Drakeview

Terms of endearment

For the better part of the year, Brad Feld, Managing Director at Mobius Venture Capital and general counsel Jason Mendelson have been working up their guide to Term Sheets - the contract between entrepreneurs/businesses and professional investors.  As one might expect it has vocabulary and context unique to the relationship and the transaction.  And it places the novice entrepreneur in a unique position dealing with an investor for which the terms, conditions and situations are routine.  This is an excellent guide written by a Venture Capitalist with the intended audience being the startup founder or business executive.  Even after reading the entire 20 part series remember the admonitions of a trial judge confronting a defendant handling his own defense -  only a fool represents himself in these proceedings.  Here is the last in the series that includes links to the entire series:  Term Sheet Series Wrap Up

VC funds downsize

Mayfield XII closed Friday after hitting their target of $375 million.  Mayfield XI, one of the early $1 B megafunds quickly oversubscribed in 2001 is still adding to its portfolio.  In the last several months VentureWire Alert reports that Canaan, Accel and PrismVentures have all raised funds smaller than the preceding fund.  Is this is a trend suggesting that VCs are having trouble fund raising from their Limited Partners?  Hardly.

The Mayfield XII was oversubscribed and secured commitments in just 3 months.  For awhile it has been a concern that megafunds shifted VCs priorities toward the later stages.  Early stage companies were too small to meet the megafund's investment criteria.  Mayfield XI typically invested $15 million at a shot.  So the new smaller funds are merely the VC ecosystem adjusting to market needs.   The trend toward small indicates VC's appetite for early stage companies has returned.  Growth is indeed back in the venture capital lexicon. 

Mayfield has been a fixture on Sand Hill Road for 30+ years and has $1.9B under management.  They have funded over 450 companies of which 100 have gone IPO and another 150 were acquired or merged.  They prefer early stages - seed through B.  SanDisk, TIBCO, 3Com, AMGEN, Compaq and Tandem have been in their portfolios.  And as early stage investors they expect to help the entrepreneurs with more than just money - taking a seat on the board, exposing their network of resources and relationships and mentoring the founders through tough times that invariably occur.

VC success rates

Yesterday while going through the Carnival of the Capitalists I read an entry by MobHappy (Russel and Carlo's blog on mobile tech) this reference:

One of the issues facing us all is that innovation is either very difficult or executed very badly (depending on which theory you believe) resulting in pretty dismal success rates. For instance, less that 1% of toys launched ever succeed. Actually, all the following sectors have less than 5% success rate; mobile telephony (of course), groceries, music, airlines, financial services, computer hardware and software.

But then we come to VC Firms' success rates which have a staggering (in comparison) 31% success rate - actually 4 times better than the next successful sector of pharmaceuticals.

Russel expressed surprise - not at the low number for various sectors but the claim that VC's success rates were 30+%.  It isn't a surprise it is stunning if it is true.  Some googling about turned up this paragraph from GRI Equity's July newsletter:

The observation of cash surplus mentioned above and the resultant decline in innovation is complimented by research that indicates that the best source of innovation is not these tech oriented companies themselves but VC backed innovation.  The average innovation initiative success rate is 4.5%, with the highest non-VC being pharma at 7.5%, while the VC success rate is over 30%.  A very powerful indicator that a VC investment partner can make or break the success of a venture.  Research also shows that successful innovation is enhanced by new approaches including networked decision making, open space, parallel decision making and flat organisational structures.

Where did these numbers come from?  On the surface it seems unbelievable, especially after the heyday where literally thousands of firms were funded by VCs but mortality was estimated to be as high as 90%.  But then for the longest time we've believed that the likelihood of launching a successful business was only 1 in 15 or 20 and that number proves to be too low if analyzed closely and with clearly defined definitions of success or failure.   I suspect the 31% success rate is due to some very casual definition of success - the greater fool theory in play here.  Perhaps a successful investment is one that produces positive results and so perhaps in a typical start-up with 4 or 5 rounds of fund raising, the first 4 rounds are considered successful (even with cram downs, etc.) even if the venture goes bust after the 5th infusion.  I don't know.  I'd like to know.  So if anyone has access to the data, please leave a reference in the comments.  Thanks.

VC activity in the news

VentureWire Alert, the free daily update from DowJones, has a few items this morning that highlights some insights provided by the panelists at the LAVA VC session last week.  Leading off was a brief on Warburg Pincus quickly raising an $8 B fund from their core investors.  WP is one of those firms that will just as soon take a company private as invest to hold it off the market in addition to its venture financing.

