ROCKY TOP MBA

The following tidbits are from the Fenwick and West Q3 Silicon Valley VC Activity Report.

• 70% of rounds were up rounds, 15% were down rounds, and 15% were flat.  This is a much healthier quarter than the six previous quarters.
• Confidence from VC professionals is declining for the second time in 11 quarters, most likely due to the continued weakness in the IPO markets and significant global economic turbulence.
• VC investment was $8.4B in 765 deals for Q3 2011, according to Dow Jones.  Northern California received 38% of investment capital, and 2011 is on track to exceed the amount invested in 2010.
• Acquisition activity (including buyouts) was $13B and 122 deals, according to Dow Jones.
• IPO activity showed 10 US venture-backed companies going public in Q3 2011, according to Dow Jones.  On a not-so-positive note, half of them listed on non-US exchanges.
• Venture capital fundraising continued to be pitiful with $2.2B reported by Dow Jones.  2011 is on track to to be the fourth straight year that VC fundraising is less than VC investment.

Typical Silicon Valley deal terms for Q3 2011 were:

• 31% had a liquidation preference with 100% reporting a 1x multiple
• 39% of deals were participating preferred deals
• 6% of deals had cumulative dividends
• 97% of deals had weighed average anti-dilution
• 21% of deals had preferential redemption rights
• 2% of deals required corporate reorganization

If they provide it, I’ll do another post with a summary of the VC Experts reports on terms of non-Silicon Valley deals.

A man with more experience and knowledge of valuation than your humble author, Mr. Joe Bartlett, provided the commentary that inspired this post.

How do you value something that has no historical and only has speculative future cash flows? A seed or early-stage company? A spin-out or licensing of a technology? The hard answer is that you can’t with current valuation techniques.  Discounted cash flow is inadequate (I hear the cringe of finance academics every where) because the cash flows you model are speculative, making your valuation speculative. Industry performance benchmarks are also inadequate, because the metrics you’ll be analyzing and applying valuation multiples to are also speculative, causing the same problem as before.  Comparable analysis would be an efficient and accurate way to facilitate the valuation, but the companies receiving investment and their investors are not likely to disclose the terms of those transactions.  How do you solve this problem?

My suggestion is that you use an approach that embraces the speculative nature of the opportunity and provides a reality check for what any valuation means in a future liquidation event.  Let me explain using an overly simplified but easy(ish) example:

Let’s say we have a technology company named WhizBang , Inc. that needs to raise $500K to bring their product to market. They have a successful beta test with a handful of customers, an experienced team, and the technology appears defensible (to the extent that IP can ever be defended). The company projects revenue at $1M in year one, $3M in year two, $9M in year three, and $25M in year four.  They anticipate being acquired in year four at 2x revenue (or $50M).  What is a valuation of that company?

Instead of trying to understand the intrinsic value of the company, focus on the investor’s potential return. Let’s assume the company is selling common stock with no dividend and liquidation preference (not realistic, but keeps the math easy!) at a $5M pre-money valuation (also not realistic).  Pre-money means the value of the company before the investment, and post-$ means the pre-money value plus the investment.  In this case, the pre-money is $5M and the post-money is $5.5M.  If you invest $500K on a $5M pre-money value, you’ve purchased a 10% position in the company ($500K / $5M = 10%).

Lets assume that the company only raises this initial $500K round (again, overly simplified to keep the math simple).  Lets also assume that we have research and agree with the company’s expectation that they’ll be acquired at 2x revenue for $50M.  If the investor owns 10% of the company, the investor has rights to 10% of the acquisition price or $10M.  That is a net ROI of 9x and a XIRR of 72%.  Not too bad!  Research from the Pepperdine University Private Capital Markets program says most venture investors have a target IRR of 38%-42%, so we definitely cleared that hurdle.

Let’s say the investor digs into the business model and get some expert opinion on the sales forecasts that say the $25M sales goal will take eight years instead of four and that the acquisition multiple will be 1.5x revenue ($27.5M) instead of 2x.  How does that play out?

The investor’s ownership translates into 10% of the $37.5M liquidation vent, or $3.75M.  That is a net ROI of 6.5x and a XIRR of 28%.  Ruh, roh.  That investment greatly under-performed.

The scenarios above are overly simplified for ease of understanding, and a real situation would most likely include some combination of follow-on rounds of fundraising, anti-dilution, dividends, liquidation, preference, etc… and that’s just terminology and variables for the transaction.  The two largest risks of failure–market and execution–are independent to the transition itself.

When you think about the value of your pre-revenue or even pre-profits company, try to put yourself in the investors position.  Imagine you own a football franchise and you’ve been given the opportunity to put a contract on a middle school student that’s top tier in his peer group. He comes from athletic parents, he’s in a sports program that has quality equipment and coaching, and the student is in exceptional health for a middle school student.  Would you pay that student $1M now with the expectation that they’ll make you $10M in eight years when they’ve completed high school and college?

Something to think about.

In the president’s address to the American people and Congress, he referenced the patent reform legislation as an example for the type of legislation we need.  He says this legislation will create jobs.  I didn’t think much about it but I was encouraged that our patent system, which hasn’t been updated in 50 years, was the focus of congressional attention and received a name-drop in a presidential address.  I should have known better.

Since intellectual property is a strong contributor to having a competitive advantage, and since a defensible competitive advantage drives up the value and attractiveness of an early-stage business, I decided to do a little homework on the coming patent reform.  Here is a quick summary of my findings:

Current system:  The current system hasn’t been updated in 50 years, resulted in an incredible backlog of around 700,000 unanswered filings, an average waiting period of three to five years for a response, and a catalog of issued patents that are broad and contradicting.  There is an entire website devoted to the ridiculousness of some patents (http://www.patentlysilly.com/) including the comb-over haircut, body-hair trimmers, and lap-dance protection gear (see image above).  On a more serious note, and based on personal experience, I’ve seen a broadly written patent slow down the formation and launch of a company from 3 months to over 12 months and counting.

