Richard Swier
August 7, 2005
Volume 1- Issue 1
The purpose of this newsletter is to provide observations and insight into the private equity market from the viewpoint of an Angel investor1. In this issue, we will discuss general trends in Angel Investing and Venture Capital and how they affect the investment strategy and philosophy of early-stage investments.
VENTURE CAPITAL TRENDS
We are seeing three major trends that are defining the future (or at least the next 5 years) of Venture Capital. The three trends are 1) New Liquidity Market 2) Seismic Shift toward Late Stage Investments and 3) the New Entrepreneur. TREND 1: New Liquidity Market The first trend is a combination of valuations and the ability to achieve liquidity on private equity investments. The challenge in today’s market is that Venture Capitalists have built their model and investment strategy around having a solid IPO Market. Without an IPO Market to achieve liquidity, the only other alternative is mergers and acquisitions. In the past few years, the M&A activity is increasing and has given many private companies very good returns to their shareholders, however the dynamics are quite different then an IPO. The primary difference is that the average M&A deal for Venture-backed companies is hovering around 50 to 100 Million (see graph below). The average valuation after the IPO is much higher.
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An investor who invests directly into private, start-up companies, usually considered among the most risky investments.
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The “New Liquidity Market” poses a serious problem for Venture Funds that need to invest 5 to 20 Million dollars into a company and achieve the return expect from their investors. The “old” equation on how VC’s make money does not add up anymore. Old VC Equation 1. 2. 3. 4. Invest 20M into Company at pre-Money of 20M Own 50% of company worth 40M Let Portfolio mature over 5 years 20% of Portfolio achieves liquidity at IPO or Sell for 10x
Flaws in the Model 1. In today’s environment, most early stage ventures have much lower valuations (due to the adjustment made in valuating private-equity companies since 2000). Therefore it is difficult to meet in the “middle” between Entrepreneurs and Venture Capitalists on valuations and the ability to still invest 20 Million. Thus VC’s are forced to invest less (5M) for 50% of the company, or invest in later-stage investments that can be valued at 20M (which created Trend #2 – see next section). Most pre-revenue companies have valuations less then 2M. In order for Venture Capitalists to create value in ventures in order to make the securities marketable, the valuations are inflated to 40M or higher. Once the valuation becomes inflated it makes it difficult for to seek a liquidity event that returns a significant multiple. Since the “Old” Equation depended heavily on IPO Market or significant acquisitions, it was okay to have a majority of ventures fail, because the return on the few were significant enough to show a return on a large venture fund. With a very selective IPO Market and the average acquisition falling below 100M, the equation begins to fail.
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TREND 2: Seismic Shift toward Late Stage Investments The second trend clearly affecting the state of venture capital is the shift away from early-stage investments to late-stage investments2. The obvious logic in shifting to the more mature companies is to reduce the “unknowns” and in return reduce the risk. However, the old saying “No risk, No reward” is still adhered in the investment world so the returns on many of the late (albeit safer) investments do not return the profits needed to achieve Venture Capital type returns. One of the biggest myths in venture capital is that it takes 20-50M in venture money to create a successful company. The fact is that less the 1/3rd of the Fortune 500 Companies ever received venture capital funds. As more institutional Venture Capital focused on late-stage investments, the capital gap increases and makes it more difficult for ideas to blossom into companies and forces entrepreneurs to change their business model to be more conservative with cash and boot-strap operations until revenue and eventually profitability (and potentially bypass the institutional investment all together). TREND 3: The New Entrepreneur It is only natural that when the venture market changes the entrepreneur must change as well. The “New Entrepreneur” faces the new challenges of raising capital from angels and angel funds and not depending on the Venture Capitalist to invest during the early-stages. The New Entrepreneur also is wary of giving away half of the company purely for the capital. The bumps and bruises gained during the economic downturn increased appreciation of core business principals and most of all understand the appropriate use of capital. The business model of today is to focus on the business and work hard to achieve the key milestones without a significant amount of capital, and potentially position the venture for liquidity instead of raising venture capital and being diluted and giving up control.
The Changing Role of Angel Investors Venture Capital is not the only model that is changing. Angel investing is also changing in order to embrace the new dynamics described above and also to better organize the process on how angel investors operate. One of the key catalysts to the change is the lack of dependency on early-stage institutional venture capital. Many angel investors look to the venture capitalists to fund their portfolio and reduce the risk of their companies running out of capital. This strategy of “bridge funding” is becoming more difficult since venture capitalists have become more risk-adverse and are driven by the “old” equation (see above). Angel investors and funds are now forced to take on the role of the “Round A” investor and assure that each investment has the ability to reach stability and succeed without dependency on institutional funds.
In 2004, Venture Capitalists invested over 18 Billion of which 300M were in early-stage ventures. (Angel Capital Association)
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In order to effectively operate like a professional investor, Angels are grouping to join Angel Funds and using the collective intellect and experience as a sounding board. Angel Funds are taking the responsibility of funding the initial key milestones of the ventures including R&D, product and revenue. In most situations, the Angel Funds lack the capital to fund a company who requires 2-5M, so they are finding ways to address the “capital gap” between Angel Funding and Venture Capital (or Profitability). Today, the capital gap is being connected by doing the following: 1. 2. 3. Boot-Strapping the venture – Being more conservative with cash, and building businesses at a more conservative pace, and forcing the entrepreneurs to keep their heads above water while they move toward profitability. Syndication – Much like Early-Stage Venture Capitalists, Angel Funds are also building alliances with other Angel Funds in the hopes of co-investing into deals. Alternative Funding – Many companies when they can reach the first key financial milestone (Revenue) are becoming more creative on finding financial vehicles to help support building inventory and delivering product. These alternative vehicles range from Strategic Capital (investment made by a company that shares interest in the investments market) or through tradition banking (factoring receivables, lines of credit)
Conclusion The economy of the startup has changed, the market valuation of early-stage technology companies has changed and the liquidity market has changed. These three pillars of Venture Capital have all changed, but we haven’t seen the Venture Capital community change (except for a few). The dependency of the entrepreneur has shifted to the Angel investment community, and the Angel is being forced to scale their model to fill the Capital Gap. The market valuations in M&A activity and the challenges of the IPO market force investors to look at the liquidity strategies of their prospect investments and portfolio.
ABOUT THE AUTHOR
Rich Swier Managing Partner, Startup Florida Ventures rich@startupflorida.com Rich is a seasoned entrepreneur who has founded and exited numerous technology companies in IT Software, Communications and Internet-based businesses. In 2002, Rich founded Startup Florida, the first operating angel-investment fund in the State of Florida, with the clear intention of empowering the entrepreneurial community and offering investors a professionally managed private equity fund that engaged with quality opportunities. Today, Startup Florida is expanding into new regions including Massachusetts, New York and Connecticut to grow its network of investors and entrepreneurs.
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