Private equity firm Warburg Pincus LLC has closed its largest-ever fund, Warburg Pincus Private Equity IX, at $8 billion. It will be invested in both start-ups and in buyouts globally, a change from the firm's previous tactic of raising separate funds for U.S. and international deals.

Warburg's business is distinct from many of its peers, as it dedicates one-third of its fund to venture-capital investing and another third to what it dubs high-growth companies. The firm's most recent fund has so far produced a net internal rate of return of about 28%.

And further on in the update:

The challenge now facing Warburg and the other firms is where to put their money to work. Given the sheer size of their funds, they must find large enough investments to produce returns that in industry parlance "move the needle." That means private-equity funds are now targeting companies that would have previously been far off-limits, with some potential targets sporting market capitalizations of $15 billion to $20 billion.

Also included in the update was news about Irvine based Alteer Corporation, a physician practice re-engineering service firm.  The firm started out licensing its software solution for improving administrative, claims and patient handling chores that impact doctor offices but has found traction in process improvement services.  Alteer is in the midst of a $16.5 M Series A recapitalization round that will be used to expand sales and marketing efforts.

And in an intoxicating announcement, Tech Coast Angels has led funding of an oversubscribed $1.75 Series C round for brand marketing firm Progressive Beverages - a firm that imports Asian liquor and wines for US markets.  The proceeds will be used to market HAN vodka, introduced to California markets in July. 

LAVA VC Panel - Part 2

This post is the 2nd of two parts covering the LAVA Venture Capital Panel for 2005. In Part 1 the panel members and session moderators were introduced and data from Ernst & Young provided an overview of VC activity for the last 3 years or so.

This week the 15th annual Venture Capital Panel was presented by the Los Angeles Venture Association. Below is a quick pass at some of the insights and observations from the panel members.  These are not direct quotes but a paraphrase of their comments.  The orientation was to focus on southern California's unique opportunities and characteristics, though generally the advice and comments are relevant for entrepreneurs everywhere.  The main points:

There are regional differences between Southern California and the Silicon Valley.

• VCs are biased toward the Valley.  One panelist mused that it is hard for some VCs to accept that 3 guys in Glendale can come up with a $ billion idea while the collective wisdom of Silicon Valley's savvy, experienced and credentialed entrepreneurs and investors have overlooked the opportunity. 
• Southern California's investment environment is more casual. 
• Review, due diligence, amending plans and signing the term sheets can take up to 9 months locally given the level of experience in start-ups and the management teams. 
• VCs often have to recast and re-purpose the business to a greater degree than in Silicon Valley.
• The primary business types for southern California IPOs last year were biopharma and medical devices.  Startups in the north are focused on equipment, semiconductors and IT.

Overall trends in the investment environment effect VCs and entrepreneurs regardless of location.

• Valuations are depressed from the dot-com period.
• VCs need more market validation (orders, sales, revenues) today than several years ago.
• The movement toward conservative large later stage investments has about run its course and VCs are again looking at earlier stages but:
  • Megafunds (multi-billion dollar pools of Limited Partner's money) have had a chilling effect on Series A.  With very few exceptions early stages don't offer returns and risk profiles consistent with a megafund's investment criteria.
  • There is competition for Series B and later stage investments among VCs, not so much so in Series A.
  • The appetite is increasing for earlier rounds and their risks but carries the possibility that outcome potential won't meet post-money valuation targets.
• Lack of IPOs as an exit strategy for moderately sized companies is exerting a strong influence on the venture ecosystem.  M&A activity is solid, but unspectacular as these transactions are capped on the upside. 
• Private equity investors are changing the landscape by stepping up and keeping growing businesses off the market (as acquisition targets or IPO candidates) in an effort to make the business an attractive size for an IPO at a later date.
• Only about 50% of the deals done go well for a variety of reasons - the management can't scale the business, the market never develops or perhaps a stronger competitor comes out of nowhere.  Every effort is made to do a good deal but it is a given that even after excessive scrutiny many will fail.
• On-demand amnesia is a requirement for a good VC.  After all, they told their Limited Partners that they only do "good deals."

The panel shares some advice for entrepreneurs.

