The Venture market: Is there trouble brewing at the exit?
People are wondering if the mega buyout party is coming to a close.
The private equity and debt market have been been in bed, for a little while, and it was looking to be a cozy relationship - like that of two people who sorely need each other. Large buyout funds were using the arbitrage opportunity between debt and equity, and easy access to cash, to fund large deals.
Now, one of the partners is not so rich, and not so free wheeling, anymore. With the sub-prime snafu in the debt market, LBOs are finding themselves up against the wall as far as access to easy debt capital.
The doomsday scenario is already starting to play out a bit, according to WSJ. Two anticipated IPOs in the hedge fund business, Man Group and MF Global fared less than, well, stellar. Both fell short of their targets in initial raise.
Then there was Blackstone and their spectacular IPO (highest ever for a Fund). That IPO is also finding itself in the doldrums, now.
So what does all this mean for the venture market? Used to be that start-ups that fared well, would go one of two ways. They would have an IPO on Nasdaq, or they would get bought out by larger companies, which in turn have been snapped up by large hedge funds in recent years.
First came Sarbanes-Oxley, and taking a company public became like a political race. You couldn’t go to the party unless you had really rich parents. Worth about $500 million and up. Some companies dodged the bullet by staging an IPO on AIM, the London stock market, where it costs 60% less to IPO. Nasdaq certainly became a less attractive option for all other than the well heeled and the brazen.
Then came the LBOs and a wave of, we hope, rational exuberance. Suddenly venture firms could see the “Exit” sign in the distance. The money started flowing into start-ups again.
Now there are rumblings of discontent in the private equity arena. If the deal flow slows down, it could affect the venture market, which is down the financial food chain.
There is also the dynamics of the venture funds raising capital. The PE funds are the pick of the litter there. Large pension funds such as Calpers, which invest in PE and VC funds, prefer to place larger amounts of money since, as they see it, it is about the same amount of work for them (in due diligence etc.) to invest $5 million in a fund, as it is to invest $100 million. So late stage funds have an easier time raising funds, than early stage funds.
In principle, one would assume, that if the PE funds were to fall out of favor, smaller venture funds would swoop in and pick up the extra cash. But I don’t think that is going to be the case. If there is a perception that the pipe is choking up at the exit, it will affect all sizes of funds, in their ability to raise and deploy capital.
So far, the numbers show an upbeat picture in venture land. The large companies like Google and Cisco which have been snapping up start-ups in the last few years (this year, Google surpassed Cisco in venture backed acquisitions - 5 versus 4 as of early June), aren’t that sensitive to the capital markets, as long as they keep growing and hitting their numbers. This year, the total volume of mergers and acquisitions in the first half of 2007, was above a $1 trillion, an overall record according to Dealogic.
Notwithstanding the shenanigans in the hedge fund IPO business, the market for Venture backed IPOs continues to hum. Venture backed IPOs raised $2.73 billion for 22 companies that debuted in the second quarter of 2007, an up higher already, than all of 2006.
It is not clear if there is trouble brewing further down the road, but so far, venture traffic continues to move along smoothly.
Tags : Opinion, Venture Capital
What valuations/ exits are VCs looking for?
The question is often asked, what is considered a “good return” when there is an exit in venture land? Here are some rough guidelines for early stage companies, along with some “VC-speak” that you might hear, when such exits are discussed.
1. Company exited at 0-1x (ie 0 to 1 times the money invested)
“What company? What investment?”
Nobody made money. Founders are broke.
2. Company exited at 1-2x
“We broke even on that deal”
This is not the deal that the VCs are going to brag about.
Generally VCs have “liquidation preference” clauses which mean that they get to take out their money first. Very likely the investors made nothing after the debts were paid off. Founders are, very likely, still broke.
3. Company exited at 2-5x
“We had a good exit”
VCs made some money. Founders made some depending on how good they were at ironing out the initial term sheets. The founders are planning their next venture. Unless the numbers were large, this is not enough to retire on.
4. Company exited at 10x and above
“I told you this was going to be the next Facebook!”
This is the 1 in 20 or so “make the fund” deals that funds hope and pray for.
VCs are entitled to crow, and they do! Everybody is happy - mostly.
Side note for entrepreneurs on valuation: When presenting a business plan, if you are showing a company that is going to be worth 2x in 3-4 years, then it is time to go back and look at the market size and other factors. Most investors will beat a fast path to the exit sign unless they can be shown an expectation of about a 10x or more, or more on their investment, in 3-5 years.
