My hypothesis that the greatest increase is between the A and B rounds bears out very clearly in the technology sector. You can also see it in the biopharma data. The cleantech data may be unreliable because the sample size is small.

The reason I have been looking at this data is that I have a couple of clients that are debating internally whether to raise a B round or try for an early exit.  While I think there are many factors to weigh in this type of decision (obviously valuation is one issue, expected size of exit is another and time to the eventual exit is yet another), these statistics are, I think, the first step in an analysis that could well lead to the conclusion that, in most cases, the best return for the entrepreneur is going to be in an early exit.

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.

I have often heard senior advisors refer to the decision to raise venture funding as going down a path  where the final destination invariably means losing control of your company. Determining if you want to walk down this path is a question often not given enough serious thought by founders.  Think of it as an identity crisis of sorts - one way to determine if the founders are ready to take the VC route is for them to ask themselves: Am I ready to make distinction between myself and the start-up? If the answer is "NO - there is no distinction", then the path from start- up through venture funding to hopefully an exit will be at best more painful and angst ridden than normal and at worse will be a disaster of sorts. 

However, if you think of your company as its own entity (albeit one where you have significant input and credit for it's existence) then it helps to think of going down the venture capital route as sending your kid off to college. He/she is going to grow up to be their own person and though you will always have some influence in their lives, increasingly your sphere of influence will diminish and be replaced by that of their peers, partners, teachers etc..

Letting go also helps entrepreneurs do what they do best -find new problems to solve and start new companies!

Copyright: Micahel Valdez, iStock Photo

- Posted using BlogPress from my IPad. 

SVB's analysis shows that after the Tech Bubble the software and the hardware sectors have been steadily recovering with exit multiples in 2009 equaling 2.3X and 1.3X for software and hardware sector respectively. Consumer Informatics had a crazy up year in 2004 (think Google = 80X average!) but since then exits have settled to 2.7X in 2009. SVB's in-depth look at the exits warrants further commentary. Any thoughts?

Here are some excerpts from the presentation - Source: SVB Analytics & Dow Jones/VentureOne

Posted using BlogPress from my iPad.

Percentages are fixed, however #'s are always changing.  When a founder is promising a consultant, advisor, team member, investor (or whomever) a percentage of the company he/she is no doubt promising them a percent of the company at that point in time (so if there are 1,000 outstanding and issued shares, 20% would be 200 shares).  However, the pie is always growing so that 1,000 shares today might be a 1,000,000 shares in the future and that 20% is all of a sudden 200,000 shares. 

Now you're probably wondering, PT are you seriously saying that someone could have a credible argument that the 20% of 1,000 shares could be extrapolated to mean 20% of 1,000,000 shares?!! Get real.

I'm not saying it does, but depending on the facts and the circumstances, someone could very possibly make an argument that it might. Also, if it does or does not is besides the point.  Take this in the perspective of an exit or a large round of VC financing.  You really want this joker showing up a week before you close the deal with a document or a written agreement stating that you promised him/her X% of your company?  Granted, it might not be a very credible argument, but it's going to take either time or money (or most likely a lot of both) to make this go away and even worse it will create doubt in the mind of the investor/buyer, at the very worst could crater the deal.

Promising someone X% of your company? Don't do it - you'll sleep easier and so will your lawyer.

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….

Rick Briggs, Managing Director of Consilium Partners a Boston-based  investment investment bank that provides clients with buy-side and sell-side merger/acquisition and capital -raising services recently gave a talk at a Tech Talk Tuesday event hosted at our Emerging Enterprise Center and moderated by our very own David Pierson.

Rick focused mainly on the role of investment bankers through the exit process, the importance of planning for the exit and having competent and knowledgeable counsel through the exit process.  His slide on the top 12 attributes that drive a premium valuation for a company during exit really caught my eye and with his kind permission I share these with you...

Top Twelve Attributes Most Critical to Attaining a Premium Valuation For Your Company:

1. Record of consistent revenue growth, with outlook for continued growth in the future
2. Strong and improving margins (especially mature companies)
3. Diverse customer base with absence of big concentrations
4. Defensible industry niche(s)
5. Continuous investment in R&D / new product development
6. Complete and well functioning management team, with clear succession plan
7. Ownership participation among members of mgmt team and key staff
8. Rigorous internal financial controls; complemented by quality independent CPA
9. Minimal ‘private company expenses’ and / or non-productive assets
10. IP well documented
11. Well-maintained facilities with up to date production equipment; legacy environmental or product warranty issues well addressed
12. Corporate structure friendly to stock and asset buyers

At first blush this statistic seems to run contrary to the accepted story that Massachusetts companies have traditionally been sold off (often to the west coast).  Having said that, it is not at all clear what the statistic means.  For example, was it a statistical fluke because the sample period was short? 

