Fascinating pair of events in Atlanta this week… the DLA Piper “Venture Pipeline” and the Angel Capital Association annual summit. I’ve learned a bit, and have definitely gotten a few ideas to think about.
No surprise to anyone who’s active in the startup community… investment in early stage companies is down but not out. Deals are still getting done. And the most savvy investors realize that prices of early-stage equities are as cheap now as they will be for a long long time… it’s a good time to buy.
(That’s not the greatest news for the entrepreneurs, but don’t let it stop you. Waiting for valuations to go up just means you’re letting your competitors run unopposed.)
The most interesting discussion so far was led by Basil Peters. He’s crunched a lot of numbers in writing his book “Early Exits” and come up with some non-intuitive conclusions.
First, check his premises:
- Venture economics dictate that VC funds must have a certain number of home runs to make up for the number of deals that simply go broke.
- The average size of a venture fund has grown from $100M to $350M in ten years. That means the home runs have to be bigger… as a rule of thumb, you probably need to exit at $200M to “move the needle.”
- The angel market has matured so that syndicates of angels can now invest $3-5 million over the life of a deal.
- The rise of cloud computing, SaaS, Asterisk, BPO, and other outsourcing services means that many companies now require an order of magnitude less capital than they did a decade ago. (Not true for biotech, but certainly true for software startups!)
- The IPO market for venture-backed companies is dead. Thank you, Sarbanes-Oxley.
- 92% of U.S. M&A exits are for less than $20 million.
- Related: The number of potential acquirors is much larger for a $20M purchase than a $200M purchase. As Basil relayed, a Fortune 500 friend of his said “I can get a $20M deal approved at the divisional level. A $200M deal requires the board of directors, and that’s not going to happen right now.”
Any issues on that list? Any one of them is probably worth a blog post, but it’s hard to argue with any of them as representative of the current situation in 2009.
And one item that Basil didn’t point out, but it’s probably in his book:
- The death of the IPO market means that participating-preferred shareholders (meaning VCs with liquidation preferences) will get a disproportionate amount of cash out of an M&A transaction.
Alright, toss all that in a pot and simmer. What do you come up with?
The interests of angel investors and venture capital investors are inexorably diverging.
That’s a big deal. It has the potential to change the dynamics of the entire early-stage investment market.
I’m typing this sitting in an ACA session on the current angel market. The angel and VC markets have always been synergistic, and somewhat intertwined. Getting a VC to invest in your early-stage firm has always been a “seal of approval” for your angel investment, and 62% of angel deals last year attracted VC funding. Some angel groups won’t invest in a company if they can’t convince themselves that the deal will attract VC money. A lot of senior or emeritus VCs are active individual angels. Now, VCs are even inviting top-end angel groups to join their Series A syndicates.
And Basil claims that it’s all headed for divorce.
Venture Fund Economics
The economics of a venture fund are pushing them towards deals where they can put at least $5M to work. Do the math: a 10X exit means the VC equity has to be worth $50M; if they own a quarter of the company, that means a $200M acquisition. And deals are taking longer… the DLA Piper presentation emphasized that average holding period from Series A to liquidity has grown from barely two years during the Bubble to over eight years today.
Ten-year funds aren’t ten-year funds anymore. The average ten-year fund doesn’t wind up until Year 14, and a non-trivial fraction last until Year 18 or even longer.
Time is the enemy of VC firms. The longer you hold the equity, the higher multiple you need to hit your IRR target (and venture firms live and die by IRR). Waiting until Year Seven for a 10X exit that you expected in Year Five means your portfolio IRR can drop from 35% to 20%. That may be the difference between raising a new fund and being invited to explore other career opportunities.
So all the forces are pushing VC firms to do bigger deals, that consume more capital, that deliver the potential for ever-higher multiples. 10X may not be enough… maybe your target now needs to be 20X, or 30X. You’re swinging for the fences every time.
If you’re an angel investor, this may not be a good idea.
If you can put $2M into an angel investment over two rounds and sell your stake in Year 3 for $6M… that’s only a 3X multiple, but a a 54% rate of return! If you own a third of the company, that means an $18M acquisition… as mentioned above, that can be done as the divisional level at many, many large companies.
No substantial VC is going to be interested in a deal that sells for $18 million. “Doesn’t move their needle.” “Failure to launch.” If they have one of these in their portfolio, its counted as a failure.
But if you’re an angel investor, investing your personal capital, that’s a darned good deal! It’s not going to let you retire to Cayman Brac, but it’s certainly going to pay for some nice trips and toys.
And for those of us concerned about economic development and technology-investment ecosystems… the funds from that exit are available for reinvestment in the next deal much more quickly! Once the angel is back from a three-week golf trip or dive trip or whatever, he or she has substantial liquidity available, and is likely to want to do another deal, and another… and probably in the same local market. By contrast, the VC fund exit, whenever that occurs, gets distributed back to their institutional LPs. With all the chaos on Wall Street, who knows when, or if, that money will ever make it back to the local market?
The conflict arises if you are the angel investor looking at a potential $18M acquisition, but you’ve taken VC money. As seen above, the VC is pre-programmed to need a $200M exit. The VC syndicate is going to control the board, and they’re likely to “double down”… rather than taking the early exit, they’ll plow in more money (most VCs have plenty of money), maybe try to roll up a competitor, and build that $200M exit. If they miss, the deal goes into their list of writeoffs. And it’s probably too late to go back and make that $18M sale that was available four or five years earlier. That potential acquiror has moved on.
Basil quoted a study by Robert Wiltbank of Willamette University (funded by our indispensable friends at the Kauffman Foundation). He looked at a large historical database, and compared results for companies that only received angel investment versus companies that received a mix of angel and VC dollars.
When angel investments attracted VC dollars, the overall number of exits in the 5X to 10X range increased by about 8%. That’s good.
But the number of exits in the 1X to 5X range fell by nearly 20%. That’s bad.
And the number of complete failures increased by about 12%. That’s terrible. How many of those companies would have had solid “base hits” exits if the venture investors had not been swinging for the fences?
Impact on Entrepreneurs
So if you’re an entrepreneur… what does all this mean for you?
It depends. (The answer to almost any reasonably complex question is usually “It depends.”)
If you’re discovering pharmaceuticals or building medical devices, nothing changes. Structural issues in your market, such as FDA approval, will continue to drive you towards raising large amounts of venture capital from VC firms.
If you’re developing a new Web 2.0 service… you might want to think about an angel-only strategy. Your likelihood of a profitable exit goes up, even though the likelihood of being on the cover of Wired goes down. Make enough money to fund the next company yourself… and that one might get you on the cover!
And if you’re in another sector… well, it depends. Cleantech deals are looking more and more like biotech (heroic amounts of capital, long holding periods). Some software deals may begin look like SaaS deals, where you can run them on a relative shoestring. It’s certainly worth understanding these dynamics before you start mixing streams of angel capital with venture capital.
Venkman said “Don’t cross the streams!” It’s still good advice.