Twitter and A123

Posted on September 28, 2009 by Dave Broadwin

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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IPOs and the Venture Model

Posted on July 29, 2009 by Dave Broadwin

It is a truth universally acknowledged that investors in tech companies get the best exit valuations in IPOs. This has been accepted as axiomatic as long as I have been practicing law. As far as I can tell, when public companies get acquired the buyer usually pays a premium over the public valuation. This premium, often referred to as a control premium, suggests that there is “extra” value in not being public. If companies typically command a premium when control is sold, why are they not valued at a discount when they go public and control becomes diffuse? I can imagine a number of rationalizations for this anomaly (that companies command a premium when they go public and another premium when they go private), one is that these companies may have been public for a while and their public values may have sunk considerably from the halcyon days following the IPO.

But the point I want to get to is that you might think that selling a private company would produce a bigger premium than taking it public. The seller could jump all the way to the final control premium price. Another thought is that most venture financed companies that have gone public in the past ten years have not performed well. Obviously we are in the Great Recession, but this observation was, I think, widely thought to be true even before the Great Recession.

One possible explanation, among many, is that IPOs were hyped and sold rather than researched and bought by thoughtful investors. In other words, as Healy Jones said in his blog Startable some time ago, the public was sold a lot of stock that really did not have good investment characteristics (it was a load of crap and people lost a lot of money investing in it). Of course, there were and are a few stars (Google for one). Having said all this, it may be (perhaps certainly is) true that private buyers such as Google, Microsoft, AOL, Zimmer, etc. are just more discerning and more able to accurately value acquisition candidates than public investors.

If you agree with the thought that most of the venture backed companies that have had IPOs should not be public, then you probably agree that the IPO market should not return to pre-Great Recession norms. How much below these norms the IPO market should/will return to is impossible to tell. But, if the so-called venture model is dependent to a material extent on a robust IPO market which in turn is dependent upon investors making poor decisions, then there really is something wrong with the venture model. The venture model needs to work based upon returns obtained from sophisticated private buyers – who seem to pay less than the public.

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No Exit

Posted on July 6, 2009 by Dave Broadwin

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. 
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IPOs of venture backed companies in 2009

Posted on June 26, 2009 by Dave Broadwin

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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April bringing signs of life?

Posted on May 1, 2009 by Dave Broadwin

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. 

Here is one quote from the article on M&A Deal Uptick Holds Caution for VCs:

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.
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Ritual Wringing of Hands

Posted on April 13, 2009 by Dave Broadwin

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.

I have it on good authority that in Dubai, they built an indoor ski slope. Imagine building an indoor ski slope in the middle of the desert. Just stating the proposition demonstrates its absurdity and hubris. It palpably demonstrates that the pendulum has swung too far. So a ski slope number is one that demonstrates palpably that the pendulum has swung too far.

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.
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IPO Watch

Posted on February 2, 2009 by Dave Broadwin

Well the new year is not exactly off to a roaring start. According to VentureWire, it appears that there were two (2) venture backed companies that filed for IPOs in January. They were Medidata Solutions Inc. and Open Table Inc. If this pace keeps up, 2009 will see 24 IPO filings, representing an almost 500% increase over 2008 but still something in the general neighborhood of one-third of 2007. Also, we need to remember that filed and closed are two different things.

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Funding and Exits

Posted on November 14, 2008 by Dave Broadwin

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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