If You Build It…

Stuart Ellman

Eric Wiesen

“Should I build my company to be a profitable, standalone business or should I be aiming to fit into the long-term plans of my likely acquirers to facilitate an M&A exit?”

This is a question that entrepreneurs ask themselves every day. If you asked a hundred venture capitalists this question, I suspect the overwhelming majority of us would give you the canonical answer – build for long-term profitability and a standalone business, because the tides of M&A can come and go. In the previous era, many VCs liked to see every investment as an IPO candidate. And that made sense in an era when a pre-revenue web company burning cash could actually go public. But in today’s market, when even nine-figure companies with positive EBITDA can’t go public, it is worth asking this question again.

The argument for the traditional answer is simple and compelling – when you go to start your company, you don’t know what Google or Cisco or Dell will be buying in 3-5 years when you achieve sufficient scale to be interesting to them. As a result, if you build toward M&A, you’re likely to build toward whatever they’re buying when you start, and that will likely change significantly over the build period of your company.

There is also a huge issue of stage and valuation. Acquisitions tend to happen in two lumps. First is the “cheaper and quicker” route. This means that Dell can buy something for $10 to $25mm because it is cheaper and quicker than building it themselves. The second is “they already have scale” route. Obviously, a company like Dell can pay a great deal more for a company that sufficient scale that cannot be reliably replicated simply by recreating the technology. A good example of that would be the acquisition of Pure Digital Technologies (creator of the Flip video camera) by Cisco. Could Cisco build its own version? Sure. But they paid almost $600mm because Flip already had brand and scale . (BTW, kudos to Jonathan Kaplan, CEO of Pure Digital and a former RRE CEO). If you are selling in the “cheaper and quicker” category, it better be at a single-digit valuation. Nothing past a Series A.

The emerging counterargument is that the IT landscape has so significantly consolidated that the it’s become easier to project the tectonic movements of the “continental” companies like Microsoft, Google, Cisco and Dell. But is this true? Can you forecast what these companies are going to do? We sold MessageOne to Dell because it wanted to make a big move in hosted services. Could we have forecasted this in 2001 when we funded the company? Again to the Pure Digital example, how could you have guessed that Cisco would be going after the consumer market in 2002 when Jonathan was raising his first round.

We think this question is being answered in real-time. The standard advice to build for the long term is still good advice, but if all the exits are going to be via M&A for the foreseeable future, we’ll be thinking pretty hard here at RRE about what the big guys are really looking for. We still want to fund great entrepreneurs solving big problems in growing markets. But we also want to know what acquirers are looking for. Time to get smart in this area.

Flat is the new 40% Markup

Stuart Ellman

I was in a board meeting yesterday and somebody was talking about selling some shares. He just wanted to sell his shares at the same price as the last round of financing. No problem, right? Actually, yes problem.

This is an issue with mark-to-market pricing of private companies. The assumption tends to be that, since no new round has been done, the company is worth the same as it was the last time money was raised (and hence a valuation was determined). That just isn’t reality, although during normal conditions it tends to be close enough. Today, however, most of the major public indices are down 40% or really close to it. Some of the tech indices are off even more, but let’s stick with 40% since it is a nice, round number.

You might reply (and some do) that because there is no IPO market, the public market pricing has nothing to do with venture valuations. This is totally wrong. Everything is priced off of public market valuations eventually.

Not a pretty picture...

When a VC invests in a company, many factors are in play, but there is one overriding consideration: at what IRR (Internal Rate of Return) can I exit this deal? We work for our limited partners. We can be the greatest guys in the world, but if we don’t make money for our limited partners, we are out of business. So, we invest assuming there will be a public market.

Well, you may ask, what about acquisitions? The answer is that the best acquisitions happen when the alternative is going public. For example, if I can go public at $500 million, I might be willing to take $450 million from an acquirer to save the risk of an IPO. However, when I cannot say to the acquirer that my alternative is to go public at $500 million, what is he going to offer me? What is his incentive to offer $450 million? More likely than not, he will put in a low-ball offer because I have no liquidity alternatives. And, by the way, when I do want to go public, the bankers will value the company against public market comparables. In the end all pricing derives from where the public market comparables are trading – even when using typical discount models from recent private transactions.

