure companies in New England, and there is lots of money in New England and New York to fund these businesses.  It is efficient to be near the relevant infrastructure (the advertising world).  Apologies to Nivi and all the other “you have to move to the Valley” proponents, but if you are working on a digital media company – don’t relo to the Valley quite yet.

So, with that as a background, below is my usual table comparing actual deal terms.

Comparison of Terms for Q4 2010 Venture Deals from Foley Hoag and Fenwick & West

(some percentages are approximate)

It pains me every time I write this, but there is a persistent and consistent difference in terms between New England and Valley deals.  Look at cumulative dividends and redemption.  The numbers are consistent quarter after quarter.  At least as to these terms (and painful as it is to admit, I suspect as to others), entrepreneurs get a better deal in the Valley than they do in New England.

The article makes for excellent reading, and I will not rehash its contents.  Rather, I’m going to focus on the efforts by lawyers like myself to curb the ability of holders of stock of emerging companies to resell their founder’s stock or vested options to third parties in a private transaction before the company’s stock is available on the public market.  Why do we do this?   To control your shareholder base, after all, as an emerging company the last thing you want (as the founding/executive team) is to be dealing with a belligerent activist shareholder.  There are some other side benefits to this as well.  Keep reading for more...

A right of first refusal gives the company the ability to buy back the shares that a seller is contemplating selling to a third party.  The process usually involves the seller of the private stock approaching the company once he/she has received a good faith offer for his/her shares from a third party.  The potential seller must divulge the identity of the third party, the number of shares offered for sale and the price offered for such shares.  The company then has a set period to decide if it wants to purchase the shares at the price offered.  The company also has additional time to raise/arrange for the funds if it does decide to make the repurchase.  To top it all off, the shares that are transferred to the third party might STILL subject to the right of first refusal and potentially even further restrictions that the original shares might have been subject to, for example if the stock was initially granted subject to a voting rights agreement. 

It might be an understatement to say that all of this has a chilling effect on any transactions in the private company stock market.  For one, any potential outside buyer would have to be aware, or would quickly be aware of the company’s right of refusal and right to match any offer made by them.  Imagine for a second you make an offer on interesting stock only to be told that not only does the company  have the right to match that offer once all the particulars of your offer have been divulged but also that they have 30 days to consider if they want to match such an offer.  Unless we are talking about a Facebook or Zynga, chances are most suitors would probably say, “Forget I ever made an offer.”

Why make this process of selling the company’s private stock so difficult?  As hinted before, we don’t want the company to lose its ability to control its stockholder base while the stock is not publicly listed.  Sure, the stock was offered in consideration of work or investments of some sort, but they still have strings attached.  Directors answer to shareholders and in effect shareholders (in the majority) influence the direction of the company.  Activist shareholders, even those with minority stakes, that have goals for the company that are at odds with those of the founding team can be a giant pain to deal with (read: expensive in terms of time, money and distraction).  The right of first refusalin effect gives the company some control on whom its shareholders are.  Equally important, it allows the company to control the number of shareholders it has since having more than 500 shareholders might require registration as a Public company under the 1934 Securities Act.  The rights of first refusal also facilitates two signaling factors that might be valuable to the company: a) the identity of a potential suitor (you want to know who is interested in purchasing stock in your company) and b) the perceived value of the shares of the company in the market (and hence by some extrapolation the perceived value of the company, though only in the eyes of one potential suitor).  As the old adage goes – “something is only worth what someone else is willing to pay for it.”  Having someone make a bid for the private stock of a company can help determine what the value of the company to an external player, which can be invaluable when considering corporate strategy decisions (read: expansion, mergers, acquisitions etc.)

The right of first refusal, one could argue, helps balance the desire of stockholders for liquidity with the company’s desire to control its stockholder base, while still delivering some fringe benefits to the company.