The period covered was 2008, which we all can recall was the beginning of the great recession. Does this suggest that Massachusetts companies were stronger at the beginning of the recession than companies in other states?

This is an interesting piece of data because of its relationship to expectations, but until someone can draw a conclusion from the data, it won't be information.

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.

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.

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.

In this type of economy, you expect to see certain types of investment terms (onerous ones) increase in frequency as investors try to find ways to increase their expected returns. One popular one is, of course participating preferred. According to our research (published in EEC Perspectives, and we are soon to publish the next issue), in the first two quarters of 2008 there were three New England based Series B and later stage deals with full participation, six with capped participation and 12 that were non participating. Compare that to the second half of 2008 in which we reported that there were five deals with full participation, 10 with capped participation and only 3 with no participation. In Q1 of 2009, the numbers for Series B and later stage deals were 9 with full participation, 3 with capped participation and 4 with no participation. 

The thing to note about participating preferreds is that they increase the investor’s return in low and mid range M&A exits. Given the situation in the M&A world, it can hardly be a surprise that the use of participating preferred is on the rise. Other provisions that we may start seeing more of are full ratchet antidilution and increased used of dividends. 

In response to the lawyer mentioned above, let’s get some of the facts right: The last IPO of a venture financed company was RackSpace, which went public on August 7, 2008. It bombed. Here is what Fortune had to say at the time:

Rackspace took the IPO plunge Friday and fell flat on its face, which will only make other startups more hesitant to follow its lead.

 

The web-hosting company had planned to offer 15 million shares at between $12 and $16 per share in a modified Dutch auction, but hopes ran even higher. Scott Sweet of IPO Boutique told TheStreet.com that Wall Street chatter indicated Rackspace (RAX) share would price as high as $17; MorningNotes pegged it at closer to $16. The shares ended up pricing Thursday night at $12.50, and they began trading closer to $10 per share. They rose as high as $11.58 in mid-day trading before settling back near $10.

 

If people were looking for this deal to turn things around for the market, it certainly hasn’t done that yet….

The fact that a couple of non-venture financed companies are going public is relevant only to the extent that it is evidence that someone can go public. Non-venture financed companies are, I believe, not necessarily built on a tight concise tight investment thesis, as many (most?) venture financed companies are. 

A company built on a tight, narrow investment thesis is not likely to be a good candidate for a sustainable public company because its prospects are not likely to be big enough. ThermoElectron was a huge success as a public company, Google, Microsoft, EMC etc. -- all great companies. RackSpace? Many venture financed companies have identified and are addressing a narrow pain point (it could be big in the sense of a sales potential of hundreds of millions in some cases more). At the risk of stating the obvious, these companies are logical product extensions for bigger companies. The VC industry tends to reward tight thesis companies with investment and to shun larger more broad less defined visions. I suspect that business schools teach tight business plans in their entrepreneurship courses, but I could be wrong. A tight narrow thesis may make a fine VC investment, but it has limits as a public company.

On to Sarbanes, everyone blames Sarbanes for putting a wet towel on the hot IPO fire. It has come to symbolize the deadening hand of government regulation. Personally, I agree that all Sarbanes did was transfer wealth and power to the big four accounting firms. (By the way, the very people who were not minding the store when Enron et. al. pulled their shenanigans, which suggests that perhaps accountants are not the right people to wield all that power.) Having said that, what is the real impact of Sarbanes on the IPO market? It makes IPOs (and regular public company existence) more expensive and more painful than it needs to be. I can’t say that I have made a study of this, but based on what I hear from my clients and contacts, for a small public company (one with a market cap in the mid hundreds of millions) the incremental cost of accounting services is a couple hundred thousand more per year than it was before Sarbanes (with a big hit on the IPO). If the economics of being public are so tight that a difference of $200K moves the needle, maybe you should reconsider going public. Now, I am not in favor of paying accountants more for less work, but let’s get real, Sarbanes is not what is wrong with the IPO market.

