Venture Capital Firms Chase New IPO’s
Bill Warner Friday, June 19, 2009
We all know that the IPO market for venture-backed companies has pretty much disappeared, substantially destroying their business model that requires high value exits via an IPO. Dixon Doll, in his interview with the Wall Street Journal gives us an update on the reshaping of the venture capital industry. Doll is a seasoned business consultant, a leading venture capitalist and the outgoing Chairman of the National Venture Capital Association (NVCA).
NVCA’s “Four-Pillar Plan”
The NVCA’s Four-Pillar Plan is targeted at restoring the venture-backed IPO market, and it takes unprecedented cooperation between the private sector and the government’s taxation and regulatory policies. Given the slap that the venture capital world just took in the SBIR renewal bill, that cooperation is not evident.
The NVCA’s direction is to convince venture capital firms to modify their financial models and business practices to focus on small-cap IPO’s, moving away from blockbuster winners. Another bubble is bursting. This will require substantial reshaping of the way venture capital firms structure their deals and the transition will take five to seven years to complete. But, given the state of the IPO market, this makes sense.
This means that venture capital firms will have to go after more deals, with less money per deal, driving for quicker exits, and culminating in smaller IPO’s. This opens up the venture-backed IPO market to a whole new set of investment banking firms that will be able to service this opportunity. It won’t be just the big firms like Goldman Sachs and Morgan Stanley.
The task ahead
Doll points out that this is going to be a painful transition. Some venture firms won’t make it. It will require a massive education initiative to explain how this can work. This education will have to include entrepreneurs, venture capital firms and investments banks who currently don’t view that they have an IPO market available to them.
There is considerable skepticism throughout the industry. Even if the NVCA pulls off this first pillar, the government regulatory and taxation policies will represent another giant hurdle to jump over. Doll has always been a positive and aggressive thinker. If anyone can make this change happen, he can.
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Institutions Decrease Private Equity Investments
Bill Warner Tuesday, June 16, 2009
As we all know by now, institutions who invest in venture capital are backing away from this asset class. Now, the Coller Capital report provides some quantitative evidence in its most recent survey.
Institutions reduce investments
The bottom line result is that 20 percent of institutional investors plan to decrease their allocations to private equity this year; the largest decrease since the survey started in 2004. Another 15% plan to increase their investment, but even that is substantially down from previous years.
The core problems with institutional investors
The report cites the fact that there are fewer private equity firms to invest in, and many more will not be able to raise additional capital because of their poor performance. The survey predicts that there will be a 28 percent decline in the number of venture capital firms that will be able to raise additional funds. A shocking 84 percent of the institutions have chosen not to reinvest with their existing general partners. We know that the IPO market for venture capital backed companies has dropped to near zero, and that acquisitions are harder to get as well. This puts a major hole in the venture capital firm’s business model which requires a huge upside exit in order to achieve their expected returns.
Well, institutions haven’t fared that well either. Many have experienced 30 to 40 percent declines in their value with the market downturn, putting pressure on the ratios that govern how much they should be investing in this asset class. So, there are problems on both sides of this coin.
Expect a power shift in venture capital
There is good reason to believe that institutions are going to have more power in any negotiations for new funds. It’s a buyer’s market. There will be a lot of pressure on getting higher value for the fees that venture firms charge and deal terms between them are going to be more favorable to the institutions.
All said and done, this means that entrepreneurs have really got to have a great business story to attract venture money. It has been getting harder and harder to acquire venture money since the end of 2008, and it doesn’t like it is going to get any better this year.
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Manage Your Financials Like a Pro
Bill Warner Monday, June 15, 2009
Wow, here is a great testimonial from Anita Campbell, a small business owner, about managing your financials. I wish every small business owner had this much discipline.
Cash is really king
The biggest mistake that small business owners make is not really understanding their cash flow. Unfortunately, the result is too often running out of money followed by business failure. All of this comes from properly accounting for all of your revenue, cost, expense, and other cash transactions. If you are doing this, you simply need to look at your cash flow statement to see where you are. There you can see where you stand with:
- Money that is owed to you by customers
- How much you owe others
- The effect of depreciation
- The gains from financing activities
- Implications of changes in inventory
- Cash implications on debt
If your ending cash balance is declining, you may be in trouble. Watch this metric like a hawk.
Look to the future
Equally important is your projection of cash flow for the next 6 to 12 months. I strongly urge you to develop a cash flow projection on your own or with the help of a professional financial person. You may be fine today, but the growth of your business may put particular strain on your cash position. Think ahead to see future cash crunches so you have time to find the financing that will carry you through it.
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Factoring Is Hard to Get
Bill Warner Monday, June 15, 2009
Factoring your receivables has always been an alternative to satisfy a short term cash need. Read about some of the details about how it works in Open Forum. Although factoring continues to be a financing alternative in today’s economy, it is increasingly hard to get.
Factoring hurdles
Remember that banks are really tightening their due diligence and qualification criteria for any form of business financing, including factoring. In order to qualify for this form of financing, you face a redoubling of your justification:
- You have to have a solid history of positive financial performance
- Your debt ratio will be analyzed closely
- The receivables have to be from very reliable sources
- It would be better if they know you and you have a positive financing history with them
- You may be asked for additional backing, including personal guarantees
Other financing alternatives
Really, there are not many other alternatives except for factoring companies. They are hard to find and you really need to check them out before you engage them. A positive referral from someone you know who has had a positive experience would be the most desirable.
Nevertheless, when you are in a cash crunch, this is an alternative that you may not have a choice in passing up.
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A New Breed of Entrepreneur
Bill Warner Thursday, June 04, 2009
We are hearing more and more about many people starting businesses because they are out of work and cannot find a job. This is really happening. It’s a different form of passion driven out of the necessity to have an income. It may be as strong as the passion any entrepeneur has for bringing a technology to market, solving an important industry problem, or changing the world in some material way. Tim Barry talks about this briefly in Entrepreneur.com.
The rules are the same
This new breed of entrepreneur is really good news for the economy, but the rules of the road are the same as for any entrepreneur. They need a well thought out business model that:
- Cites an attractive market opportunity
- Focuses on real buyers
- Is competitive
- Spells out a clear marketing and sales path to success
- Is managed effectively
- Has the necessary financing to get to a positive cash flow position
Give them support
These new entrepreneurs need our help. Give them support and advice as they try to crack into the business world. It is likely they are very concerned about how they are going to succeed at something they have never done and their support structure is pretty lean. Chances are you will get something in return down the road.
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Venture Capital Correcting Valuations
Bill Warner Monday, June 01, 2009
Venture capital firms are finally making corrections in their valuations in response to the downturn in the economy late last year. Read about the details in the WSJ, but this decline in valuations represents an adjustment to the value they place on their portfolios and to any company they are considering for new investments.
The adjustments are not uniform
The sharpest decline is occurring with later stage companies whose valuations declined about 43%, dropping from a median of $56.1 million in the fourth quarter to $32 million in the first quarter, all of which is pretty comparable to the decline in public markets last year. The median for the third quarter was $64 million. Likewise, their limited partners have felt the squeeze as well in that their portfolio values have dropped a similar amount.
Second round companies had a similar drop from $16.1million in the fourth quarter to $10 million in the first. But, first round companies faired well by rising from $6.6 million in the fourth quarter to $7 million in the first, but usually show less volatility to changes in the public markets.
Venture firms are buffering their pain
In the first quarter, 57% of all venture rounds were done by the current investors, giving them the chance to tamp down the pain of the write-down thus protecting the fund’s performance. New investors would be much more likely to want a more aggressive reduction in valuations.
Good and bad news for entrepreneurs
Entrepreneurs of start-ups that are going for their first venture round should expect valuations that track consistently from the last two quarters. Unfortunately, this is a bad time to have to go out to raise later stage VC money. The company will probably be faced with a down round where the company’s value is less than what it was at the time of the last round, and it’s all due to the economy. The hard thing to swallow is that even if the company performed well and met all its milestones, it still will get punished with a lower valuation.
If you need the money though, you have to do it. This is where tightening the belt and conserving cash pays off.
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Venture Capitalists Open a Stock Market
Bill Warner Wednesday, May 27, 2009
Last week I wrote about angel investors becoming super angels and replacing the role of the venture capital firms in investing in early stage companies. Well, venture capitalists are not standing still. With institutions backing away from venture investing and the IPO market drying up, venture capital firms are rethinking their strategies. Take a look at what Tim Draper is doing to reposition his firm. However this comes out, this is all good news for entrepreneurs who need to raise early money.
A New investment entity
Draper is corralling money from other private equity firms and high net worth individuals to create what he calls an exchange for trading shares in early stage companies.
In addition to being an informational network for investors and companies, the exchange provides a facility for matching investors with companies and a platform for actually buying and selling company shares. It’s a private stock market, giving investors the opportunity to invest in high potential companies and getting some early liquidity in lieu of an IPO.
Although this is not a new idea, it is the first time that an exchange has been pulled together for venture capital.
How this helps entrepreneurs
The exchange provides a service for entrepreneurs to raise money for their ventures, while at the same time offering investors a new way to get a return on their investment short of an IPO or acquisition.
This service doesn’t quite reach the pure start-up in that the company has to have at least $20M in revenue to enter the exchange. Nevertheless, this is a good thing for these companies in that they will have another viable opportunity for raising capital.
