VC Confidential

VC's Mathematical Challenge

There is no doubt that the venture industry is going through a major house cleaning right now. Much of the pruning that should have been done post Bubble is finally going on now as LP's start to wake up and pull back a bit from the asset class. One of the main challenges has been the mismatch between LP demand in the category and the declining liquidity of it. The main question people as is what is the right amount of capital that should flow into the business annually to keep it healthy. Let's look at the mathematics from the exit perspective:

Average annual number of acquisitions: 250

Average sales price: $80 million

Average annual number of IPO's: 100

Average value of IPO: $150 million

Total annual value of venture backed exits: $35 billion

(IPO's have been down below 10 recently and above 200 in healthy times but below 60 for the past 8 years)

(sale & IPO values have fluctuated but these are swags)

Assumed VC ownership at exit: 70%

Exit Value going to VC's: $24.5 billion

Target Fund multiple: 2.5-3x

Capital Deployed to hit: $8-10 billion

This means that for the industry to continue (a la 1990's) generating IRR's north of 20% net in this exit environment, no more than $10 billion should be flowing into it during any given year. If the IPO market wakes up, this number goes up. If it stays asleep, it goes even lower. In a strong year (250 IPO's & 300 acquisitions at $200 million & $120 million avg values respectively), total annual exit value jumps to nearly $90 billion. Filter this through and the industry could handle roughly $25 billion in new capital.

Well, until just the first quarter of this year, industry fundraising has been north of $30 billion for several years and the exit markets have been significantly below even the initial levels above. Our industry stays healthy if no more than $10-15 billion per year is raised. So, we've been at 2x that rate. The LP's have hopefully figured this out and we'll see smaller brand funds and fewer total funds.

How many funds can survive in this kind of market? Let's do the math again:

Couple of mega-mega funds like NEA, Oak, TCV & Menlo: say 5 x $2 billion each = $10 billion

Number of brand funds: say 25 x $500 million each = $13 billion

Number of next tier funds:  say 40 x $200 million each = $8 billion

Fundraising cycle: every 3 years

So, just these initial 70 funds results in $10 billion+ per year raised.

Assuming that there will be around 300 funds around in total, this leaves about $5 billion/yr for the remaining 230 groups. Using the 3 year cycle, this results in each of these funds being under $65 million in size. If the exit environment remains moribund, then all of these number have to discounted even more to get to $10 billion in total industry dollars annually.

So, the industry has to drop from 500-600 groups to 300 groups and the LP's need to pair everyone back. No more $4 billion Mega-mega funds, no more $700-800 million brand funds, no more $300-400 million next tier funds and no more $100-150 million remaining funds. If the LP's don't do this, we end up north of $25 billion per year again and terrible returns.

Can LP's contain themselves? We'll see once conditions start to improve in the economy. In the interim, it will be ugly times for VC fundraising...

Strategic Protectors

In difficult times, strategic partners can be essential to survival. As companies fight for air in these cash strapped times, larger corporations have valuable resources. Our portfolio companies have leveraged partners in several ways.
1) Pre-paying revenue. Some customers will pay in advance of delivered goods. Future takedowns are applied against this.

2) Venture leasing: if an entrepreneurial company is investing heavily in equipment and capacity for a customer ramp, see if they can help finance it. This can be thru their in-house finance group or by helping guarantee payment of the loan. They understand that they benefit from your getting this capacity funded.

3) Distribution agreements: corporations with global distribution can expand the addressable markets and customers you can reach. If you deliver revenue to them (bundling with your product or a cut of the sale), it can be a win-win.

4) Strategic investment: corporations that see your strategic value to them may be more likely to invest in your firm than the traditional venture industry.

There are a million caveats around embracing strategics. You want to avoid firms who are known to be litigious or difficult to negotiate/ work with. More so, if they are known to absorb information and then build competing product, avoid them at all costs. There are many in the consumer electronics world that frequently do this.

Realize that corporations have limited cash themselves. But bringing solutions or ideas that bring incremental revenue or discretely reduce cost today (no "productivity gains") and they will take the discussions seriously.

Be careful not to lock yourself into having a one acquiror situation. Getting multiple strategics engaged, having other distribution channels and creating other alternatives gives you more freedom.

