Emerging Enterprise Center Blog : Boston Startup Lawyer & Attorney : Foley Hoag Law Firm : Startup Financing, Venture Capital

Having recently had a pretty bad skiing accident that required surgery and will require a long recovery (while chasing my son down the lift line at Ninety Nine 90 in the Canyons), I have not been able to write many posts, but now that I am past the initial stages of recovery, I have had some time to think about the tech world again.

Here is one of the somewhat intractable issues that have troubled me. I know, from internal research at our firm, that the average life of a venture financed client (from the time the company becomes a client until exit) is about 10 years. I also know from discussion with a VC friend that the average time to exit for companies in his portfolio is 8 years (at least that is what he is telling people). Remember, these are average numbers, so many investments take longer to get to exit. Also remember that our firm’s numbers reflect investments from a broad variety of VCs from the top tier to the little know funds. My friend is with a top tier firm, so their results may be somewhat better than those for the industry as a whole.

OK, so why waste time thinking about this number? Well, most funds have a ten year life. Ideally during that term, the fund is fully invested and fully liquidated. Most (all?) funds provide for extensions to liquidate laggard investments. Even still, limited partners in VC funds would like to get their return in ten years – that’s the plan.

If you know that your average time to exit is 10 years, then you know that investments made in years 3, 4, and 5 (let alone anything after that) are, on average, going to run way over. This accounts, in part, for the phenomena that many VC fundss will linger long after they are unable to raise new rounds.

But, it also may have an impact on investment style. Except in the earliest years of a fund, VCs will almost always be in the position of being under pressure to look for an exit. I am sure there are many ways in which VCs try to mitigate this pressure (doing follow on investments in new funds might be one, but that is a hassle for other reasons).

I suppose it is impossible to know how much pressure this situation exerts upon VCs to favor tightly defined business plans with a clear path to an exit over grander visions? I have commented elsewhere that VCs seem to me to favor narrowly focused tightly defined business plans that address clear pain points and have obvious exits. VCs also seem to me to have become very focused on domain expertise within their investment portfolios. This makes sense, why invest in something you don’t know about? But it also leads to a certain orthodoxy in the nature of investments.

In some sense the life of a normal fund is not suited to the life of a normal company. As a result, VCs are structurally driven to favor narrowly focused investments over grand visions.

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My last post concerning structuring to meet the needs of your financing sources, has led me to think about how to handle contracts. Businesspeople are often willing to go “skinny”. That is to say they are willing to live with contracts that are not comprehensive or rigorous. They often rely on relationships and accepted business practices (or simply trust). In many ways, this is what makes the world go around. The mere creation of a thorough carefully drawn contract that covers every (almost every) contingency and the negotiation that implies may itself be an impediment to doing business. 

A lot of the time the sales guy writes up the contract, the CFO signs off on it and the world rumbles on. If the relationship works and no third party ever has to look at it – you are fine. But, what happens when a third party gets involved. I am thinking particularly about what happens when you go to sell the business and the buyer is a Fortune 50 company (or even a Fortune 2000 company) that does not have a strong “personal” relationship with your counterparty? Or, what happens if you go to a financing source such as a name brand VC?

Family businesses (and my family used to have one, so I know) can operate at a level of informality that venture financed businesses just can’t ever get to. When IBM (or any other large buyer of companies) acquires your business, they want (need) to know that they will be inheriting the vendor and customer relationships. Assuring IBM that you and your customer have an understanding and are very simpatico just wont cut it. 

VCs get this, and they expect their portfolio companies to be set up for an exit. That means that informal arrangements (perhaps except for immaterial matters) are just not acceptable because they diminish the marketability of the portfolio company. If you are planning to get VC funding, you should assume that the VC will review your contracts (at the very least all the important ones) and a company with a squishy key contract may not be financeable (at least without an amendment to the contract).

Consider having to go from the easy squishy contract to the level of definition and tightness that IBM (or any other similar buyer) or a VC proposing a financing will want, under the pressure of a pending exit or pending financing. Your bargaining power just went out the window and your good will with the customer or vendor just went down the tubes. The moral to the story is that an ounce (or a several ounces actually) of prevention is better than an pound of cure.

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VentureWire had this to say yesterday:

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.

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There’s no arguing that the recent IPO of A123 and the huge raise by Twitter are good news for market starved for good news. At least someone had a great exit, if you can call the A123 IPO an exit. And Twitter, is such an extraordinary story, if they can’t raise money on great valuations, who can? Activity like this is great after a long period in which there has been so little activity.

