Overcapitalization

So I’m at the DLA Piper Venture Pipeline event last week, and Howard Schwartz from their D.C. office is talking. And he mentions a word that I haven’t heard in Atlanta for a while: “Overcapitalization.”

He goes on to point out that there are a lot of very large successful funds trying to put a lot money to work. And since venture capital is a very clubby business, VCs like to invest alongside their friends. If there’s not enough room in a round, sometimes they expand the round to let everyone have a piece. So they will have to let the pre-money valuation float upwards so the founders don’t instantly get diluted to a point where they’re not interested.

Toss in the competitive nature of Silicon Valley and Boston, and valuations get even higher.

That means deals get done, but at artificially high prices. And that puts pressure on the next round, and the next, and the eventual exit. (We saw this movie before during the Bubble.)

In the Southeast, we have the opposite problem. Not enough funds, not enough money, so we complain about our deals getting undercapitalized and being sold prematurely. With the occasional exception like ISS, we’re batting singles and doubles, not home runs.

I decided to run the numbers.

Let’s say we have a team of three founders with a cool idea. They don’t actually need much money to build their initial product (see the discussion here). They pitch it to the angel community and maybe a local VC or two. After a bit of ritual grovelling, they raise $500,000 in exchange for half the equity in company.

With enough money in the bank to keep the doors open, the three founders work their tails off, get something built, sell it to a couple of key customers, and look like they’re onto something good. But the Southern Curse strikes… they get an offer to sell the company for $10 million, and they decide that’s Good Enough.

The founders pocket $5 million to go to work for the acquiring company, the investors walk away with $5 million as a 10X return on their capital, and the South now has another branch office of another mega-corporation headquartered in California or Boston. A base hit, not a home run. A lot of people claim that this is a failure for the community. But is it?

Let’s take the same three founders with the same cool idea. Bear with me here, and don’t let your eyes glaze over. I’m translating three pages of Excel into English.

Instead of raising $500,000 locally, they make the rounds in Boston. A $200 million fund up there likes the idea, likes the team, but can’t invest less than $1 million in a deal, and wants to know they can put at least $5M to work over the life of the investment. And they like to syndicate everything they do, so they bring a cooperative VC to the table with similar constraints.

So now there’s no way to do a $500,000 deal for half the company. The founders are looking at taking $2 million in Series A… and, since the Boston VCs want to be generous, they’ll assign a valuation to the founders’ shares of $1 million… twice what the local yokels would have done. Woo-hoo! Carve out a 17% option pool, and let’s get going. Series A closes at $3.6 million post-money.

With $2 million in the bank, our founders hire aggressively and start thinking about product extensions. The money gets burned up quickly and it’s soon time for Series B. The Boston VCs double down at $2 million each, and bring in a third member of the club for an additional $2 million. Since development and early sales are going so well, let’s double the price as well, and the $6 million Series B gets done at $13.2 million post-money.

Now it’s time to get serious. We recruit and relocate a world-class CEO; the founders are still involved in the company, but they’re no longer in charge. The new CEO holds out for an option package equalling 9% of the equity. The growing company starts getting some attention as a category leader, it scrapes past break-even to profitability, and investment bankers start coming to visit. It’s too early to sell — we’re swinging for the fences here! — so after a year or so, it’s time to raise Series C.

Everybody is still happy with the progress, especially with our new CEO, so the original investors put in another $2 million each. The Series B investor, with a bigger fund, goes over pro-rata for $6 million. And a new mezzanine investor leads the round with $10 million. He’s not going to overpay, so he values the gangly enterprise at $25 million, insists that the option pool get re-upped to 10% of the equity, and closes the $20 million Series C at $45 million post-money. A great trajectory.

Now the company is competing against the big boys, and life is difficult. Their superior product opens certain doors, but they’re trying to establish a sales channel in the face of long-standing purchasing relationships. Version 3.0 slips by six months, a key developer leaves, and suddenly that $20 million doesn’t look like so much runway after all. When the 400-pound gorilla calls to say, “Hey, we know we can crush you in this market, but we really like your technology and we think your team would thrive in our corporate culture” — the board listens. After a round of haggling, you agree to sell the company for 10X EBITDA, which turns out to be $75 million.

Now, $75 million isn’t a Google, but what is? That’s a sizeable chunk of change, and for current conditions, would probably be ranked as one of the year’s more successful deals in the Southeast.

But how did everybody do?

The Series C investor is disappointed, with a 1.6X return on investment. Series B makes 2X, and Series A grinds out 2.7X. Not the proverbial “ten-bagger” that VCs are shooting for, but not bad at all. This one gets half a page in the private placement memorandum for the next fund.

The CEO, assuming he vests on change of control and doesn’t stay with the acquiring company, walks away with $3.2 million. Not bad for two years’ work.

The employees’ 10% share is $7.5 million… which means the senior staff can pay off their houses, and junior staff can buy new Infiniti G35s.

The three founders? They walk away with 6.7% of the acquisition price… which translates to $5 million split among the three of them.

Remember the local-yokel deal up front? The one that fell victim to the Southern Curse of selling prematurely for $10 million?

Same payday for the founders. But they got it faster, with far less stress, a less-demanding board, and without the ego hit of having to watch a bunch of outsiders run “their” company.

And those local-yokel investors? Their ROI was four times as good as the Boston investors got in the “swing for the fences” deal, without the risk of a cram-down or wash-out round if things turned bad.

Maybe these Southern boys (and girls) aren’t so stupid after all.