More importantly, use these activites as a way to start courtships with potential acquirors. Both sides will get a chance to understand where synergies and fit are. It is an investment in the future.

So, be careful but realize that strategics can provide essential lifelines to you.

The Art of Selling Your Firm

Despite the markets' gyrations, 2008 was the best year for liquidity in our firm's history. In fact, our largest exit (Lefthand Networks) closed in November in the heart of the downdraft. In looking across these exits, the strong exits all had several common elements:

1) Self-sufficiency: the old saying in venture is that companies are bought and not sold. If the acquiror knows that time is it's friend, they will slow roll the process, driving harder terms with each passing month. Don't go into the process without a long runway (or a strong forcing mechanism). Your gut will tell you how much of the process is your pushing versus their pulling. Don't push.

2) Mortal Enemies: the surest way to have a healthy process is to get two bidders that viciously compete with each other. During one process, we tried to leverage a weaker competitor to motivate our lead buyer. They laughed and encouraged us to sell to them. We subsequently engaged their fierce competitor. The result: LOI in weeks, closed in 6 weeks.

3) Existing Relationship: people do deals with people they know. You can either try to convey your value during an impersonal pitch or let them experience the specific facets/nuances of your firm or technology through interacting with you over time. Most firms know who are the likely buyers. During this downdraft, it is a good time to build these relationships. You can get their attention if you can deliver revenue to them or reduce concrete costs. Don't ever taint this process by pushing or even hinting at selling the firm as it will set you back.

4) Few Alternatives: scarcity is at the heart of a good sale. Few or inferior alternatives swings the balance in your direction. If there are an array of available solutions, you will lose your leverage in the process. A superior/strong product can sell itself. If you have strong synergies with competitors,you can carefully & selectively consolidate or rationalize your sector. Now is the time to distance yourself from the pack, outlive competition and consolidate so you are the logical acquisition.

5) Visible Scalable: you invest in companies if they demonstrate a scaling revenue model which has visibility on the growth drivers going forward. Acquirors will do the same. Have you proven out your revenue model and can you show how it will ramp significantly if owned by them. Show it becomes more profitable with them.

6) Strategically Central: if your product or service is a central component to the acquiror's future, you will get attention. If not, you may likely get lost in the noise. This can be the product that is missing but is a key growth driver in their industry or can protect/enhance core existing products.

So, while exits are harder today, now is a key time to position for exits when the conditions improve in coming years. Build relationships now that will be essential later.

Term Sheet Tool

The gang at Wilson Sonsini have created a very interesting term sheet generator. In addition to its practical value, it is also an interesting educational tool. If you are an entrepreneur or a new VC, it goes through all of the key term sheet elements in very specific details with the most common option highlighted and explanations for most. Definitely work a look. Be forewarned that it takes a bit of Q&A to get through it as it asks about all the key elements.

Click here: Wilson Sonsini Term Sheet Generator

Enough Wall Street, Enough

"Even as I write I am watching the eunuchs now posing as Wall Street CEOs bend over backward before some congressional committee...We at Morgan Stanley are pleased by your investment. Now, if you ever want to see a dime of it back, go away. We’ll call you if we need you." -- Michael Lewis

It boggles my mind how many articles I am reading that defend the short-sighted land grabs at our banks & insurance companies. Does Wall Street get it?  If you lose so much money from stupid & greedy activities that your firm is insolvent, you don't get to stick your hand in the piggy bank for bonuses. Show contrition, not indignation. The way that the rest of the world operates is you get to the end of the year, you look at your profits and your cash balances. If you have the cash to pay the bonuses, you pay them. If you don't have the cash, you don't. So, Wall Street, if your performance has been so strong that it deserves bonuses, pay them out of your cash. Oh, wait, you don't have the cash...

Some of the Wall Street crowd claim that their divisions were highly profitable and, therefore, their groups deserve bonuses. Sounds good to me. You just need to have the groups that hemorrhaged all the losses pay back that capital to the firm. If you can't get this money back, guess what...no bonuses. If you feel that this isn't fair, join the crowd. You are part of a single firm. You rise and fall together as a single firm. You can't keep the positives and ignore the negatives. With hedge funds, buyout funds, real estate funds, venture capital funds and commodity funds, if one partner's deal is a huge hit but another partner's deal tanks and wipes out the profit, no one gets a bonus (carry). This is because the fund's management team rises and falls together. Is it a bummer for the partner who delivered the big win? Yes. Does this mean he/she is owed a bonus? No.