Tags : Entrepreneurism, Opinion, Venture Capital
Carried Interest Tax Debate and why should startups care?
Unless you were caught up in the iPhone hype or busy with the Paris Hilton saga, you are probably familiar with the “Carried Interest” Tax Debate in the VC community.
In a nutshell this is what the issue is and let me illustrate it with a concrete example:
Let’s say Frank wants to start a new venture fund; he calls his friends and other investors and raises $50M. Frank is the general partner and the other investors are limited partners. Frank’s compensation is some management fee, plus a portion of the “up side” of the fund. If the fund gains by 10%, he doesn’t get anything, but if it gains by more than 10%, he gets 20% of the increase, i.e., if the fund gains by 15%, Frank gets (20% of extra 5%) which is 1%. Different funds have different numbers and different thresholds, but the concept is the same.
Under the current tax code, the 1% that Frank gets (his “carried interest”) is treated as “capital gains” and it gets taxed at the rate of 15%.
Under the new tax bill that is afoot, the 1% will get taxed at the rate of personal ordinary income tax, which is about 35%.
The investors (limited partners) will continue to get taxed at the capital gains level of 15%, only the general partners (Frank in this case) gets taxed at 35% for his portion.
And why does Congress want to pick on Frank, the general partner here? They put forth two reasons: the first one, in a nutshell is “Frank made a lot of money and we want some of it”; and the second argument goes like this: “Hey, Frank didn’t put up his own money here; why should he get capital gains treatment, its all income to him! - lets get him.”
To show that this is all really asinine; lets take another example. Frank now wants to start a Pizzeria, he calls his friends and investors and they put up the money. They agree that the investors will own 80% of the business and Frank will own 20% of the business. Frank works hard and in a few years the pizza place is a great success. The pizzeria is sold for a handsome profit. Now for the questions - the 20% that Frank makes, is it ordinary income or is it capital gains?
If you get options at the company that you work for and if you hold them for a while and the options increase in value - is that ordinary income of capital gains?
In neither of the cases above, the person getting the “capital gains” tax rate, put up any of his own money. But we all know that in both of these cases, the increase in value is “capital gains”. All parties contributed to the success of the enterprise, they all took risks. Some brought in money, others brought in expertise, and some brought in know-how.
To me, these are simple partnership issues; if the underlying asset qualifies as “capital gains”, then for each of the partner; it is “capital gains.”
And what kind of logic is it to tax somebody more, just because they succeeded! Venture funds have contributed so much to the economy; they should be rewarded not punished. Moreover, the equity managers are generally in control of their own taxation, before the ink on the amendment is dry, there will be new methods devised, new Blocker Corporations setup to ensure that the carried interest gets treated at 15% (or even less) rate.
How does this affect the startups and emerging companies? It affects them directly. If Frank gets taxed at higher rate, he will either charge higher management fee or increase his carried interest so that he comes out even. And people who get less are the investors and that means they will be less likely to invest. The next time you have a Web 3.0 epiphany, you might not find as many people wanting to write you a check.
The place where the effect will be most directly seen would very likely be in “smaller markets”. The Silicon Valley, the southern California, the New England area, all of them will continue to get funding; managers will continue to manage, but when somebody wants to start a regional fund for North Carolina research triangle or for the Energy Corridor in Houston, the venture funds and the catalysts that make the funds happen, will be less likely to be there.
VCs have provided one of the most important economic engines in recent times; lets keep it moving and not burden it with more taxes.
Tags : Legal IP, Opinion, Venture Capital
Event: Tech Coast Angels summer party 2007
The Tech Coast Angels Los Angeles chapter, held its annual summer party on June 24th, 2007. The event was hosted at the home of TCA member Elizabeth Tito and her husband Dennis Tito (Dennis Tito is founder of Wilshire Associates and originator of the Wilshire 5000 index. He was also the first space tourist, and spent 8 days in space on board the International Space Station).
The party was attended by 100+ TCA LA members and spouses. TCA founder Luis Villalobos of Angel Venture partners, and TCA president Frank Peters of the FrankPetersShow, were also in attendance. The fabulous event was organized by TCA members Joyce Freedman and Elizabeth Tito. The TCA board of governors - Richard Morgenstern, Al Schneider and John Morris, was present in full force.
The hilltop Tito home provided a magnificent setting for the late afternoon event, with views of the Bay, Century City and downtown LA.
Tags : Events, Venture Capital
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