Having said that, the question remains if this presages a better environment for less extraordinary stories. Fred Wilson makes a good point in his blog to the effect that a financing is just a financing and not really a successful corporate event. As far as I can tell, A123 needs to be public because of the massive amounts of capital they will need to address their market opportunity. In this respect it looks like a biotech company. But the valuations are great, and it is hard to deny that investors are willing to take big risks.

The bad market returns of 2008 (even though the market has bounced back, it is still way below where it was before the fall) probably reflect in large part a reaction to an acute crisis in the financial markets as opposed to chronic long term issues. If this is true, then it should bounce back when the acute pain is over. But, it is hard to tell if long term trends have not been disguised by the presence of acute problems. I suspect that we will find out over the course of the next 12 or 18 months. If a "normal" exit market does not return in that time frame, we will need to be looking past the crisis for what the issues around capital formation are.

How will we know? We will know if solid companies (substantial companies that address real economic needs) but are not Twitter or A123 have good exits with investment justifying returns in this period in numbers that look more like 2007 than 2009.

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I recently met with an investment banker client.  He asserted, and I believe him, that middle market M&A activity is at 20% of the ten year average (he was talking about numbers of deals) and 33% of what it was in '01 and '02.  That is the bad news, his take on these numbers is that we are poised for a big rebound in 2010.  Hope springs eternal in the human breast.

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LogMeIn has now successfully opened trading – the fourth IPO of a venture backed company since RackSpace in August of 2008. Four is better than zero. But if you consider how many there were in 2007 (fifty something, if memory serves me well), we still have a long way to go before there is an IPO market that will sustain the so-called venture model. In the meanwhile, consider a recent article in VentureWire to the effect that there were 137 M&A exits for venture backed companies in the first half of 2009, and – here is the truly alarming news – only 2 of them reported prices in excess of $100 million. There is more detail in the article about average prices in M&A transactions, but the take away is that the smaller deals don’t represent good returns for venture investors. As a historical matter, most exits for venture financed companies are through the M&A process – not the IPO process. Not long ago, I posted the observation (from Mike Feinstein) that there are north of 9000 venture backed companies and only 30 exits north of $100 million last year. If the IPO market is down approximately 90% from 2007 levels; it is hard to even conceive of how far down the M&A market is.

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As of now there are three: SolarWinds, OpenTable and Medidata. It looks like LogMeIn will make the fourth. Before these you have to go back to RackSpace in August of 2008. Nothing else need be said. 

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In a recent press release Mark Heesen of the NVCA had this to say:

"The venture capital industry will evolve significantly in the next few years as the asset class responds to a Darwinian contraction resulting from the recession, the rise of innovative industry sectors such as clean technology and the continued interest in venture capital outside the United States," said Mark Heesen, president of the NVCA. "As the survey results suggest, we will see more globalization in the next decade, not only in terms of investments but also in fundraising and exits as well. Those countries that can nurture entrepreneurs and investors as well as offer attractive exit opportunities have the most to gain economically in the next decade."

This comment causes me to think back to my trip to China of a few months ago. While in Tianjin, I visited an incubator where 930 tech companies were being incubated. I don’t know about India, never having been there, but at lease one of our competitiors is working on a scale that is hard to comprehend.

Beyond the comment about venture capital outside the United States, is the comment about offering attractive exit opportunities. Exits have been few and far between in the last year and more. In the end exits drive the whole investment model and somehow, directly or indirectly, the deployment of new technology in business and personal life drives the rate at which companies will be acquired or go public. Obviously other factors impact it as well, but I wonder if the aging of the U.S. population doesn’t slow down the rate at which, as a country, we can/do absorb new technologies. Is demographics a drag on innovation?

Consider how comfortable your grandfather, father, you, your children are with Facebook, iphone apps, or whatever. I still have not programmed the automatic garage door opener in my new car. I write this blog and I send the occasional tweet, but if the world has to depend upon me to drive adoption of the next big thing, you could be waiting a while.

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One of my favorite quotes is from Steve Jobs. I believe he said, "those overnight successes sure take a long time." As I, and others, have noted, the VC investment model is based on a ten year cycle of fund raising, investing and exiting. This model works well for a lot of companies, but one size does not fit all. A quick look at my client base, suggests a couple of issues with the time dimension of the VC model. (There are, of course, other dimensions to be considered such as the amount of money needing to find a home etc.)

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I have just finished reading yet another article on the subject of the impending revival of the IPO market for venture financed companies. I also recently heard a partner in a prominent Massachusetts law firm, explain that the IPO market for venture financed companies was going to “come back” this fall. The recent IPOs of Rosetta Stone and Bridgepoint Education (neither of which was venture financed) seems to have people panting. Oh, yea, and there was a Chinese company that went public on the NASDAQ recently. Hence all the titilting trailers hoping to foment excitement for the movie to be released this fall. There has been a lot of discussion about why the IPO market is in the dumps, and it cannot be separated from the general economic collapse we are all experiencing, but people seem to be focusing on a few items as if “fixing” these will somehow bring back IPOs. It is not at all clear that these discussions are focusing on the right issues.

