Saturday, November 15, 2008

Who are those guys? What makes a good VC. Final Episode 5

It’s taken me a few months to get to this fifth installment. I was stalled at first because there hadn’t been a lot of “Exiting” going on in the past year or two. And I had the feeling the concept of Exit was undergoing change. Then we experienced the economic meltdown of the past two months. Like other active VCs, my fund responded by focusing our attention on our current investments, helping them position themselves to weather the downturn. So I apologize to those of you who emailed wondering if I had died or something. No, I’ve just been very busy, and a little reflective on my subject.

The classical view of venture capital is that a VC invests in a company, grows it into revenue and breakeven, and then sells equity in it to the public in an IPO. The exit part is the VC’s can then sell their ownership interest in the startup to that public market of buyers as the company grows in value, or distribute their now-liquid shares to their limited partner investors to sell. Either way, there is a rotation of the early investors out of the stock and new public investors into the stock. In a prototypical case, a venture fund may have put a total of $10M into a startup and owns 25% of it, and later when it goes IPO, that 25% is worth $250M and the VC gets a 25x return on their investment. The buyers in IPOs were typically trying to buy into rapid initial growth from new businesses. Or they were trying to buy in early to a speculative bubble, and get out before it sank back to earth. This is what was driving much of the bubble economy of 8 years ago.

A common alternative to the IPO exit route was getting the startup acquired by a bigger company, a so-called Mergers & Acquisitions or M&A exit. This could directly result in a cash return if it was a cash acquisition, or it could involve stock in the acquiring company that might yield immediate or near term liquidity. When the so-called “IPO window” was closed, i.e. IPOs were not getting done on Wall Street, the acquisition route was the preferred backup plan for VCs. Frequently the IPOs might be failing but large acquiring companies might still be looking for new lines of business or revenue growth from startups. In the past couple of years, acquisition or “M&A” exits have been much more common.

We now live in extraordinary and seemingly unique times. It is doubtful that an IPO market will come back soon. The public market has been burned by a steep drop in values across the board. Many investors will not trust the markets for some years to come. Buying into a speculative IPO of a company with a short track record in a new market may be too much to ask of investors. There has clearly been a flight from risk, but unfortunately no risk-free place to turn. Many argue that the smaller, nimbler, trendier companies will recover more value as we come out of this downturn, but I’m not sure that will apply to IPOs.

Why do Venture Capitalists need Exits in the first place? Because they are the opposite of Warren Buffett, they are constitutionally unable to be in it for the long term. They raise their funds by making a promise to their limited partner investors that they will return much greater value to them within 10-12 years and more desirably, in 5-7 years. VCs can be seen as relatively short term, high risk investment agents for their LPs. They (hopefully) intelligently direct an endowment’s money to the best early stage investments, and relatively quickly hand back a liquid return.

I’ve been reflecting on the best way to do that in our current economic climate. Some pundits have argued that the VC world has fundamentally changed, mostly because the traditional exit strategies have become untenable. How do you invest in a start-up and get to liquidity so you can distribute to your LP investors if there is no IPO market and a seemingly limited number of acquirers. The joke around the Silicon Valley was the only exit strategy was a “GYM” strategy, i.e. sell to Google, Yahoo, or Microsoft. But there is a limit to what even these companies will buy, especially in these times, and especially if it Microsoft buys Yahoo.

So I’ve been pondering alternative exit strategies or holding actions until the traditional exits come back. For example, I have the impression that in a lot of markets there are too many startups addressing market niches that can’t support them all. In a tight market of investment capital, there may be more room for, and a need for, creative mergers of early stage companies. Maybe startup teams need to merge with other startups addressing the same markets. In effect, the two startup’s investment syndicates need to join forces to address a shared market interest with their collective teams. The danger of having too many spread-out competitors is that NOBODY survives because they are forced to resort to desperate competitive tactics. Merged together, they can more efficiently address their market niche and combine the best features of each one’s original offering. There is no doubt that this means redundancy will be trimmed and teams will be smaller. But that makes more sense than a war of attrition where no one survives.

What I’m thinking about here is something like a bottoms-up roll-up strategy. Earlier stage companies may need to look at their competitors as partners to join up with. The investor groups end up diluted but owning the best of both companies and with more syndicate partners and probably more money and staying power around the table. The resulting consolidated company benefits by having less mutually destructive competition in their niche. The market benefits by getting a more rounded product offering from a better-positioned company. There will obviously be some egos bruised as two entrepreneurial, aggressive start-up teams are merged and trimmed. But it’s a survival strategy in a down market, probably makes a company more fundable, and is a better outcome than getting shut down.

Obviously there are reasons why this strategy doesn’t work in all situations. Frequently neither company has enough money to survive much longer. The old aphorism that “tying two stones together won’t make them float” certainly applies here. But when an VC investor group is faced with doing an inside round or a bridge to one of their start-up companies because there isn’t enough capital in the company or there isn’t an attractive exit, but there IS the gist of a good company, maybe that is a good time to look at the competition and try to craft a creative merger. The result may be more fundable.

This posting has morphed into more of a discussion about exits in our current climate than about what makes a good VC. I do want to finish this series on what makes a good VC from an exit perspective. But given the above discussion, my bias in the coming paragraphs will be on deal-making skills rather than IPO/investment banking skills.

A good VC is helping their start-up team deal with operational challenges as they build their company. Since the majority of venture-backed companies will fail or exit at below their cash-in value, the majority of exits a VC must execute on may be under less than advantageous terms. A “dealmaker” mentality succeeds best in these situations, i.e. that individual who knows how to read the acquirer’s needs and get the most for their start-up by positioning it to meet those acquirer’s needs. It is salesmanship.

Other previously mentioned skills like a big rolodex are obviously valuable here. And VCs that have previously backed now very successful acquirers (think Google) can often have better luck selling their subsequent start-up companies to that earlier success. They know the management and key opinion leaders in the acquirer. Frequently those senior managers may even be limited partners in that fund.

I doubt there will be many IPOs in the coming couple of years. The skills that make a VC successful in a world of IPO exits aren’t likely to be useful now. They aren’t that different than what is valued in an M&A exit world. It may be important for a VC to understand some of the foreign exchanges that have been able to provide IPO exits in the past couple of years. Toronto and London exchanges were getting IPOs done a few years ago, so a VC with good international experience and even overseas partners might have been at an advantage then. But those days are over now.

My next posting will try to summarize this 5 episode rumination on what makes a good VC. I’m looking forward to talking more about how the VC world is evolving as it matures and adapts to changing economic times.

Thanks for waiting.

No comments: