venture counsel

The second quarter of 2009 was much improved over recent quarters according to statistics compiled by the National Venture Capital Assocation (NVCA) (report available here:  http://www.nvca.org/index.php?option=com_docman&task=doc_download&gid=464&Itemid=93) – although still not up to historical norms.  The NVCA says there were 5  ‘venture-backed’ IPOs in the second quarter, and 59 acquisitions of venture-backed companies.  Prior quarterly results for venture-backed IPOs reads like binary code (0, 0, 1, 0) since Q1 of 2008 when there were also 5. 

Although the number of M&A exits (59) was slightly lower than Q1 (62), the disclosed valuations were much higher, with a disclosed value of $3.2 B in acquisition value during the quarter.  This brings the average deal size to $197MM for the last quarter, which is a fairly good number compared to deal sizes in the past several years – as opposed to the abysmal average deal size of $49M in Q1.   It also appears that ‘good’ deals for the VCs (deals that returned at least 1x invested capital and in some cases 4x or even 10x) were up compared to the last quarter; however, the number of deals for which data was available for this analysis was a relatively small set, so it’s hard to guage whether that held true over the entire deal universe.

In the IPO market, the small number of exits (5 according to the NVCA report, 4 according to others), is still better than 0, which is where we’ve been for a while.  And most of these IPOs continue to trade above their initial valuations, which is a good sign.

So what does this mean?  It’s hard to tell how much of this capital was returned to venture capitalists, since some of the money in the M&A deals would go to the founders and employees, banks and other creditors, etc., and some of the value paid may have been in stock of varying liquidity instead of cash.  With the IPO market, the report doesn’t discuss what value the IPO prices would put on the VCs’ stock in the companies, and since the VCs are almost certainly all subject to lock-ups, who knows what the market for the stock will be when their trading window opens up and they’re able to liquidate their positions.

However, we do know this much: it is better than where we’ve been and even if this is the state of the exit market for the rest of the year, it offers hope.

As you might remember, last fall university endowments and other large LPs made drastic cuts in their allocation to venture funds and many LPs were calling their VCs and asking them not to make additional capital calls for new investments (i.e., http://dealbook.blogs.nytimes.com/2008/10/06/venture-capitalists-are-hearing-footsteps/?scp=2&sq=endowments%20LPs%20venture%20allocation&st=Search).  Earlier this year, some VCs publicly were doing the math and discussing whether the VC industry needed to be “right-sized” (in particular, a mathematical exercise by VC Fred Wilson became a hot discussion topic: http://www.avc.com/a_vc/2009/04/the-venture-capital-math-problem.html).

This week has seen a flood of news articles discussing whether the industry as a whole should be smaller and even, a slightly different concept – whether funds themselves need to be smaller to be attractive (http://bits.blogs.nytimes.com/2009/06/05/investors-want-smaller-venture-funds/ and http://bits.blogs.nytimes.com/2009/06/05/venture-capitals-elders-say-think-small/).  These articles include input from venerable VCs and LPs arguing that once a VC fund is big enough to run like an asset manager, it begins to lose some of that spark and drive that makes the VC class work so well - the VC is out there in the weeds, picking the early winners among a new technology, rolling up his or her sleeves and actually adding value to the investment.  Over lunch, Bob Summers described these as the “craft” VCs (like “craft breweries”), which I think is a great term.

Now, a report put out by the Kauffman Foundation makes the argument that the VC industry overall needs to shrink by half in order to survive and make sense (report available here: http://www.kauffman.org/newsroom/venture-capital-industry-must-shrink-to-be-an-economic-force-kauffman-foundation-study-finds.aspx).  Many entrepreneurs out there looking for funding right now would probably disagree vehemently, but the report makes some good points.  And in the end, having a right-sized VC class would probably avoid some of the current hangover that is seriously affecting the ground floor – VCs funding new startups.  Already the ability to love again (or in this case, to invest in new startups) is creeping back in to the industry (starting on the West Coast), but for the long-term this report makes some good points that many have made for years – that the allocation of overall investment dollars to the VC class has a limit.  Once too much money is invested in the industry, there are investment-opportunity limitations and some natural “industrialization” that begins to occur that bring the potential overall return down – which leads to the cycle of over-exuberance and drastic pull-back that we see now (exacerbated in this case by the overall economic and capital situation).

In any event, it appears certain that there will be some permanent right-sizing.  The question is whether this will delay or hamper the return of VCs investing in your exciting, new business over the course of the next year.  I feel fairly positively about the next 12 months, and believe you will see many more VC term sheets out to new businesses from VC funds that have solid footing, even non-West Coast funds.  A few area companies have already experienced a new wave of interest (and, in some cases, term sheets) and it almost feels like Spring.

The numbers for the first quarter are out (https://www.venturesource.com), and aside from the decrease in total investments (which you already knew from other sources that are released earlier), the notable trend is a decrease in valuations for later-stage, follow-on financings.

The median pre-money valuation for later stage rounds was: $32 million.  This is a 43% decrease from the median of $56.1 million in Q4 ‘08 (however, this was pretty high historically speaking - in fact, the median in Q3 ‘08 of $64 million was the highest since 2000).

The median pre-money valuation for second round financings was: $10 million, a 38% decrease from the $16.1 million in Q4 ‘08.

First round financings increased a little (from $6.6 million to $7 million).  Overall valuations (including first, second and later rounds) actually increased a little, but this is probably due to the fact that proportionately more financings were later stage (which would naturally skew the overall numbers larger).

Many of the later stage financings are insider-only, or VCs propping up their “walking wounded.”  (Or less skeptically, they’re continuing to fund favorites through this financial morass where new sources of financing (or acquisition) are few and far between.)  But the decrease in valuations indicates that the VCs are more realistically valuing their companies given the new financial landscape.

This decrease in valuations for insider rounds means that the VCs will be required to take a valuation hit on their portfolios if they haven’t already.  This means the reports that go out to their LPs (and potential new LPs) will include some bad news.  According to today’s Venture Capital Dispatch (http://blogs.wsj.com/venturecapital/2009/06/01/later-stage-valuations-tumble-as-venture-investors-reset-expectations/), LPs have been seeing writedowns of 10-15% recently, but these down rounds may result in writedowns of 30-40%.

Hopefully this decrease in portfolio values (or the reality that caused it) has already been “priced in” to the decisions by LPs in recent quarters to drastically decrease their allocation to the VC class, and will not result in additional decreases to the amounts of money that VCs are able to raise in the near future.

The WSJ has a report today about startups starting up in areas well outside of the traditional “top tier” venture capital areas (Silicon Valley, Boston, Austin, etc.) (article here: http://online.wsj.com/article/SB124329530359452757.html).  The article highlights places like Kalamazoo, Michigan and Toledo, Ohio, who are actively providing tax breaks and other incentives to get technology companies to locate in their communities.  The economic development authorities recognize what we’ve discussed here in the past few posts, that not only do these startups provide good, high-paying jobs now – even more important, they are the potential big employers (and big tax-payers) down the road, helping to attract more talent, more money, all the things that can lead to a self-sustaining entrepreneurial ecosystem.

The article does point out that in some cases  startups that start up in, say, Kalamazoo, end up moving to more established areas like Silicon Valley at some point during their life cycle because of a need for significant venture capital investment or easy access to top technology talent.  However, that is not always the case, and even those who move to richer climes will have increased the experience, skillsets and recognition of their birthplace.

The areas mentioned in the article are offering the traditional grant money and tax breaks to get companies to locate in their area, often with strings attached (such as staying in the area, creating jobs, etc.).  In Kalamazoo, private investors have created an economic development fund that will invest in, or loan money to, companies agreeing to locate in Southwest Michigan.

In the end, as economic development authorities and investors have learned time and again, you can’t completely create a technology hub from scratch (at least unless you’re that rare case that is able and willing to spend billions of dollars – enough not just to provide the normal incentives mentioned above, but to build, staff and fund legitimate research institutions, to invest in the companies you lure to your area, build out transportation and telecommunications infrastructure, and provide massive financial assistance to allow your companies to lure world class executive and research talent). 