Well, the Q2 results have now been reported on by many sources, including the three law firms that publish data, Foley Hoag (my firm), Fenwick & West (a Silicon Valley based firm), and Cooley.  Unfortunately, I think Dave Pierson from my firm put it well in his analysis of New England based activity, “the environment for venture investing … has generally improved compared to the dismal conditions prevailing last year, but also that pace of improvement has stalled.”

Fenwick described third party analysis of the venture industry as follows, “2010 reported a significant increase in venture investment, mild improvement in venture funded company liquidity, and continued difficulty in capital-raising by venture funds.”

Cooley had this to say, “the second quarter of 2010 produced mixed signals for the venture financing environment.”

In my last post on quarterly results, I described what each firm covers in its reports so I won’t go into that again except to say that my firm’s publication, Foley Hoag Venture Perspectives, is devoted to venture financings for companies headquartered in New England.  Fenwick’s publication is devoted to companies headquartered in Silicon Valley.  Cooley’s is devoted to information taken from transactions in which Cooley served as counsel and is not focused on any particular geography.

Activity Levels

According to Foley Hoag’s research, as a general matter, activity levels for both Series A and Series B and later rounds in New England were up significantly when compared to Q2 of last year.  The data shows a more mixed performance when compared to Q1 of this year.  Perhaps the most striking piece of data is that there were no (as in none) cleantech deals in New England in Q2.  Variability is too great from quarter to quarter to draw much of a conclusion from this fact.  Having said that, it is consistent with anecdotal evidence indicating that VCs are being very cautious about cleantech deals.  Also the flattening between Q1 and Q2 is consistent with anecdotal evidence of a general slowing in the economy.

Fenwick had this to say about activity in the Valley, “Up rounds exceeded down rounds in 2Q10 55% to 27%, with 18% of rounds flat.  This was an improvement over 1Q10, when up rounds exceeded down rounds 49% to 32%, with 19% of rounds flat.  This was the fourth quarter in a row in which up rounds exceeded down rounds. … In general, the cleantech, software and internet/digital media industries had the best valuation-related results in 2Q10, while the life science and hardware industries trailed.”

But, Cooley seems to have slightly different experience.  Cooley had this to say about their findings, “Overall, our data points to mixed signals in the venture financing environment. In Q2, we saw a reversal in a recent trend of increasing up rounds. Though the majority of deals were still up rounds, the percentage decreased to 52% from 61% in the prior quarter. Median pre-money valuations were also mixed. The data showed valuation increases for Series A and C deals, while pre-money valuations declined for Series B and D+ rounds.”

Looked at from 30,000 feet, reports from all three firms seem to have picked up on some mixed results for Q2.  While it is not clear what this augers for Q3 and beyond, it does seem to reflect the general queasiness of the general U.S. economy.

Terms

The flattening trend, if that is a fair description, is also reflected in the terms for transactions.  I have tried to consolidate the deal terms reported on by the three firms in the table below.  This table shows the percentage of deals having a particular term and compares the findings of each firm (to the extent that the firm covers the particular term) with respect to particular terms that appeared in deals closed during the first quarter of 2010.

Cumulative Dividends

Consistent with a long standing trend and as was the case last quarter, the most striking comparison in this table is the fact that more than half of all New England deals carry cumulative dividends but less than 10% of Silicon Valley deals have them.  As I noted last time, “That is huge difference.  And, it is hard to explain. Many VC funds have offices in both markets.  Based on that fact alone, I would have guessed that there would be a tendency to have some homogeneity within a fund and that this alone would cause differences to be much narrower than an order of magnitude.  So, I checked out historical numbers going back a couple of years and this seems to be a persistent and consistent difference between New England and Silicon Valley.  It certainly suggests that Silicon Valley is more founder friendly than New England, I am sorry to say.”