If you don't have the money to pay the bonuses, why not just borrow the money? Isn't this the fundamentally sound way to run a business? Bankrupt your firm and borrow money to pay your bonuses.  Also, make certain that you go to the bank and tell them to give you the money but leave you alone to do whatever you want. Why do they insist on silly things like covenants, coverage ratios and sound business practices? Sorry to burst your balloon but lenders (including the government) have a voice.

If you've dug yourself so deep into a hole that no private sector firm will (or can) lend you money, sounds to me like you need to really tighten your belt, get real or go under. If the government is the only one who will give you money, even more so. Actually, this usually means that your firm is toast and existing contracts are voidable. I don't believe that the term "bonus" ever makes it into the dialog.

I agree that it took an entire nation to get us into this mess. I also agree that we should not make Wall Street the scapegoat for everything. However, Wall Street seems to be one of the few insistent that they should get rewarded. The other culprits are enjoying having their homes repossessed or investment portfolios cut in half. So, Wall Street, grow a pair (to quote Mr. Lewis) and do the right thing. Don't extort excessive compensation from a vulnerable country because you think you have leverage. And to everyone else, please stop the parade of articles and op ed's trying to take the offensive on this issue. It will only get worse over time.

Some very rational people, people that I respect, seem to be jumping on the band wagon to justify all of this behavior. They are indignant that a populist witch hunt is descending upon Wall Street. Unfortunately, unless Wall Street wakes up and smells the coffee, this will get worse and worse. Actions have equal and opposite reactions. When J&J had its issues with the Tylenol scare, it didn't tell people to stop complaining and go back to buying Tylenol. It took the financial hit and aggressively addressed the issue. In fact, it went beyond what most people expected.

Somehow, finding ways to sneak additional cash out of the system while continuing to ask for more loans does not strike me as an effective show of contrition. Furthermore, being vocal and indignant in your response does not seem to advance the cause much either. Worse, it really angers an already volatile population. Put gas on this fire and I will guarantee you that you will get the Populist Revolution that you fear. And, everyone earning more than minimum wage is going to get dragged into your Class Warfare if you keep this up. 

One last, tangental thing. Unless we rebalance things here in the US, we are in a lot of trouble. When we reward financiers significantly above entrepreneurs (not to mention doctors or teacher or...the usual list), we will end up with a nation of arbitragers versus engineers, manufacturers or founders. Our best and brightest will go where the money/bonuses are. Not so good in the long run...

Why Great Companies Get Started in the Downturns

I have always been amazed by how many of our success tech stories, as well as Fortune 500 companies, started during drastic down turns. Innovation does not take a holiday, and in fact, thrives during difficult times when pain & need are greatest. While the current downturn is historic, it pails in comparison to the 22 year depression the US experienced from 1873 to 1895, triggered by the Vienna stock market crash.  During this extended drought, a large number of Fortune 500's & major corporations started including Eli Lilly, IBM, Merck, Hershey's, Gillette, Alcoa, J&J, Chevron, GE, AT&T, Abbott, Lilly, Coors, Johnson Controls, Bristol-Myers and PPG to name a few.

During the great depression (1929-1939), Texas Instruments, HP, 20th Century Fox and United Technologies all launched. Since much of the Valley's legacy came out of HP, the seeds for the current Silicon Valley were planted while the stock market was crashing nearly 90% and unemployment approached 30%.

Other periods: during the Oil shock & market crash (1973-1976) Microsoft, Genentech & Apple started. The biotech and PC revolutions emerged when the market was down nearly 50% and inflation was racing into double digits.  In the crisis of the early 80's (1980-1982) with mortgage rates peaking at nearly 21%, Amgen, Sun, E*Trade, Autodesk, Adobe, BMC, EA and Symantec were created. The question is why does this happen?