• Founders must get sufficient capital to reach a milestone that they can use to ratchet up their valuation.   In their haste to get funding entrepreneurs may undercapitalize and limit the growth prospects of their business.
• The founders also have to demonstrate that the target market for their product or service can support the next level of valuation.
• VCs work backward through hurdle rates to arrive at initial valuation. 
• Valuation is an art not a science.
• Entrepreneurs have to be realistic in pre-money stages. 
• VCs are looking for deals that scale to appropriate levels of valuation to meet their investment criteria.
• Costs of going public are huge and costs of Sarbanes-Oxley for a small company to be brought into compliance can be as much as $2 M. SOX will impact any start-up company going public or that might be acquired by a public company.  SOX is not just a one-time activity and it has significant valuation impact on an M&A target or IPO candidate.  (One of the panel members observed that SOX is inhibiting CEOs of small firms from seeking funding or going public.  Post-SOX the majority of a small firm's CEO and CFO time is spent on administrivia rather than focused on growing the company. Drake Associates is now advising our start-up clients that they build SOX compliant systems from the get go if there is any desire or even possibility that they may be acquired or seek professional investment.  This advice is not appreciated but they ignore it at their peril.)
• Customers/markets are always ahead of the curve so finding a sizable psychographic or demographic and thoroughly understanding it is a key to success.

What makes a start-up attractive?

• Project the maximum economic impact from becoming a successful business.  VC firms look for the big upside.  Do not mask the potential of the business in some smaller package to appear more viable. 
• Businesses that are category killers are favored by more aggressive VC firms.  The only way to get better than revenue multipliers is to create a category in a fundamental large market.  But VCs and analysts are not particularly prescient about what new categories might deliver big returns.
• Market timing is a big concern and there has to be a well documented case that the business is in a position to capitalize on a trend or on an emerging market.
• VCs are focused on the people running the firm to a much greater extent than is generally appreciated.  And the people running the prospective portfolio company will get the majority of scrutiny, whether it looks or feels that way.  The wrong C-level can cost a firm significant value.
• VCs sometimes have a problem putting themselves in the position of an average consumer.  So they may not understand why a product or service might appeal to a market - even a very large market like mobile gamers (see below).  Entrepreneurs can educate the VCs about the opportunity but it is usually better to keep looking until they find a VC that acknowledges and appreciates the plan.  It is critical for entrepreneurs to match their business idea to a VC with experience investing in the market, technology or industry space.

True confessions:

• Three of the panel members had at various times the chance to invest in local mobile game platform developer JAMDAT - and they all passed.  Qualcomm did invest.  JAMDAT raised $60M last year in their IPO.
• One panel member passed on funding a start-up started by his neighbor because it was not within his firm's investment theme.  That company was Intermix, acquired last week by News Corp for $580 M.
• Another member suggested they don't worry so much about what they missed but rather the investments they made that didn't turn out as well as they should have.
• All the members agreed that they have had problems with changing management - even when the founder had agreed that at some point a change was needed or expected.
• One member remarked that Henry Kravis (of MBO icon KKR) said a mistake is not moving fast enough once a problem is recognized.  If partners around the water cooler start asking about how a particular portfolio company is handling a problem - it is already too late!  And once a move is made, they always wonder why it took so long to get it done.
• VCs as a group follow the hot trend or the same fast followers.  And they tend to avoid things out of favor or unknown. 

The panel briefly touched on the $4B IPO for Chinese search company Baidu that was listed at $27 and closed at $122 on the first day of NASDAQ trading a week earlier.

• Incredible (record setting, first day increase of 354%) and unique.
• It has already fallen significantly as the hype wears off and the realities of the small ad market in China takes over.  BIDU priced at 100x sales and 300x cash flow.
• Big winners are driven by projections of a big future and are notoriously difficult to predict.

LAVA VC Panel - Part 1

This will be the first of two parts.  Today's post sets the stage with an overview of VC activity with an emphasis on California and particularly southern California.  The follow-on post will share some insights and comments from the panel members.

The Los Angeles Venture Association 15th annual VC panel session was held earlier in the week.  As is usually the case at this event the VCs were refreshingly candid.  They talked about the environment for investment, what they liked and didn't like, mistakes they'd made and the current state of venture activity, particularly around southern California.  The panel was stellar: John Dilts of the Keiretsu Forum (the largest organized angel group), Brian Garrett of Palomar Ventures, the venerable Robert Kibble, founding Partner of Mission Ventures, Klaus Koch of Kline Hawkes & Co, Eve Kurtin of Pacific Venture Group, Joseph Marks of early stage and mid-stage SBIC venture fund Smart Technology Ventures III, Greg Martin of Redpoint Ventures and Phil Ressler of Clearstone Venture Partners.  Doug Burke of M&A specialist PageMill Partners and Brad Weirick of Gibson Dunn & Crutcher co-moderated.  Ernst & Young, a sponsor for the event, provided the slides and great handout with charts and graphs.  All of the data presented below is from that hand-out.