Preferences with Participation

Also consistent with last quarter, the similarities are striking when it comes to participation.  Foley Hoag’s numbers for Series B and later stage deals and Cooley’s numbers for Series C transactions seem to be higher than the norm, but this may well be due to peculiarities in the sample.  As I noted last time, “This really begs the question why there is a seeming convergence around participation but not dividends.”  I would love to get some commentary from readers on this inconsistency in convergence.  BTW, I have again run across a New England based VC (and counsel) who insist that founder reps (covering all the company reps in a superseed deal but with recourse limited to the founder’s equity) are the norm.  I don’t think this is ever asked for on the West Coast, and I think it has been many years since some version of this was the “norm” on the East Coast, but I would also love to get some commentary on founder reps in the context of superseed deals, as well.

Redemption

With respect to redemption provisions, Foley Hoag continues to find that redemptions provisions exist in more than half of all deals or twice as much as Fenwick reports.  Last quarter I thought I had identified a trend away from redemption, but the numbers seem to be holding steady.  I will be curious to see how the numbers trend over the next few quarters.

Pay to Play

The incidence of pay to play provision is low across the board, and I don’t think the small differences are meaningful.

Antidilution

No surprises here:  Weighted average antidilution rules.  Full ratchet deals are rare everywhere, and, I believe, that they reflect unique circumstances.

Conclusion

While it would be nice to be able to report a steady upward trend across the country and across various factors, it ain’t happening.  But the news if not great is not all bad.  As one of my partners, Dave Pierson, put it in his article in Foley Hoag Venture Perspectives, “Thomson Reuters and the National Venture Capital Association have reported that exit activity for venture-backed companies was up during Q2 2010…..There were … 92 M&A exits, down from Q1 2010 but up significantly from Q2 2009.  The M&A exits with reported values generally yielded more favorable returns than in Q1 2010.  Venture-backed M&A exits with reported values greater than 4X the venture investment represented 65% of the Q2 2010 total versus only 45% of the Q1 2010 total. Venture-backed M&A exits with reported values less than 1X the venture investment represented 15% of the Q2 2010 total versus 31% of the Q1 2010 total.”  In addition, there were 17 venture-backed IPO’s in Q2.  This is the most in any quarter since 2007.

Source: Venture Economics, Prof. Paul Gompers HBS      n=1927

Yes… you might want to avert your eyes for this one.

The chart above was first brought to my attention by David Aranoff of Flybridge Capital and geekvc.com fame at a recent ENET event, where he coined it quite appropriately the “Yuck Chart” (a full presentation on the state of Venture Financing can be found on David's blog). Based on this, only the top 25% of VC companies have made a profitable return. The rest have lost money. The chart is even more skewed when you factor in the exit multiples from the milk and honey days of the internet boom.

David posits quite logically that this is a result of something going terribly wrong along the way…and I don’t think he was talking about just the economy. The VC model went from being one where an overabundance of great ideas and an undersupply of capital resulted in only the best ideas being funded to one where an overabundance of similar ideas and an oversupply of capital results in nearly every good idea being funded. Literally, there was just too much cash chasing ideas that just were not up to par. As a result today there are too many entrepreneurs out there who fairly, given the experience over the last decade or so, believe that their ventures are prime candidates for VC financing. Unfortunately, they just might be wrong, 

And with the emperors slowly realizing that their fine new clothes might not be what they originally thought they were, entrepreneurs who think that their venture is VC fundable or a good candidate for VC funding might do well to take a long hard look at their company/start-up and ask if they fit the “best” idea or “good” idea model. From the looks of it from a VC investor perspective, "good" might just be enough for VC funding in the future.

Since I generally hate playing hide the ball, look for a future blog entry that helps shed some light on determining whether VC money is right for your company….

Reports from these firms cover a lot of the same types of material however they each look at some different things and they each source the data in different ways.

Foley Hoag, my firm, is headquartered in Boston. Our publication, Foley Hoag Venture Perspectives, is devoted to an analysis of financings for companies headquartered in New England. We try to cover all New England deals (that is we don’t limit our reporting to deals in which our firm is involved). We cover activity levels, valuations, and terms. In each case we break it up between Series A investments on the one hand and Series B and later stage investments on the other hand. We also report on activity and size of deals by industry.