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In yesterday’s VentureWire there were two articles indicating more signs of life in the entrepreneurial world. One had to do with M&A activity and the other with the NVCA ‘s efforts (such as they are) to bring back IPO activity.   Based on my own subjective experience, ther is more postive buzz than there has been for some time.  These two articles fit this mode. 

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I ran into Mike Feinstein in the hall a few days ago and he told me (now I am going to get the numbers wrong but he can correct them if he wants) that there are something north of 9000 venture financed companies out there and that last year (I probably have the time period wrong but it does not really matter) there were only about 30 M&A exits at valuations north of $150 million. The exits represent about .3% of the financed companies. That is what I think of a ski slope number. Let me tell you what I mean by a ski slope number.

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Last week Fred Wilson and I had a good back-and-forth going via comments on his post about venture capital returns . I’ve been thinking more about what I wrote concerning the proper measurement period for calculating returns and I thought I should follow up to Fred’s last reply . So, here are a couple of thoughts: (1) No matter how you calculate returns, an actual improvement will help the industry. The internal revenue code (IRC) is biased against venture capital investment in a material way. One change in the IRC would have a material impact on venture returns. More below. (2) I’m no accountant, but I believe LPs in venture funds have to account for their investments as a liability from the time they agree to invest. (3) Maybe, LPs in VC funds have sophisticated models anticipating calls etc. But that may be more scary than good.

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Yesterday I moderated a panel on the subject of the venture investment climate in 2009. The panelists were Axel Bichara of Atlas Venture and Austin Westerling of Charles River Ventures. The big picture take away from this event was that the investment climate is not as bad as advertised in the press.  In each case, Atlas and CRV have made a number of investments in the last year and continue to be actively looking for new investments. If I can generalize, their advice was (1) be prepared for a thorough diligence and, perhaps, a longer than normal process and (2) be realistic about valuations.

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There has been a lot of hand-wringing about the downturn in the venture industry and what it forebodes for entrepreneurs and VCs. The sites and commentaries are too numerous to mention. One post describing an entire industry event devoted to this issue can be found on Startable. There is also an article in the December issue of VCJ on the subject of the venture capital model. I think one (if not the main or even the only) issue is the lack of exits at decent return rates to investors. While that means returns to the VCs, it also means returns to their investors. The money won’t flow to the entrepreneurs or the VCs from the ultimate investors – pension funds and the like -- until they see a healthy return on a reasonable horizon. How is that for stating the obvious?

The problem then becomes how to promote good returns. It is impossible to get investors to buy IPO stock, if they don’t see good price growth in the stock. It is impossible to get an acquirer to buy at a favorable price if they don’t see the market return. In this world it becomes harder and harder (and less desirable) to start a company. As a result entrepreneurship declines, technological improvement slows, new company formation slows, employment slows, etc., etc., ...

So, the issue is, how do you improve the economics? I am sure there are a lot of ideas out there, but one idea is to change the tax treatment of NOLs so they are not lost in a sale (and not almost always lost in an IPO). Since NOLs, in a venture-financed company, are likely to approximate the amount of investment dollars, the tax benefit to a buyer (or the investing public in an IPO) would be equal to the total invested multiplied by the tax rate of the buyer (or in the case of an IPO, the tax rate of the company itself). This is a significant value boost. It would make deals more attractive. For a more detailed analysis of this issue, see the article Rick Schaul-Yoder and I wrote for the December issue of VCJ (registration required).

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In case you needed another signal that times are tough in the entrepreneurial world VentureWire has published and article entitled Turnaround Firms Busy As Start-Up Woes Mount. The gist of the article is as follows:

The number of aging start-ups facing a shortening runway has grown in recent months, these firms say, and some venture capitalists are losing patience with longstanding portfolio companies that have no exit in sight. That's especially true for venture firms with large funds dating back to the tech bubble years of 1999 and 2000 that need to relieve congested portfolios before reaching the traditional 10-year funding cycle.

As I have noted in the past, the number of series A financings has dropped in 2008 compared to 2007 but the number of Series B and later rounds is holding pretty much steady.   I believe this is due to continue to finance existing portfolio companies, but many of these financings are likely to be at disappointing valuations or to be inside rounds.  This article suggests the obvious -- that the commitment to portfolio companies is not infinite and, in a world without exists, will eventually come to an end.

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With reference to IPOs and exits, TechCrunch had the following to say: 

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).

