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.

This situation is the context in which entrepreneurs have to do deals today and the deals done (or not done) today will have a huge effect on tomorrow. One VC with whom I have dealings from time to time commenting on a transaction for one of his portfolio companies put it rather graphically. When describing terms proposed by an outside investor for a follow on round, he said something like, “the market has spoken, we have to bend over and take it up the ***.” One point of all this is that the numbers are horrible so deals are not getting done, companies are being sold off for asset value, people are out of work etc. (By the way the unemployment numbers for June are 9.5%.) Another take away is that the terms and conditions under which money is being raised and entrepreneurs are working is not healthy.

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.