Fenwick describes its report as “Trends in terms of venture financings in Silicon Valley.” This firm reports on venture financings for companies headquartered in Silicon Valley, and reports on financing rounds, price changes, and something they refer to as the Fenwick & West Venture Capital Barometer (you will have to look that one up for yourself). They also report on a variety of deal terms.

Cooley has this to say about its report, “This quarterly report provides data reflecting Cooley’s experience in venture capital financing terms and trends. Information is taken from transactions in which Cooley served as counsel to either the issuing company or investors.” This firm reports on numbers of deals, valuations and certain terms. Cooley has nine offices, so their data comes from many regions but, as noted, is limited to deals in which they were involved.

Because we cover similar data (but not the same data) in different ways and present it in different ways, it just isn’t possible to compare the data from all firms on an apple to apples basis. So, I have focused this post on (1) activity levels (that is numbers of deals) and (2) deal terms. 

Activity Levels

All three firms are reporting increased activity in Q1 of 2010 over Q1 of 2009 and over Q4 of 2009.

Foley Hoag found that activity levels for Series A investments in New England measured by the number of deals was up both compared to Q4 of 2009 and Q1 of 2009. The picture was mixed for Series B and later stage investments. The number of these deals was down from last quarter but up from a year ago. It seems to me that variability is too great from quarter to quarter, so the year on year comparison seems to me to be more telling of the general direction of the venture economy.

Fenwick had this to say about the results they found, “1Q10 results were similar to 4Q09, with up rounds exceeding down rounds in 1Q10 49% to 32%, with 19% of rounds flat.” They also noted that according to their findings, internet/digital media had the best results while cleantech had the worst results.

Cooley had this to say about the deals they were involved in, “Though we saw a slight decline in deal numbers, we saw a significant increase in invested dollars compared to the same quarter a year ago. Additionally, up rounds reached a level we have not seen since the middle of 2008.”

In a big picture way, all three of us observed a modest but steady upward trend in the tech economy. 

Terms

The upward trend also appeared in the terms that companies are getting from their venture investors. I have tried to consolidate the deal terms reported on by the three of us in the table below. This table shows the percentage of deals having a particular term and compares the findings of each firm (to the extent that the firm covers the particular term) with respect to particular terms that appeared in deals closed during the first quarter of 2010.

Comparison of Terms for Q1 2010 Deals from Foley Hoag, Fenwick & West and Cooley
Term	Foley Hoag New England Series A	Foley Hoag New England Series B and Later	Fenwick Silicon Valley All Series	Cooley Internal Series A	Cooley Internal Series B	Cooley Internal Series C
Cumulative Dividends	54%	69%	7%	X	X	X
Preference with Participation	46%	56%	48%	65%	45%	63%
Redemption	54%	64%	24%	X	X	X
Pay to Play	23%	28%	7%	6.30%	11.10%	11.10%
Weighted Average Antidilution	100%	94%	94%		84% all Series
Ratchet Antidilution	0%	3%	5%		16% all Series

Cumulative Dividends

The most striking comparison in this table is the fact that more than half of all New England deals carry cumulative dividends but less than 10% of Silicon Valley deals have them. That is huge difference. And, it is hard to explain. Many VC funds have offices in both markets. Based on that fact alone, I would have guessed that there would be a tendency to have some homogeneity within a fund and that this alone would cause differences to be much narrower than an order of magnitude. So, I checked out historical numbers going back a couple of years and this seems to be a persistent and consistent difference between New England and Silicon Valley. It certainly suggests that Silicon Valley is more founder friendly than New England, I am sorry to say.

Preferences with Participation

If the differences are striking when it comes to dividends, the similarities are striking when it comes to participation. Cooley’s numbers for Series A and Series C transactions seem to be higher than the norm, but this may well be due to peculiarities in the sample. This really begs the question why there is a seeming convergence around participation but not dividends. I don’t even have a good speculation around this one.

