Emerging Enterprise Center Blog - Commentary and Analysis For Entrepreneurs and Startups

I have long had a theory that (for companies with up rounds) the greatest valuation increases occurs between the A and B rounds.  So, I recently had occasion to do some data mining in our database of New England transactions.  Below is a table of the results:

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.

This recent article titled: "Entrepreneurs need to know when to let go" by Michael Skapinker  of the Financial Times raises a good point and got me thinking of an analogous example in the very early stages of a start-up. Letting go does not start with selling the company. It needs to start much earlier than that for technology teams looking for venture funding for their idea.

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. 

Every time I hear a founder or entrepreneur say they want to give X percent  of their company to this team member or that investor - I cringe a little.  Why?

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.

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

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.

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.

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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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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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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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).

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).

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.