The most insightful comment on why the IPO market for venture financed tech companies is so bad that I have read recently came from Startable (a blog written by Healy Jones of Atlas Venture). He wrote, and I quote, “the big buyers of small-cap technology IPOs have left the building - I’m not 100% sure why but I bet it has something to do with the fact that in the late 90’s a bunch of crap was sold to them.” 

To bring back the IPO market, companies need to bring real long term value to investors. This means building great companies on great visions rather than add ons for IBM, Google, EMC et. al. The buyers have awoken from their torpor and all the finagling with accounting rules and SEC regulation in the world wont help – we need good candidates for IPOs.

Now, Williams said, these buyers are dipping their toes back into the water. "We're announcing an acquisition [of one of Montgomery's clients] tomorrow in which we actually had multiple bidders bidding up on a deal. We haven't seen that happen in the last four months."

Williams, speaking at the National Venture Capital Association's annual meeting Wednesday in Boston, said his firm has 12 active term sheets for its clients. "So people are putting offers out there, but the question is how you get from that term sheet to closing that deal," he said.

Other anecdotal information suggests that there is increasing M&A activity but this evidence also indicates that it is hard to get deals done on strong valuations. Activity is activity and it needs to start somewhere.

Here is one quote from the article titled NVCA Unveils Plan To Jump-Start IPOs:

A four-point plan announced Wednesday at the NVCA annual meeting in Boston incorporates a wide range of elements, some of which the trade group has talked about for a while. They range from encouraging small IPOs led by boutique investment banks to preserving tax breaks for long-term capital gains.

Every little bit helps.  While it is hard to see how a robust IPO market develops any time soon, any market is better than no market. 

As I have noted before, I continue to believe that changing the treatment of NOLs would do some good for both the IPO market and the M&A market. I also think that now is the time for such an initiative.

It is spring and I hope we are not cruelly deceived by these early signs of life.

At the risk of going to the absurd place myself, it is possible that our VC friends have made 8970 crappy investments? Or, even half that? I don’t think so. Is the exit market shut down? Absolutely, but that doesn’t mean that people made poor investments or that the much publicized poor asset class returns for venture investments are going to stay that way. Those 9000 odd companies represent pent up exit demand. When the conditions are finally right, exit activity will skyrocket.

It is, of course, impossible to know when conditions will be right. But here is a contrarian sign. I recently attended a telecom industry event at which an HBS professor announced, with the conviction of the recently converted, that the next five years will be boring. Now, as far as I can tell, academics are notoriously poor at predicting the future. It is a ski slope statement. So, my prediction is that all the money that is being injected into the world economy will generate lots of activity. The nature and amount of that activity is still to be seen.

• We have five beta customers and want to raise $15M to scale the business
• This is a great fit for XXX [name a large company buyer]. They will have to buy us next year.
• Many of our $1M+ customers pay 12-15% maintenance per year.
• We are a software startup. The $10M we want to raise will last about 15 months.
• Our product is a great long term investment for our customers.

Austin noted that in the current climate there is a bell curve for companies from the early stage to the late stage and that it is easier for companies at each end of the curve to get funded than for those in the middle. If I understood Austin right, this is, at least in part, a function of the uncertainty in the market for IPO and M&A exits. Separately, he also noted that CRV has a high degree of interest in the wireless space, among others.

Someone from the audience asked if onerous terms such as multiple X preferences and full ratchet provisions were likely to start appearing. From my vantage point there was consensus among the panel that there might be a trade off between onerous terms and valuation but that as between the two, a company is better off with a “realistic” valuation than with these kinds of terms. The primary reasons are that these terms are likely to have an adverse effect on the entrepreneur’s return (i.e. valuation by another name) and they are likely to inspire the next round investors to ask for the same. 

When asked if the limited partner investors in their funds were balking at capital calls, the response from both Axel and Austin was “no.” Axel pointed out that, compared to LBO funds, the amounts of money that venture LPs are being call to pay is very small and that they are not called until significant time and work has gone into the development of an opportunity.

No one expressed any confidence or certainty around how long the downturn would last.

Going back to the opening point, it is not the best investment climate, there will be pressure on valuation and, perhaps, terms, and it may take longer than you would like, but deals are still getting done.

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).

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.