Dogs Will Try New Dog Food
When everything is going well, few people or companies want to change behavior, process or vendors. They have little incentive to do so and risk upsetting the apple cart. However, when their hair is on fire, customers & business partners are willing to try new or different approaches to address the pain. So, while some would say that sales cycles stretch out significantly during downturns, I would argue that for new technologies that solve real problems, they compress considerably.

Take Care of Darwin
Leading entrepreneurs have a maniacal focus on efficient use of capital and on fulfilling customer needs (versus nice to have's). During troubled times, these entrepreneurs are even more focused on these. Cash is spent only when absolutely necessary and no to few features are built that aren't demanded by the customer. Those less disciplined will find themselves victim to Darwinian realities. Companies "forged in hell" have a much more durable and advantaged DNA coming out.

Power of an Equity Culture
In these times, firms either bootstrap or fund themselves from modest equity rounds. Credit, other than credit cards and such, is not readily available. Furthermore, the start-up world is an equity culture versus the credit/debt culture of buyouts. So, they are able to survive when banks won't lend and credit lines are non-existent. Equity can be a beautiful thing.

Weak Gazelles are pruned
During boom times, sectors get overfunded and weaker competitors destroy the economics for everyone involved. They create significant noise in the market place, create skeptical customers by overpromising and underdelivering and have undisciplined pricing policies. In hard times, there are many fewer competitors which allow companies to scale quietly during the trough and take significant market share when conditions improve. Furthermore, these firms enjoy rational pricing, higher profitability/margins and lower cost structures given their DNA.

So, yes it is ugly out there and about to get even harder but start-ups are used to hard times and are well suited, if managed properly, to thrive in the downturn and accelerate during the recovery. The trick is to stay alive one day longer than your competitors...

Why VC Returns Languish

So you see a pattern here?

Number of VC-backed IPO's:
1995    205
1996    272
1997    138
1998      68
1999    250
2000    202
2001      22
2002      20
2003      23
2004      67
2005      43
2006      56
2007      76
2008        7 (none in Q2 or Q4!)

Average Time to IPO
1998    3 years
2008    9 years

Number of Companies Funded:
1998    1,896 ($14.0B invested)
2008    1,930 ($14.1B invested)

When you cut through all of this data, what you see is that VC's portfolios have filled up with deals while there has been little liquidity.  With 1,930 companies funded but only 7 IPO's (and another 300 M&A's), you have a lot of overhang in the existing company portfolios. The average time to exit has grown linearly since 2000. For entrepreneurs, what this means is exits will take longer to realize, requiring a long-term perspective to decision making and strategy.  Also, VC's are going to be very pre-occupied managing existing companies and have less time to a) due new deals and b) spend time with those deals.

The IPO machine will not likely return until the markets have hit bottom, stabilized and begun their growth again. Additionally, the notion of a promising $30m in revenue company (like Apple was) going public has been replaced by $100m thresholds. This means M&A is the primary driver of exits for some time ahead, which requires less swinging for the fences and more low burn/capital raised.

Interesting stats...

Josh Lerner on Serial Entrepreneurs

"A good hockey player plays where the puck is. A great hockey player plays where the puck is going to be."
        -- Wayne Gretzky

peHUB had a recent post by Connie Lolzos on Josh Lerner's recent research about serial entrepreneurs. There are two general camps. One states that success begets success and serial entrepreneurs are likely to repeat. Lightning does strike twice (or three, four, etc times). Another position is that success is driven predominantly by serendipity which greatly reduces the chance of serial success. Furthermore, once a founder has hit it big, is he/she as hungry the second time when their bank account overflows.

Josh Lerner looked at a cut of data around success rates of serial and first time entrepreneurs (Paper link: Download 09-028 ). As Connie mentions:

According to its authors, including renowned HBS professor Josh Lerner, successful entrepreneurs have a 34 percent chance of succeeding in the next venture-backed firm, compared with 23 percent who failed previously, and 22 percent chance for new venture-backed entrepreneurs. (Honestly, I had no idea new entrepreneurs, or even second-time entrepreneurs with one failed company, had a one in five chance of succeeding. If I were a new venture-backed entrepreneur, I’d be pretty heartened by that data. Those are way better odds than you’ll find in, say, the restaurant business.)