Key problems of current system: Oh, where to start…

• Process– The waiting period and scrutiny is tedious and often not productive.  Over 700,000 unanswered disclosures with an average to three to five years is not an indicator of a healthy and functioning system.  The filing and consideration system should be tiered and more resources should be dedicated.  The US Patent Office actually generates more than it consumes in revenue (I know, I was shocked too), but the excess revenue is funneled off for other congressional pet projects (not shocked by that).  Go here for an editorial by Senator Tom Coburn on this problem.  The process needs to be streamlined, the USPTO need to be expanded, and the proceeds from filing fees need to stay in the USPTO.  Also, I think the USPTO should offer a fast track option that cost marginally more if the patent is being practiced in a commercial product within twelve months.
• Litigation reform– Broadly written patents end up sitting on shelves and not being used for commercial application, only to be un-earthed years later as a weapon in a lawsuit against a start-up or a more mature company introducing a new product.  There should be some restrictions, or at the very least some award caps, on non-practiced patents.
• Troll, troll, troll–  The current catalog of broadly defined patents has resulted in equity funds and companies purchasing portfolios of patents with the expectation of using as tools against competitors.  While this isn’t necessarily wrong, it isn’t the most productive behavior from an economic perspective.  These companies often don’t practice the patents, using them as a foundation to file expensive an onerous suits against competitors and start-ups.  These guys would make the ugly fellow living under the bridge blush.  The way to solve this problem is to increase the cost of renewing the patent at it’s four year anniversary if the patent isn’t being practiced.

From the VCExperts non-Silicon Valley report, which is provided as a contrast to the the Fenwick & West Silicon Valley report.  The deal characteristic with the highest occurrence:

• 53% were participating preferred (as opposed to convertible preferred)
• 53% were pari-passu with earlier preferred investors (as opposed to senior)
• 96% were a 1x liquidation preference (as opposed to greater than 1x)
• 71% were non-cumulative dividends (as opposed to cumulative)
• 92% had weighted average anti-dilution protection (as opposed to full ratchet)

Let me preface this post by saying that I have not decided on how I will vote in November 2012 other than to say that I want a candidate and platform consistent with my principles.  Also, this post isn’t intended to be a Romney endorsement.

President Obama is taking the podium on Thursday night to address Congress and the American people with what he is describing as a economic growth plan focused on tax cuts for the middle class.  While the specifics of his speech are forthcoming, I’m naturally skeptical of any economic growth plan that starts with a stump speech to a union crowd.  In what is a loooooooong overdue response by Mitt Romney, the former Massachusetts governor has preempted the president with a USA Today editorial announcing his own economic plan(with details forthcoming this week).  In a side comment, I think Romney’s action was influenced by the entrance and surge of support for Rick Perry.  This is Romney’s attempt to stay on the offensive against Obama and put his flag in the ground as the candidate that understands the economy.

Here are some comments on Romney’s editorial:

• Romney proposes 59 specific proposals, including 10 actions to be taken on his first day in office.  This could be a rallying point for scholarly and economic conservatives.  For me, the jury is still out until we see the details.
• Romney points with clarity to the key issue of the 2012 election– President Obama and the democratic platform believes the government can create sustaining jobs.  Romney proposes an alternative platform that accepts the notion that government cannot create sustainable jobs and that only the individual initiative of citizens can create sustainable jobs.  Government’s responsibility is to protect and nurture those individuals, that attitude, and an encouraging environment.
• Romney calls out for a revamping of the tax system, although he doesn’t provide many details.  Frankly, some of his suggestions sound like a furthering of the tiered tax structure we currently utilize.  I’m not sure that a flat tax wouldn’t be a better system.
• Romney says he will reduce regulation and eliminate ObamaCare.  With the hyper activity of the Obama regulatory environment, it should be pretty easy to accomplish the goal of easing regulations.  ObamaCare is a different battle.  You need a viable alternative and you need to address the large healthcare issue of this country.  But I think this is one issue where you keep it simple during the campaign.
• Romney refuses to accept current trade policy and singles out China as the abuser and manipulator.  I agree, and I think this is one issue where Romney can own the discussion.  You can have a free trade economy without the reckless and harmful behavior of China.
• Romney wants to consolidate federal workplace training programs into a single, more competitive and focused program.   The current 47 programs is a great example of bureaucracy and low-laying fruit in reforming government.
• Romney wants to put a cap on spending, which I agree with and support.  I think it should be fixed at a percentage of GDP.  In a point that I’m still undecided on, Romney supports a constitutional amendment to a balanced budget.

In closing summary, this type of concentrated, results-oriented campaigning is needed.  This action makes the Republican field better and differentiates the Republican platform from the Democratic platform (which was highlighted yesterday in President Obama’s follow-up speech to Jimmy Hoffa’s hit man rhetoric).   2012 is decided on a simple question… Are you pleased with the last four years, or do you think another candidate has a better plan?  It is ideological and it is partisan.  If you like a union friendly government that utilizes bureaucratic controls and government spending to (attempt to) drive economic growth, then vote for Obama.  For me, I’d like to see an alternative because the current unemployment numbers, growing levels of debt, and stagnant gross domestic product are unacceptable.  And I don’t think I’m alone.  A recent Washington Post/ABC poll found that only 43% of American’s are satisfied with President Obama.  History has demonstrated that a president is vulnerable during a reelection at below 45%.

Republicans, whether its Romney or not, need to keep working this comparison.  It softens Obama’s support and public image, making people ask that critical question of “Am I better now than I was four years ago?”