Fortunately for the New River Valley area, nothing has to be built from scratch.  The engine of entrepreneurship (top-notch R&D) is here already – the labs and classrooms of Virginia Tech, for one.  Much of this is funded by outside grant money and is producing commercializable technology every day.  The Corporate Research Center provides a reasonably-priced and very supportive environment to startup a company around technology.  There are experts and support groups to help entrepreneurs begin and grow a company – Jim Flowers at VT Knowledgeworks and Cory Donovan at the NCTC being two very important contacts for any startup.  And although some venture funds only invest locally – most will tell you that the capital follows the quality startups (some focusing mostly on management, some on the technology – but if you build it, they will come), and there are area entrepreneurs who are able to access Rolodexes around the country (and beyond) and have successfully gotten term sheets from VCs up and down the East Coast, in Silicon Valley and elsewhere.

But more does need to be done on the incentive and economic development side.  There are groups like the CIT Gap Fund and Running Start to address the “gap” funding for startups (proof-of-concept or feasibility money for companies who don’t qualify for SBIR or other available risk funding).  There are angel groups around (VAAN and the Piedmont Angel Network) looking at early-stage companies.  However, we need more active angels, and more public-private partnerships providing funds for risky, early-stage, R&D work on startups at the very early, riskiest stage of the business.  This is crucial.  There are some of us working on these very items right now, and we hope to report back with successful news in the near future.

Yesterday, we highlighted an article about a longstanding Boston VC firm that was moving to Silicon Valley because the firm wanted to be where the startups were.  Lest one think that Boston might no longer be a fertile ground for entrepreneurs, take a look at this study of the impact that companies founded by MIT grads have on the Massachusetts (and, indeed the national and even global economy): http://www.kauffman.org/uploadedFiles/MIT_impact_brief_021709.pdf

The study, called Entrepreneurial Impact: The Role of MIT, is an in-depth look at the wide-ranging positive impacts that companies started by MIT grads have on the economies in which they are formed.  Judging conservatively, the study says, if the companies founded by MIT grads were their own separate nation, it would have the 17th largest economy in the world.  Impressive.

The study looks at companies founded by MIT grads in all geographies, but also takes a look at the impact on the Massachusetts economy.  MIT benefits the State of Massachusetts by retaining these profit-creating entrepreneurs – although less than 10% of MIT undergrads grew up in Massachusetts, approximately 31% of all MIT alumni companies are founded there.  The number of companies being founded there has accelerated over time, and currently the sales of MIT alumni companies makes up 26% of the sales of all Massachusetts companies, and the MIT alumni companies headquartered in Massachusetts (6,900 companies) employ over 1,000,000 people worldwide.  Again, impressive.

The study gives a good perspective on what contributes to a thriving entrepreneurial community:

“When asked what factors influenced the location of their companies, the most common responses (in order) were: (1) where the founders lived, (2) network of contacts, (3) quality of life, (4) proximity to major markets, and (5) access to skilled professional workers (engineers, technicians, and managers). Taxes and the regulatory environment were rated as less important factors for most industries.

High-tech startups depend heavily on the availability of skilled professionals to build reliable, high-quality, innovative products. The startup companies locate where these professionals like to live. These findings offer a new perspective on the factors listed above in the location decisions of MIT alumni founders for their companies. Quality-of-life issues include access to a strong educational system, cultural facilities, open space, and good transportation.”

Looking at this list, clearly there are some factors that our area will have a tough time developing in the near-term (such as proximity to major markets, and access to large pools of skilled technology workers wiating for jobs).   However, there is opportunity to learn from this, enhance what we already have, work on those things we can, and come up with creative solutions for the areas that we don’t.  As discussed before, efforts such as the Creative Leadership Class in Roanoke, contribute much toward this effort, and the loyalty of Hokie grads (and desire to return to the area) can’t be overstated.

This study shows the magnitude of the potential positive impact on our region and State that a thriving entrepreneurial ecosystem can have.  We have a great start here, now it is time to enhance and grow.