This would support the serial entrepreneur camp's claims obviously. Furthermore, it also quantifies the chance of success for those first time entrepreneurs...around one-in-four. I would imagine that this number goes up significantly during downturns like today when competition is reduced and a likely liquidity event occuring during a market recover (in 3-4 years).  Timing of launch has a strong impact on venture success.  Lerner comments that great entrepreneurs are more likely to launch during these times and have the vision to see what could be versus what is.

Connie also pointed another interesting fact about how many venture backed deals involve serial entrepreneurs. It looks like only 13-16% of the time do VC's back serial entrepreneurs. So, 6 out of 7 times, a new entrepreneurial team (often coming from other start-ups though) gets the VC money. Another positive for emerging entrepreneurs.

Apple Slices

I came across an article from last year from Fortune, Steve Jobs Speaks Out, in which Steve discusses Apple's approach to business and innovation as well as its culture. Entrepreneurship is part passion & execution and part mentoring. The best entrepreneurs continually learn from the examples of those around them. They are curious about what lessons others have learned or what experiences others have had. You can learn in one of two ways: do it yourself or learn from the mistakes/successes of others. Clearly, nothing repeats itself so these efforts are more about creating, as Charlie Munger says, "Lattices of Mental Models". He is an avid student of a broad array of disciplines which he applies across discipline. Anyways, interesting article...

...Or Assuredly We Shall All Hang Separately

"We must all hang together, or assuredly we shall all hang separately." -- Benjamin Franklin at the signing of the Declaration of Independence

Dan Primack set off an interesting dialog around his article Radically Reinventing Venture Capital. There is a growing wave of articles about new or revised models and debate around what went wrong.  He described a suggestion by one Boston VC who proposes that LP’s think about funding individual VC’s as single partner entities. These are all interesting and thoughtful discussions, but I believe that they are over thinking things. I offer that the heart of our issues rest in our industry’s compensation incentives mixed with a fine market melt down.

Venture capital used to be a business about creating revolutionary businesses to change the world for the better. Wealth was driven by carry, the GP’s share of profitable investments. Investor, entrepreneur and VC were aligned, all focused on profitable investing. This has broken down.

The LP community has moved aggressively into alternative assets to kick start unfunded obligations. Furthermore, consultants, advisors and staff have concentrated this capital on a shrinking list of investment firms.

At the same time, market disruptions have basically shut down the IPO world and the VC’s main escape hatch. With public options diminished, acquisition multiples have declined, which has reduced the frequency and size of investment exits. For example, while investments normally take 3-6 years for exit, in this environment, only 20% of deals have exited since 2003. This had backed up VC’s portfolios.

The toxic result is that VC’s look increasingly to management fees instead of carry for compensation. This breaks the alignment between LP & GP. This incents & focuses VC’s on raising larger funds, more often and deploying it quickly.  If a group raises $800m every two years, it adds management fee in $20m per year chunks. Three funds, eight partners leads to $6-8m/yr per partner in just fees. Carry is a nice to have versus need to have.

As long as LP’s go along with this, things won’t change. Unless the money drives this, behavior & incentives won’t change. They need to regain the alignment between their interests and the VC’s.  One heretical idea would be to move current compensation from being based on assets under management to salary based with escalators. By relatively fixing the current compensation regardless of assets (increase it for new hires), VC’s will have less incentive to raise capital for the sake of driving current fee. Rather, they will be focused more on the carry. Granted, carry grows with fund size assuming returns are the same, but we all know that returns suffer when funds are too big and are deployed too quickly. So, there is some governing factor to imprudent asset accumulation.

I also liked the structure of Warren Buffett’s first funds. He established a base rate (say a 6% return) upon which no carry was charged. So, the first 6% of IRR is free which makes sense, as venture’s goal is to drive alpha above more conservative asset classes. Unlike with hurdle rates, he did not have a “catch-up” after 6%. Rather, he charged 25% of the profit above the 6%. So, a VC is worse off (from a traditional 20% carry) until IRR’s in the low teens and then better off above the low teens. This gave no bonus for poor results and superior compensation for strong results.

I don’t know if the LP community has the appetite for this kind of approach regarding fees. They are fighting to get allocation into a narrowing list of venture firms so are unlikely to rock the boat for fear of exclusion. They are, unfortunately, in for a rude awakening if they can’t find another way to align their interest with those they entrust their capital.