Redemption

With respect to redemption provisions, Foley Hoag is finding numbers that are twice as high as Fenwick (Cooley does not report on this term). This one, however, I think has an explanation. In New England the incidence of redemption provisions is trending downward rapidly. As I have said elsewhere, I suspect that this is in response to changes in accounting practices. The numbers probably reflect a more rapid response to these changes in Silicon Valley than New England, but I predict the will converge at a very low percentage over the next year or so.

Pay to Play

The incidence of pay to play provision is low across the board, but higher in New England than in Silicon Valley and higher than Cooley reports. My sense, entirely subjective, is that the difference is not particularly dramatic and probably reflects a slightly more conservative investment culture in New England than in Silicon Valley. I also predict that, as the venture industry works through the current very rough fund raising environment and more funds know where the stand with investment dollars, that the incidence of pay to play provisions will both decline to a lower number and converge across the country.

Antidilution

No surprises here. Weighted average antidilution is the universal standard. Full ratchet deals are rare everywhere, and, I believe, that they reflect unique circumstances.

Conclusion

While it is nice to be able to report an upward trend in our sector of the economy, it is not time for kumbaya yet. Let’s remember that it isn’t 2007 (which was a good, but not a great, year). We are staring at some chronic problems (trends like the retirement of the baby boomers and how is that going to be paid for and the staggering debt the U.S. and other countries have run up) and some acute problems (the debt crisis in Europe and the volatility of the stock markets). We are not going to dig our way out of this hole with a strong manufacturing comeback. We need a thriving entrepreneurial tech economy to lead the way. Fortunately, this sector looks like it may come back to life.

Scott Kirsner’s column in Sunday’s Globe caught my attention for a couple of reasons.

First, the levels of investment in cleantech companies in California as compared to Massachusetts is way more skewed than I would have said. But here are his numbers (attributed to The Cleantech Group LLC), and I don’t have any basis to dispute them.

Massachusetts numbers seem scary low to me. If I did the math right, last year there was approximately 6 times as much cleantech investment in California as in Massachusetts, and, as Scott Kirsner points out, of the Massachusetts amount $100 million went to one company – A123. Texas is closer to Massachusetts than Massachusetts is to California. 

Part of the point of Kirsner’s article is that there are some systemic issues that adversely affect investment in cleantech. The principle one being that many of these companies are capital intensive. He compares them, with some justification, to biotech companies that are also capital intensive. But, as Scott points out, the biotech industry has an established practice of getting investment from large established companies in the form of joint ventures, which the cleantech industry does not have.

But, actually, it is worse than that. Big pharma understands that, at some level, it is dependent upon technology and innovation for its product and continued profits. The traditional energy industry (and oil and gas in particular) actively resist new technology. There are still plenty of people who think the future is in “drill baby drill” not in solar, wind, tidal etc. There are actually people in responsible positions that don’t’ think there is an energy problem that can’t be solved with more wells. Big pharma is basically a tech business; big energy is not. Don’t hold your breath hoping that the biotech model will bail out cleantech.

I think that Scott is predicting a not so great year for cleantech investment in 2010. I, and others, have made the next point before, but very large capital needs and long horizons to exit (to say nothing of an uncertain exit market) are not a formula that is attractive to venture capital investment.

There is going to have to be a new approach to cleantech investment for a variety of reasons including the ones just noted. Whether this means developing an industry co-investment model similar to biotech (seems unlikely any time soon for the reasons noted above) or whether it means more government partnership (seems unlikely given the debt burden our government has just taken on) is not clear to me. 

Here is a prediction. China, where there is a lot of capital and where they are more interested in funding jobs (even at economic losses) than in garnering profits soon, will have both the money and the patience to invest in the longer term enterprises that will be needed.

Maybe there is another model out there. An IPO market would help since the public might be source of the needed capital and patience. But, without something new, you should expect to be importing your energy solutions from China.