As the NYT reported yesterday, one of the oldest venture funds in the industry, Greylock Partners (circa 1965) has decided to move from Boston to Silicon Valley (article here: http://bits.blogs.nytimes.com/2009/05/19/is-boston-still-a-venture-capital-hotbed/).  Essentially, the fund’s partners said that they needed to be where the startups were.  Boston is often considered the 2nd or 3rd most active startup/VC market in the country, so this capitulation to Silicon Valley could be a blow to the Boston market, at least reputationally.  The numbers cited in the article show that VC investments in Boston companies fell from $3.9 billion in 2007 to $3.3 billion in 2008, while VC investments in Silicon Valley stayed steady at $11 billion (yes, eleven billion dollars).  What’s remarkable is not that Boston’s investments fell over the past few years, but that Silicon stayed the same during this recession – or, that it generates $11 billion a year to begin with.

What interests me about the article is not the anecdotal evidence that Boston may be losing sources of capital to Silicon Valley, but rather the evidence that capital follows a good entrepreneurial environment – not the other way around.  Particularly important are the comments quoted in the article from Paul Graham (founder of Y Combinator), which earlier this year made a similar decision to close down its Cambridge, Mass. offices and operate only in the Silicon Valley.  His reasons?

“…in Silicon Valley, investors are less frightened of risky new ideas, lawyers are more familiar with start-up deal terms and entrepreneurs have more support from other founders and advisers. The differences start early; Stanford students think about working at start-ups while MIT students think about working at big companies…”

This is as succinct an explanation as I’ve seen of the ingredients of a healthy entrepreneurial ecosystem.  Notice that it doesn’t include capital as an ingredient — rather, it is an explanation of why the capital goes where it does.  More capital available for startups will help, yes, and is a necessary ingredient but — as this move by Greylock shows – the capital will follow the talent and the environment.

As for Blacksburg and the New River Valley, the potential for a thriving, sustained entrepreneurial ecosystem is great.  The most important point is that what we do have in abundance is the engine of entrepreneurship – invention and innovation.  Among other sources, the research labs and classrooms of Virginia Tech are constantly putting out technology ripe for commercialization in many areas, including the current hot area: energy.   And there are many people actively working on the other components with an increasing self-awareness and cohesiveness - including VTIP, VT Knowledgeworks and the service providers in the area with startup experience.    We’ve got our end goals, we’re just in the process of getting together our Gantt charts, responsibilities and action items.

This interview with Intel Capital president Arvind Sodhani (http://blogs.wsj.com/venturecapital/2009/05/13/intels-venture-capital-arm-sees-no-signs-of-slowing-down/) indicates that at least one fund still has available capital and is actively looking for investments.  We know of at least one Blacksburg company talking with Intel about a potential investment now.  Still, it is hard to know for certain – many of you seeking venture capital have had the recent unpleasant experience of going through the motions with VCs who say that it is business as usual, only to find out at the end that there really is no capital available for investment – at least not in true seed/risky stage companies. 

Still, from what we’re hearing, some of the west coast VCs are actively beginning to reach out to true startups, even in this part of the country.  We have to wait until early July to see true numbers from investments, but it sounds like things are picking up in the west, and hopefully that trend will follow the jet stream east to Austin, Boston, RTP and here in the Mid-Atlantic.

Among the areas that are hot, energy continues to be a leader, and an article in the New York Times today indicates that after a serious spike in Q4 2008, investors are coming back from CleanTech to companies that focus on energy efficiency, such as smart grid technology – http://www.nytimes.com/2009/05/11/technology/start-ups/11green.html?ref=start-ups.   And this uptick in private investment in energy technology is nothing compared to the government’s stimulus money set aside for energy investment (about $60 billion, including large chunks for small businesses).

This focus on energy could be a great opportunity for the New River Valley.  Virginia Tech has created a Task Force on Energy Security and Sustainability (http://www.research.vt.edu/energy/) which could lead to promising technologies coming out of the university.  Don Leo, heading up the task force, recently spoke to the NCTC and it was clear that there are many energy-related technologies being developed both within the university and in private small businesses in the area.  We are working with several groups of founders in connection with energy-based technologies, and it only seems to grow as an area of interest.  With the engineering schools and the new initiatives at Virginia Tech, this area seems like a natural recipient of some of the public and private funding available for energy-related technologies.