As background, some of the metrics for the VC community:

• Median Deal Size - $ 7 M, increasing slightly from 2002 $6.3 and steady from 2004
• Median Pre-Money Valuation - $17.0 M, up significantly from $13 million in 2004, $10 million in 2002 and 2003 
• Median Time between VC Rounds - in 2004 it was 19 months, off from 2003 high of 20 months, above 2002's 18 months and up from 2001's 14 months
• Seed Round Investments - Q1-2, 05: 314 deals and $1.7 B; 2004 - 710 deals and $4.4 B; 2003 - 615 deals and $3.5 B and 2002 - 662 and $4.1 B.  Bay Area gets 25% of these rounds, New England 9% and southern California 7%
• Nationally Products and Services get 22% of initial round investment, health sciences (bio-pharma + medical devices + services) get 25% and as has been the case for a long time IT gets the bulk of deals and dollars - 49% lead by software, communications, semiconductors and electronics

The local middle-market dominated economy isn't likely to supplant our northern neighbor Silicon Valley as magnet for VC funds any time soon, but the area is seeing a large share of venture finance in part due to more venture firms opening offices locally.  For the 1st half of 2005 over $1B was invested in southern California firms in 91 deals.  Most of the money went to bio-pharma (28% of the funding, 19% of the deals), semiconductors (18% of funding, 14% of the deals) and software (13% of funding but 25% of deals).  Comms, business services, medical devices and healthcare services made up most of the balance in both categories.

Los Angeles venture investment for 2002, 2003 and 2004 was steady at about 70 deals and $650 Million.  For the first half of 2005 the numbers are down slightly - 31 deals at $330 M.  There isn't much bio-pharma locally (4% of funding, 3% of deals) but semiconductors (26% funding, 19% of deals), software (20%, 32%) and communications (18% of funding, 10% of deals) were leading investment themes. 

There were 13 IPOs (raising $600 million) of southern California venture backed firms in 2004 and there have been 3 so far this year - Favrille (Bio-pharma), Fastclick (Business Services) and DexCom (Medical Devices). 

VC M&A activity remains sluggish with just 165 events and but a healthy $14 billion so far this year.  In 2004 there were 403 events and $23 B paid. In 2003 a total of 337 firms were acquired for $13 Billion off from the 380 deals but up from $11 Billion in 2002 actions.  The one favorable trend in the M&A sector is that the valuations as a percentage of VC investment are rising smartly.  In 2002, the media valuation was $18 Million with median VC investment at $17 Million.   In 2003 it was little different with median valuation at $23 Million for $19 million median investment.  2004 turned up with $21 million median investment getting $40 Million median valuation.  The first half of this year the numbers are approaching ratios similar to the mid-1990's with $24 million of median investment leading to $60 million of median valuation.

Part 2 will present some of the paraphrased insights and observations from the panelist including some missed opportunities - 3 of the panelist had passed on JAMDAT mobile which was one of the 2004 IPOs and one panelist didn't see how his neighbor's company fit his firm's investment theme. The neighbors company was recently acquired for a large premium.  More later.

LAVA 15th Annual VC Panel

Next Tuesday (Aug 9th), the Los Angeles Venture Association is hosting their annual Venture Capital panel discussion.  The session will feature VCs and professional service providers active in the diverse southern California area.  This well attended event attracts a stellar group of VCs who share their views on the current market, their particular investment themes and deal flow.  The service providers review current practices, priorities and issues surrounding financing and liquidity events. It is always informative and provocative.   

This year's roster of VCs includes:  Brian Garrett of Palomar Ventures, Robert Kibble of Mission Venture Partners, Klaus Koch of Kline Hawkes, Eve Kurtin of Pacific Venture Group, Joseph Marks of Smart Technology Ventures, Greg Martin of Redpoint and Phil Ressler of Clearstone.  Doug Burke of Pagemill Partners, John Dilts of Keiretsu Forum and Brad Weirick of Gibson Dunn and Crutcher will moderate the event.

Registration for this event is available through the LAVA web site.  The meeting will be held at the Regency Club, 17th floor of the Murdock Building in West Los Angeles. 

Handling RFID data

One of the problems with RFID adoption is the scale and scope of data handling requirements if taken to its logical conclusion.  And in part the opportunity to collect massive amounts of data is among the reasons so few firms have found compelling justification for RFID endeavors.  That same ability to capture and track data on an item from manufacturer to pantry is giving privacy advocates fits.  The likelihood of capturing all, must less trying to use all the data is problematic - the data storage and analytic costs would exceed benefits by a large margin. This is another case of technology enabling that we label "just because you can doesn't mean you should." 