So, the number is 40% down. What does that really mean? It means I can buy 5% of a public technology company for 40% less than I could have one year ago. It also means that private market valuations — all other things held equal — need to come down 40%. Thus, if you have a company that has grown so much that it warrants a 40% markup in valuation in a normalized market, you should expect a flat round in this market. If your company has a few issues and would likely have a flat round in a normalized market, then it should have a 40% down-round in this market. You get the idea.

The reason that it usually takes 12 to 24 months for private market valuations to adjust is because of our necessity to mark to the last round and the way that VCs can play with that. Whenever I teach my class at Columbia Business School, I explain that VCs can only mark to the most recent round. Students typically yell out that it is not fair (or clunky at the very least). But, there is no better way. There is no liquid market. If we try to mark down to an arbitrary marking, then we also need to mark up to one. Since VCs don’t like to take write-downs, they will sometimes starve a company that needs a new round so that it doesn’t take in new money at a lower price. Or, they put in a bridge which is un-priced. Both of those scenarios are simply stalling tactics where people are hoping that markets will improve. We at RRE try not to do that. More often than not, we push for the washout rounds to “right price” the companies, even when that means we hurt ourselves a bit in the process. We refer to this discipline as ‘living in the present’.

So, everybody in startup land, pay attention. Pricing is down 40% right now. Until the markets come back up, that is the reality. If you want to raise money, take a realistic look at yourself. You might not like the pricing being offered, but it beats the alternative of running out of money.

Oy Vey, says Stuart’s Mother

I got a call recently from my mother. She read in the New York Times that all the hedge funds and LBO funds are in real trouble and she wanted to know if RRE was OK.  Since most Jewish mothers like to worry all the time, she wanted to know if she could ratchet up the worrying about me.  While I hate to deprive her of the opportunity, the truth is that if a venture capital firm invested wisely, it’s likely in pretty good shape.  Let’s look at the current state of running a VC firm right now.

How does the Credit Crunch Affect the Venture World?

In a recent post we wrote about the current and near-term climate for fund-raising becoming more difficult because of mark to market issues and asset allocation.  So, let’s take for granted that the bar is raised for new investments and even supporting existing portfolio companies. Two critical (and related) points:

First and foremost, venture-backed companies have essentially no leverage.  With very few exceptions, the only bank lines these companies employ are tied simply to a balance equal to the amount of the loan in cash at the bank.  That is not leverage; it’s working capital management.  Given this lack of leverage, that bank lines are now essentially unavailable doesn’t interfere with these companies’ operations. These companies’ capital structure is (for the most part) 100% equity, 0% debt. Those companies that employ “venture debt” are few, and generally have a very heavily equity-oriented capital structure.

The second piece is that VC funds themselves are also 100% equity. Others have covered the basic structure of venture capital funds, but the short version is that we don’t use leverage. Hedge funds, private equity/LBO funds and some mutual funds raise money from investors (equity) and then borrow more money to juice their returns. VC funds don’t. We raise equity capital from our Limited Partners, and then make equity investments in companies. Those companies, as mentioned above, are also all-equity.

So the fact that the debt/credit markets are a complete disaster affects us only indirectly.

So What’s the Problem?

The real frustration for VCs is the lack of exits.  In the 1990’s, once you grew a company to $40 million in revenues, you could get one of tech investment banking firms to take you public, like Hambrecht & Quist (now part of Chase), Robertson Stephens (gone), Montgomery, or Alex Brown (now part of Deutsche Bank).   Then, after the bubble burst, the bar got raised.  In the post-bubble world, you grew a company to $100 million in revenues and then you could get Goldman, Morgan, or CSFB to take you public.  Once you filed for an IPO, or even got ready to, that also put you in play to be acquired.  Now, there is no current IPO market.  Which leads to the frustration.