Launching in September, this will be a grand experiment worth following. Stay tuned as this evolves and see how other venture firms deal with this dilemma.
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Super Angels May Replace Venture Capital
Bill Warner Friday, May 22, 2009
Here’s a slant on the angel investment world that you may not imagine. Those angel organizations that view this down economy as an opportunity to get some really good deals may be introducing a new model of angel investing that could replace the role venture capital firms play today. Read about this in Spenser Ante’s article in Business Week.
What’s new?
Here’s the idea and premise. Instead of raising huge amounts of money in venture funds, which many claim is a broken model because the IPO market is nearly dead, raise much smaller funds. Every wonder why you read so much about the health of IPO’s? VC’s need them to get the multiples they require to make their deals whole. The new premise is to raise smaller amounts of money and invest much smaller amounts in many start-ups looking for much smaller but more predictable exits.
The aggregate should be more positive exits but at much smaller values. The idea is that the overall returns will be greater than the very high risk opportunities that VC’s engage in today.
VC’s are too big
The issue may be that VC firms are just too big. They have to place so much money in any single deal that they are almost destined to fail because the exits will not be lucrative enough. It has nothing to do with the recession, but everything to do with a basically broken business model. Some VC’s are seeing the light and going back to their roots of investing in start-up companies with small amounts of money. The difference today is that many companies can be started with a whole lot less money than we were seeing in the late 90’s and early 2000’s.
Why this might work
Well, the proof of the pudding is not yet seen. An entirely new model of venture investing may be emerging; one where VC firms invest in a lot more deals at the start-up stage with a lot less money per deal. This is placing a lot more bets on much riskier opportunities. Stay tuned as this model emerges.
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Angel Investments Decline In Recession
Bill Warner Thursday, May 21, 2009
In its most recent Angel Group Confidence Report, the Angel Capital Association (ACA) reported that 2008 average angel group investments were down 9 percent from 2007. They did point out that many groups actually increased, seeking opportunities while valuations are depressed.
Why did investments decrease?
We are all familiar with the impact of the economic downturn. As institutions backed away from venture capital investments, angel investors also become much more cautious and selective. They too took a big hit in the markets. The reaction of angel groups has been to be much more selective about making investments in new companies. This has led to the decline in average angel investments. In addition, they circle the wagons and protect their portfolio companies. Knowing that their companies will need help as it became unlikely to be able to raise VC money, the angel groups have to carry more of the water.
What does it take to get their attention?
It’s not all gloom and doom. Entrepreneurs that have a great business idea should not shy away from approaching angel groups. They should really get familiar with what valuation and terms to expect in this market before they approach them.
Angels will be looking for well thought out business models that will get substantial sales traction quickly. The less money needed the better. Many web based businesses have that characteristic. It is important to portray a realistic and near-term exit strategy; the shorter the better. The management team matters even more. Gather an outstanding group of people who have both the technical and business wisdom to grow the business.
What does the future look like?
Well, I am afraid it is going to be more of the same, and perhaps a little worse, in 2009. But, again, don’t let that stand in your way as entrepreneurs. Put a whole lot of discipline in your business planning and execute smartly. Nothing beats a company that knows how to get to market. Be one of them.
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Buckle Up For New Valuations and Term Sheets
Bill Warner Wednesday, May 20, 2009
The market downturn has certainly put the damper on the view of risk by angels as well as VC’s. I keep reading that there is plenty of money out there, which is true, but the problem is that there is actually less money than last year. The personal wealth of angels and the portfolio value of foundations and institutions are considerably less by 30 to 40 percent. This puts a lot of pressure on their willingness to take on new investments.
Term sheet shock
As entrepreneurs go out with their investor stories, the lucky ones get to see term sheets that are unbelievable. See Ty McMahan’s article in the WSJ. The rest have to keep looking. The term sheets bring a new dose of current reality:
- Valuations that are up to 50 percent lower than this time last year; start-ups could pretty much negotiate a 2 to 3 million dollar valuation last year, but now, you can expect to see 1.5 to 2 million, sometimes less
- Dominant board positions for investors
- Significant control of money spent through strict covenants
- Tamping down of executive salaries
- Option pools carved out of founder’s shares
- No recovery of past founder expenses or deferred salaries
Entrepreneurs need to show maturity
It has always been the case that entrepreneurs have to show that they have a mature understanding of the equity market. Entrepreneurs that have unrealistic expectations and are not willing to negotiate and compromise will fail to get any money. However, today’s equity situation is a shocker for even the most mature of entrepreneurs. We are in a deep buyer’s market and prices and terms are very much in favor of the investor. If you need the money, this is the way it’s going to be for quite awhile.
Before you approach investors, get an update of your understanding of the market and be prepared to deal with this new reality.