A few weeks ago the Kauffman Foundation released its entrepreneurialism index results for 2008, revealing an increased level of entrepreneurialism during the past year, although a lower level of “high-income” entrepreneurial businesses being started.  Most believe the higher level of entrepreneurial activity in 2008 results in part from a large number of “forced entrepreneurs” — people who have lost their job and aren’t able to find comparable work in this economy, and are therefore forced into starting a small business – sometimes a business they’ve always dreamed of starting, sometimes a consulting business that utilizes skills they developed as an employee of a larger company and sometimes just a small business that appears to provide a certain level of income.

An interesting article in the Wall Street Journal takes a look at 5 such entrepreneurs (article here: http://online.wsj.com/article/SB10001424052970204475004574127134005990974.html).  Although none of these businesses are the high-tech businesses that are likely to seek venture capital-type funding, it still reinforces some of the important lessons of getting a small business off the ground, particularly in this economy.  Of course, for the tech entrepreneur you have to add to these simple lessons the many layers of complexity facing a start-up based around technology (protecting the IP, examining the patent landscape, understanding the business model and predicting the market for a product or service that may not yet exist, etc.).  In addition, many tech companies require large amounts of risk capital (loans or investments before the company has the hard assets or paying customers to support them), which adds another layer of complexity to the problem.

However, there are a number of service providers and advisors to help navigate the multi-level chess game that is starting and growing a tech company.  Getting an attorney (shameless plug), accountant and other professional advisor who is familiar with tech companies and venture capital investments is key, as is utilizing the area’s growing number of entrepreneurial resources – such as VT Knowledgeworks, the Business Technology Center and others) – that can help spot issues, put you in touch with other resources and generally help you wrap a company around your idea.  It is what we love to do and we’ve done it before.

Todd Dagres of Spark Capital (www.sparkcapital.com) put out an interesting idea for helping with the stagnant IPO market for venture-backed companies, which the NY Times discussed yesterday (here: http://bits.blogs.nytimes.com/2009/05/07/a-vintage-idea-for-jump-starting-the-ipo-market/).

There is 1 venture-backed company expected to go public in the near future, which will be the first in 9 months – (http://bits.blogs.nytimes.com/2009/05/07/will-opentable-thaw-the-ipo-market/).  Some have expectations that signs are pointing toward a much better IPO market for the venture community by the end of the year, or at least 2010 (http://www.avc.com/a_vc/2009/05/the-end-of-the-ipo-drought-is-coming.html - thanks Jim Flowers for that link).  However, many remain doubtful, and as a sign that many VCs believe something needs to change in order to revive their IPO exits, the NVCA has put a special emphasis on working with I-bankers and accountants who are willing to work with smaller IPOs than are the “above the bulge” professionals.

The NY Times article is interesting, and the comment one reader posted is amusing – comparing a bundled venture-backed IPO basket to the most famous recent bundled failures – the subprime mortgage pools.  However, I think the idea here is not bundling to diversify away from low quality of the companies, but rather to get to that critical mass of size that makes an IPO worth the work and overhead and can garner attention from the big institutional buyers that support the public float.

As you probably saw, earlier this week the National Venture Capital Assocation released a report with recommendations to fix the “crisis” in the capital markets (discussed here: http://www.venture-counsel.com/blog1/?p=138).  The New York Times carried an interesting article yesterday in which two very well-respected professors added some thoughts to what could help the venture industry, specifically the U.S. venture industry.

The NYT article is here: http://bits.blogs.nytimes.com/2009/05/04/what-will-fix-the-venture-capital-crisis/

Josh Lerner points out three key points that he believes would help VCs as a group: (i) changes to U.S. patent laws, (ii) federal assistance to emerging growth companies, and not just the big, struggling giants, and (iii) work by U.S. universities and others to attract and retain more foreign-born scientists and entrepreneurs. 

Lee Fleming, a professor of entrepreneurship, makes some interesting points about tech transfer in U.S. universities – claiming that instead of focusing on widely dessiminating ideas, the tech transfer offices of most universities in the U.S. now treat each discovery as if it will be a blockbuster, looking to make a profit from it, taking far too long negotiating licenses to spinouts.  This will no doubt be a provocative comment and it should be interesting to hear the other side of the equation from the university tech transfer groups.