RRE has a number of companies that had zero revenues when we invested and which are now doing $100 million or more in revenues and growing very quickly.  These companies have achieved what they needed to achieve, become market leaders, yet they cannot go public or exit under the assumptions that employees or founders assumed when they began.

So what do you do?  Sit tight, be patient, and continue to grow the company.  It’s as if somebody told you that your goal was to jump five feet in the air.  After a few years of practice, you build up the ability to jump five feet, and then they change the height to six feet.   It won’t kill you, it is just annoying.

What Next?

As the economy slows, there is no doubt that it has an effect on consumer spending.  Does this hurt all companies?  Some companies, certainly.  Other companies it should help.  Those companies that allow people to do things more cheaply or make money from activities should grow even faster.

RecycleBank will pay you for recycling.  Tendril will save you money on electricity costs.  Peek will give you cheaper mobile email service.  These companies should thrive in a down economy.  I am working on a seed deal that entails free items for consumers.   What could be better for those who have been downsized?  In addition, companies that make capital available when banks dry up such as PrimeRevenue or On Deck Capital should be huge benefactors.  There are lots of opportunities out there for startup companies.  We at RRE intend to take full advantage of them.

Mom, don’t worry about me.  We didn’t overpay for overpriced deals with no revenue.  We didn’t commit ourselves to cleantech deals that need $500mm of CapEx to get to scale.   We did mostly smart deals at good prices and continue to hold their feet to the fire to keep the costs down in these hard economic times.  And no, I will not stop buying these stupid sports cars.  And yes, I can still afford to take you and Dad out to dinner in New Jersey.

What to Do When the Sky is Falling

We are less than ten years removed from a complete meltdown in the equities markets, and yet once again we collectively find ourselves in the midst of a frightening financial collapse. The last one, from 2000-2002, was directly centered on technology, and it still feels recent to many of us. Companies had raised too much money, avenues for monetization dried up, and there was a shakeout throughout the tech industry. This time around, financial services firms are at the root of the crisis, and for a while people in the technology world were optimistic that it wouldn’t affect us much. That would have been nice.

There is a tremendous amount to be said about why this happened, who’s to blame and what happens next. But for now, here are a few thoughts about how this is going to impact our portfolio and technology startups generally. What is happening this week (even considering the public market reaction to the new bailout proposals) will have some meaningful effects on stakeholders in the technology industry, both direct and indirect. Earlier this week, we commented on likely fallout on the security industry, but even firms that don’t sell directly to Wall Street will be indirectly affected. There are a few takeaways from this:

First, be aware that raising money is going to be harder. In times like this, investors raise the bar for potential investments. This happens not because investors are cruel, but because our calculus around growth and return has to change during an economic contraction. Whether you are selling to Wall Street, media, retail, small business or consumers, economic troubles like these probably slow your growth. If you are offering a free service that will later be monetized with subscriptions or advertising, it’s time to adjust your projections for uptake. All of this impacts our view of how much money you will need to reach break-even, the likely proof-points you will have achieved the next time you go out to raise money, and how much a likely acquirer will pay for your company. This analysis raises the bar and tends to contract valuations.

Second, and related to the above, if you can raise money, raise as much as you need. There have been people calling the bottom since before the real problems began. Expect this to go longer than you think, and adjust accordingly. Cut your burn. Hire great people who can do the work of two or three. Be careful, because if this goes on for two or three years like it did the last time, you don’t want to raise twelve months’ worth of cash now.

Third, and particularly relevant to New York, expect to see a bunch of interesting, if non-traditional talent entering the market. One thing we’ve known for a long time is that there is a lot of technical talent locked up in the big Wall Street firms. A lot of those people are going to be shaken lose. First Round Capital has a great little site put up that looks to capitalize on this. If you are looking for people, this could provide a great new source of talent, and could certainly go toward the frequent complaint that New York is a hard place to recruit.

As we advise our portfolio companies and look to make new investments, we’re thinking about all of the above. The fundamentals of technology businesses haven’t changed, but we expect sales cycles to elongate, pilots to drag on, user growth for anything paid to slow and churn to increase. The IPO markets are on hold, and we don’t know for how long. Public companies will be getting their own houses in order, and with depressed stock prices will pay less for the startups they acquire.