However, Fred is looking at the supply side of the equation (i.e. the supply of money). I am not an economist (in fact I am an attorney with a graduate degree in English literature), but if you look at the demand side of the equation (entrepreneurs seeking money) you might conclude that underlying Fred’s and others’ analysis is an assumption that the rate of change along the demand curve is more or less constant. For every dollar that you take out of the venture market a somewhat consistent corresponding amount of demand increases (or to put it another way – the value of the investment dollar gets bid up in a somewhat consistent way).

I keep saying "somewhat" because I think the demand curve may be more (and sometimes less) steep at various points along the supply curve. Here is the part that I cannot "prove" or demonstrate, but I believe that the ecosystem needs a certain amount of investment activity to remain viable. In order to motivate people to pursue their entrepreneurial dreams, they have to have some hope of getting funded and, ultimately, of a cool exit. If the investment supply becomes too small, that hope may disappear and the ecosystem may not support entrepreneurial life at all. If you take enough oxygen out of the pond, the fish will die.

So, the system needs to be smaller to permit good returns to investors (or they will go away), and the system needs to be large enough to provide incentive (hope of funding), even to those who might fail. Those two points define the space of viability for the venture capital/tech entrepreneur ecosystem. The question that needs to be answered is whether that space exists at all. A second question is, if it does exist, where is it?

To me this issue also raises larger questions about the so-called venture model. From my vantage point, I see VCs investing in well conceived tight investment thesis tech companies with the plan of an M&A exit (mostly). One way to think of this (and not a particularly original way) is to observe that the buyers (Microsoft, Google, et al) are outsourcing new product development risk. That is why VC investments seem to be focused on tight investment thesis companies with a seeming clear path to an acquisition. (I can just feel the VC community pounding me with the "we want to create great companies speech," but look at what they actually do not what they say they want to do.) In part this model is driven by the ten year fund cycle. Recently, I have run across VC investments (I have two in my client portfolio), that are not driving to an exit so much as towards developing larger sustainable businesses.

While it may be that the VC diet works, it also may be that it doesn’t and something new must emerge. Either way, it is a critical issue. We need tech entrepreneurs to grow wealth and we need a way to value them and provide a handsome return to people who invest in them. If we don’t we will end up having to compete with Brazil to make Nike sneakers.

A perceived opening of the IPO markets is the focus of most of investors' optimism. There were two venture-backed IPOs in the quarter, A123 Systems Inc. and LogMeIn Inc., one fewer than the last quarter.

Public-offering activity is not expected to pick up quickly because of the "time it takes to run the SEC gauntlet," Ward said. However, a small number of successful offerings from companies like Ancestry.com Inc. and Fortinet Inc. - a Meritech portfolio company - could "set the table in the fourth quarter for what should be a good 2010."

The two IPOs from the third quarter raised a total $460.4 million, up from $232.1 million last quarter.

With successful recent offerings from companies like LogMeIn, OpenTable Inc. and SolarWinds Inc., public investors are showing a healthy appetite for small-cap technology stocks.
 

Unfortunately, they also had this to say about acquisitions:

The third quarter saw 71 acquisitions, seven fewer than the second quarter and 13 fewer than the same quarter a year ago. Nine of the companies sold were in life sciences with a combined value of $186.2 million, down from $324 million in the previous quarter and $864.7 million in the year-ago quarter. Combined with the absence of any health care companies going public, it made for one of the worst periods for health care liquidity in recent memory.
 

The venture economy (and the rest of the economy -- I think) has been suffering from the acute pain of the Great Recession.  As it goes away, we will find out if there are other problems that were masked by the recession.  If there are not, it does seem as though we should see a return to  IPO and M&A exists that will bring back an appetite for investment.

If the conclusions are true, this is certainly a harbinger of good news for entrepreneurs.  One thing to keep in mind is that we can be up 50% from a bottom (not that we are yet) and still be down a lot from "normal" (whatever that may be) times.  The economy is still shaking out, and what it will look like when a new equilibrium is reached is very unclear. 

Michael Greeley at Xconomy 
Furqan Nazeeri at Altgate
Adeo at TheFunded

Of course, beyond the broad numbers (which you can find elsewhere), their is valuable detail in EEC Perspectives about valuations and deal terms during the first quarter.      

The numbers are a little misleading in some other ways as well. Ever since the stock market started dropping, VCs, like many angel investors, have been distracted by low public valuations to the point that there have been several PIPEs (private investments in public equities) being done by traditional VCs. I worked on one over the summer that involved a very prominent VC firm. At the time I found it somewhat surprising. By the winter, this started to become commonplace. Imagine you invested in a company and brought it to a successful IPO a couple years ago at $9 a share. Within a year, the stock prices almost doubles, but since then has had a rapid decline, along with the stock markets generally. You know the company well, believe in its story, and still see a promising future for it, despite what the public markets are telling you. And now its trading below $0.50. In that case, when choosing between a company at fire sale prices you know and believe in, versus a promising but unproven startup asking for a similar valuation, where do you think you would put your money? These deals are not showing up in the numbers, so they understate the amount of money VCs are putting to work over all (although they don’t understate how much money is going to early stage startups.)

Another source of the downward numbers may be that companies (and their investors) are distracted by looking at ways government stimulus funds may be available to them. I know a number of entrepreneurs who are looking for non-dilutive government funding first, before ever approaching VCs. Whether much of this stimulus money will ever makes its way down to very early stage companies, however, remains to be seen.

As we enter spring hoping the sparse winter was an anomaly and not a sign of things to come, there have been some hopeful signs recently. First, VC exits may start to recover soon. There were actually a couple of IPOs recently, and I’m happy to report that, at least from our experiences at Foley Hoag, there has been a noticeable uptick in M&A activity. These all should eventually have trickle down effects for early stage financings, as VCs free up time and resources that can be diverted to new ventures. Second, being that it is spring, its also been business plan contest season. As in year’s past I’ve seen a number of interesting plans. This year however, I had the chance to be a mock judge for TiE Boston’s TyE program, which is for high school students (there was even a team of 8th and 9th graders). I can tell you that I was blown away by the ideas and business plans coming out of these high school students. As one of the VCs judging the panel with me said, if these kids are the future and there are similar kids across the country, I’m not worried at all about the long term future of the country and its economy.
 

Anyway, one reason law firms are a lagging indicator of general economic health is that a lot of stuff has to happen before a billable hour can be recorded. By way of example, a client contemplating an acquisition is likely to have a bunch of internal meetings to identify a target, then it is likely to hire a banker and contact the target and have a bunch of discussions, before gearing up the full legal team. All this preliminary stuff takes weeks or even months. As a result, the client has already decided on activity and done a lot of stuff, before there are enough new billable hours per day to move our statistical needle.

Billable hours per day in our business department have been trending up smartly for a few months now. I would say it is enough months to support the conclusion that this trend is more than just a random variance that happens from time to time because some particular client is active despite the general trend of the economy. This statistical evidence is supported by anecdotal evidence from both my partners and my competitors.

Anyway, one reason law firms are a lagging indicator of general economic health is that a lot of stuff has to happen before a billable hour can be recorded. By way of example, a client contemplating an acquisition is likely to have a bunch of internal meetings to identify a target, then it is likely to hire a banker and contact the target and have a bunch of discussions, before gearing up the full legal team. All this preliminary stuff takes weeks or even months. As a result, the client has already decided on activity and done a lot of stuff, before there are enough new billable hours per day to move our statistical needle.

Billable hours per day in our business department have been trending up smartly for a few months now. I would say it is enough months to support the conclusion that this trend is more than just a random variance that happens from time to time because some particular client is active despite the general trend of the economy. This statistical evidence is supported by anecdotal evidence from both my partners and my competitors.

Prepare to be horrified. Funded companies that are doing well and controlling their burn, are getting appalling down valuations from potential new investors. These valuations are often below the original “A” round valuation. Imagine meeting your milestones, controlling your burn and going from $80 million to $10 million on valuation. This is if you are lucky enough to get an offer of investment. Most of what I am seeing is people doing a bunch of diligence and then declining politely.

Series “A” money is really hard to find. It is not that no deals are being done; it is that very few deals are being done. For a while the anecdotal evidence seemed to be that VCs would invest in Series A deals on the theory that we would be through the recession before the company had to enter the market with a product or raise more money. But, now the anecdotal evidence seems to run another way. No one is sure when the recession will end, and, as just noted, trying to raise follow on rounds in this climate can be very painful. 

Angels are also hard to find, and they have the additional problem that it is often hard to get 18 months or more of financing from angels.

All of this leads me back to the conclusion expressed in my last post. If you can avoid having to spend time getting financing in this environment, you should. It may mean that you are delayed in getting to market, that you are taking competitive risks that you would rather avoid or that you put off your new venture for some time, but by spending a ton of time to raise money at a very depressed valuation, you may be condemning yourself to a poor return, even if the good times come back big and strong.

Where is the good news? One of our partners has a theory that could be best described as “the darkest hour is just before dawn.” His theory is that when there is no visibility and all the news is bad and there does not even appear to be a faint glimmer of hope, that is when you have reached the bottom. 

So, here is my question: Is it dark and gloomy enough so we can start feeling optimistic?

Data on the startup/venture industry:

Techcrunch has posted its exec summary (or a portion thereof) for its first year in review.  In an industry where good data (let alone information) is hard to come by, this promises to be a welcome new source.  Congratulations. 

With respect to antidilution:

Fred Wilson has a post on "Founder Dilution -- How Much is Normal."  It is followed by something like 62+ comments almost all of which are worth the read if dilution concerns you.  There are also a number of links that may also be of interest. 

A plague of layoffs touching all industries - specifically the finance and technology sectors - has opened the flood gates for entrepreneurs looking to strike out on their own at a time when jobs are scarce. Some cases are desperation, while others are an opportunity for talented executives to take the start-up plunge they always dreamed of.

Only time will tell, if there is really a large wave of new start-up activity. My entirely subjective sense is that it may never be a good time to do a start-up, but some times are worse than others. If you can bootstrap or if you have access to angel (or here is an unlikely thought) VC money, now may be a good time to start on the theory that you wont need market traction for a year or more and you can catch the next wave. If you don’t have a brilliant business plan and you expect to get professional investment, it will be very hard to find. My sense is that investors are not feeling a lot of pressure to invest right away. They are actually looking at fewer opportunities (even though there may be more out there) and they are looking longer and harder at them.

Updated later on January 20.  I just took a look at Don Dodge's blog.  He too has Q4 numbers to show. 

So far the downward spiral of credit and financial markets seems to have left venture capital firms and startups relatively unharmed. Even though the IPO market closed completely in the second quarter (and opened again only slightly in the third), venture capital firms continue to raise money and invest in startups at a healthy pace. During the first half of the year, venture capital firms raised about $16 billion in 141 funds and invested about $15 billion in nearly 2,000 deals.

and this:

On top of that, the exit environment for existing startups is not looking any better. A new MoneyTree report by PricewaterhouseCoopers that is out today notes that both the number of IPOs and M&A exits for startups declined precipitously:

While I agree completely with the conclusions on the number of M&A and IPO exits, our research is not consistent with what TechCrunch (and PWC/MoneyTree -- which is where TechCrunch gets its data) has to say about the pace of investment in startups. 

A more focused look at numbers shows a different picture. Based upon searches of the Dow Jones VentureSource focused on Series A financings and Series B and later round financings in New England and the country as a whole, there appears to be a decline in venture investing in 2008 compared to 2007 (see EEC Perspectives).