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Anecdotal evidence indicates that in the current environment there are a lot of "extension" rounds or bridges from existing investors.  The obvious reason for this situtuation is that it is hard to attract Series B and later round money in a climate where there is as much uncertainty as there is right now.  By extension rounds, I mean selling additional shares of the previous round at the same valuation as the previous round to the same players.  I suspect our research  will show that Series B and later round activity in the second quarter was basically flat.  We wont be able to get numbers for Q3 until near the end of November, but, anecdotal evidence indicates a decline in activity.  Clearly a resolution of the current crisis in the financial markets can only help, but  an improvement in the long term outlook for exits (both IPOs and M$A transactions) is what is needed to turn the investment tide.

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It will come as no surprise that the number of exits (IPO and M&A transactions) for venture financed companies is way off this year -- compared to last year. As I noted in a prior posting, Series A transactions are off year on year. Although some industries are faring well (greentech for one), on a macro level, series A deals in New England are down approximately 30% in the first six months of 2008 compared to the first six months of 2007. You can get more detail on this in our EEC Perspectives October 2008 issue. In addition, however, the statistics for M&A and IPO transactions are worse according to the CNET NewsBlog which points out that as of July 1, 2008 there had been no IPOs for venture backed companies and that in the first half of 2008 there were 56 M&A transactions compared to 97 in the same period last year. We are still compiling the statistics for New England based Series B and later stage deals for the most recent quarter, but these numbers should be available shortly, and I expect they will be consistent with what we are seeing in Series A deals and exits. To some extent the problem begins wiht exits. If investors  don't have good visibility on potential timing or valuation of exits, it becomes very hard to complete a later round deal. If investors are anticipating difficulty raising Series B and later rounds, they are reluctant to take the risk on the early round. The silver lining may be that there is a lot of money sitting on the sidelines, and when the market turns this money will be looking for deals.

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One refrain I have started hearing from some entreprenuers is that they have now gone a long time without a paycheck or angel funding -- let alone venture funding, and they need to pay the rent so they will soon have to put their ventures on hold.

It will come as no surprise that the continuing crisis in the finance sector has put an end to the little IPO activity that seemed to be cropping up just a few weeks ago.   According to an article in the September 23 edition of VentureWire entitled "IPO Flow Perked Up Until Wall Street Crisis Hit" (you can sign up for VentureWire here):

 Until last week, some market observers said they were seeing more companies readying to register initial public offerings in the U.S. While no one believed deals were about to pour into the market, even a whiff of future activity seemed promising.

Then came the filing for bankruptcy protection by Lehman Brothers Holdings, the sale of Merrill Lynch to Bank of America and the government rescue of American International Group Inc. The U.S. government's announcement late in the week that it was working on a plan to bail out the financial system is at such an early stage that it's impossible to know what effect it may have on IPOs

Well, I am not sure it is impossible to know what effect it will have on IPOs.  As long as there is a continuing crisis in the world of exits (IPO and M&A), there will be a drag on venture investment.  As long as there is a continuing crisis in the stock markets, there will be a drag on angel investing.  These factors will also create a drag on entreprenurial activity. 

A lot of our future and our kid's future is tied up with entrerpenurial activity and technology based entreprenurial activity, so this situation can't be good.  There are many good reasons for a bailout of the financial sector of which its effect on entreprenurial activity is a small one but an important one.

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There is a lot of money sitting on the sidelines right now. 

According to the National Venture Capital Association, 235 venture funds raised nearly $35 billion in 2007.  This is after a string of steady growth years beginning in 2002.  Furthermore according to the NVCA, 130 venture funds have raised more than $16 billion so far in 2008.  This seems to me to be a very high number.  It provides support for the anecdotal evidence that a lot of funds, including early stage funds, have been raised in the last few years.

The National Venture Capital Association also reports that venture capitalists invested $7.4 billion in 990 deals in the second quarter of 2008.  This number does not seem consistent with the general economic climate, but there may be an explanation for it that is consistent with the downturn in the general economy.  As with the amount of funds raised, I suspect that the NVCA measure includes many transactions that are not  "traditional" early stage venture investments.

I will do a little more research over the next few days and try to get a more granular focus on the activity level in the early stage fund space.

The NVCA clearly agrees with what we are experiencing that there is a crisis in the world of exits.  According to the NVCA, there have been 5 IPOs so far in 2008 compared to 86 for all of 2007, and there were 120 total M&A transactions in the first six months of 2008 compared to 169 in the first six months of 2007.

My belief is that there is a lot of money that has been raised that needs to be put to work and will not be until either or both of (a) the general economic/financial crises is behind us and/or (b) the crisis in exits passes.  When these things happen, and it could be a while, the flood gates should open because many of the funds will be several years into their 10 year life and will need to put the money work quickly.

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