Good companies will continue to be successful, but we are going to be very careful about follow-on rounds for our companies and will be encouraging them to be as lean and judicious as possible. These cycles come and go. Make sure you are managing the turbulence as best you can.

Security Feels Risky

I have been wondering about security startups recently.  We made a bunch of great security investments in the late 1990’s and at the time our underlying premise was pretty solid:  Many other types of software could be pushed off in the purchasing cycle, but important security functionality and protection could not.  This is what I called the “hair on fire rule”.  While a fortune 500 company could look at the hottest accounting, marketing, collaboration or governance software and think it was pretty nifty, they weren’t compelled to buy it RIGHT NOW.  Why not?

Largely because entrenched software vendors like Oracle, SAP or Microsoft would freeze out the startups by promising to bundle those same features into the next release within 9 months (whether they really planned to or not).  From a corporate executive point of view, why take a risk by paying more to an unknown startup company when my existing vendor will just give it to me for free for just waiting a little while.  However, security was an exception.  If your company is being broken apart by viruses, phishing or spam, then your hair is on fire.  You have to do something right now, not just wait for the future promises of larger companies.  So, you buy from the startup firms.  The startups would then get traction, ramp to $30mm in revenues, file to go public, and probably get bought. Good deal all around.

These days, however, even when the security startups seem to get to about $25mm in revenues (which are the fortunate ones) they get stuck.  What is happening?

First of all, there is a problem with the customers (and that is more true today than even last week when this post was originally written). Wall Street firms are the classic early adopters for security software.  Who needed to be more security-conscious than Citi, Lehman, Goldman, Merrill, and Morgan?   They frequently accounted for the first bunch of revenues the startups were able to book.  So what do you think is happening to those contracts today?  The big financial services firms’ own hair is on fire about staying solvent (or figuring out what to do post-insolvency). They aren’t focused on buying new software, even important software like security. At best, they are engaging in the type of endless pilots that kill startups.  So, our theoretical security startup starts to see revenue growth stagnate or start to drop.  And those who have taken corporate finance (or who have ever been part of a valuation or M&A process) will know that growth rate drives valuation, and that flattening growth kills it.

Secondly, and more troubling insofar as it’s not tied to current events quite so much, there is a problem with the public markets. Even getting to $40mm in revenues no longer means you are close to a public offering.  The public markets’ appetite for enterprise software generally (and technology even more generally) is demonstrably lower today that it’s ever been in the past, perhaps out of recognition of some of the above problems with the space.

A really smart CEO came in to see me this week.  He had been a very successful entrepreneur back in the late 1990s.  He had just finished selling a tired security company for cents on the dollar and felt lucky to have been able to do that.  As we talked, we thought about what happened to the security industry, and he had an interesting take on the situation:

He said that there used to be three levels in the security software ecosystem.

•    Big Fish: These were big companies like Microsoft;
•    Middle Fish: These were public (but not monolithic) companies like PeopleSoft;
•    Startups: New players with innovative technology.

The rules of the game were pretty well established. The Big Fish looked around and bought companies with $100 million in revenue. The Middle Fish were around to buy the startups.  So there were multiple exit points for smaller fish.

What happened is that the middle fish were eventually purchased by the big fish and by big fish in tangential spaces (like Oracle).  So now all you have are big fish, and none of the startups can grow large enough to get their attention in a meaningful way.

So where we are today is an environment where there are a number of security companies with between $5mm and $35mm in revenues that just cannot get the scale to be noticed by the big fish and don’t have the high growth rates necessarily to raise big rounds of capital to buy their way into higher revenues.  I don’t fish much but it makes sense to me – Marlins don’t eat minnows (I don’t think).

The problem isn’t the business case for security software – the hair on fire necessity around security is still there. But problems with the customers, the public exit opportunity and the difficulty of getting to acquirable scale make us very cautious in this space today. For us to get really excited about security, we’d need to believe that the problem being solved is monumental, and that the path to high revenue is both visible and achievable without large inflows of capital. That’s a high bar.