RFID adoption is pervasive and soon the little radio tags will be ubiquitous.  The ability to manage supply chains and especially inventory will prove to be too attractive for most larger companies to avoid.  And of course this will ultimately trickle down to requirements for retailers who will see the tech integrate into their existing system easily, but not cheaply.   But more than likely at each stop in the value chain there will be a data silo collecting the gozintas and gozoutas and not much concern or inquiry for what came 2 steps before or 2 steps later.

One of the companies playing in this sand box is TrueDemand - a bay area start-up that scored a $6M Series A according to this morning's VentureWire Alert.  TDemand has a software product that will help supply chain managers identify supply chain inefficiencies through collection of RFID data and predictive algorithms.  More about TDemand's business is available from eWeek: RFID Data Handling Upgraded.

TrueDemand is also taking the supply chain approach. Its suite of as-yet-unnamed applications, due at year's end, will combine new EPC data with transactional data to better predict supply-and-demand needs. The suite will provide a single environment for integrated inventory, planning and execution, according to Eric Peters, TrueDemand's CEO.

"We've put together a science team that is building next-generation algorithms on how to take event data to really model and take advantage of supply chain data," Peters said. "This is supply chain data that uses RFID data, so we're rewriting algorithms to do very short-term forecasts and predict the next order or out-of-stocks."

Alien Tech scores $66 M

Walmart and the Department of Defense are in the vanguard of organizations incorporating Radio Frequency Identification into their operations, supply chain management and logistics.  And as has been widely reported these giant consumers of retail products and military goods are pressing their suppliers to adopt the technology. 

RFID at its simplest is a wireless inventory tagging method that takes advantage of cheap, individual radio transmitters and readers that can operate from several feet to a couple of yards rapidly, reliably and repeatedly.   Tags are composed of an integrated circuit which store data on a small silicon chip and a small, flexible antenna.   When a tag passes by a reader, the tag absorbs some of the RF energy from the reader signal and then returns information stored in its memory as a radio signal.

The technology is over 60 years old but it is just in the last half dozen years that it has gained a following as the logical successor to bar codes for inventory management.  Readers have become much easier and cheaper to deploy and manage.  Some few large companies like Texas Instruments and Symbol Technologies have focused on developing and producing the readers.  Alien Technology has focused on the tags, though they also produce readers and software to manage data collection and analysis.  Three times as many tags will be used in 2005 as there were deployed in the previous 59 years of the technology's life.  And with demand drivers like Walmart and the military adopting these schemes millions of radio tags are being produced at pennies per unit. 

The estimates for how big and how fast the market for RFID tags will grow are all over the map.  A recent study by IDTechEx predicts a $25B market in the next 10 years.  Others see demand developing more slowly as retailers and wholesalers rely on the ubiquitous bar codes and the investment required by retailers or distributors to use the technology and integrated data systems beyond the warehouse is considerable.   

Alien Technology's H round of funding was lead by SunBridge Partners and included existing investors Advanced Equities, Digital Bandwidth, Equitek Capital, Lago Ventures and Miami Valley Venture Fund.  Total capital invested in Alien is more than $200 million.

VC activity in Q2-05

Ernst & Young in collaboration with VentureOne is reporting that Later-Stage Investments Push Overall U.S. Venture-Capital Investment to Highest Level In Four Quarters.  The headline paints a mixed picture.  If VCs are placing their bets on later stage companies they are responding to conditions where value is in their own portfolio rather than in fresher opportunities.  The few IPOs and punk rate of M&A activity is largely responsible.  And some funds are coming to the end of their investment life and so the money has to be put to work or returned to the LPs.  Larger, later stage deals are a way to spend more money on fewer deals.  The pace of funding is inline with 2004 when just over $5.2 B per quarter was put to work. 

The U.S. venture-capital industry showed some improvement from earlier this year, posting 524 deals in the second quarter of 2005—raising a total of $5.39 billion—according to the Quarterly Venture Capital Report released by Ernst & Young LLP and VentureOne, a unit of Dow Jones Newswires and the publisher of VentureSource. However, this represents a decline of 11% in deals and 6% in U.S. dollars from the second quarter of last year, which was the highest quarter of the past 10.

But the numbers shifted upward by 7% and 14%, respectively, from the first quarter of this year. In fact, the dollars invested are at the highest level in a year—a result related to a 9% increase in later-stage deals, which generally involve larger sums.

Through the first six months of 2005, $10.11 billion has been invested. This compares to the $21.28 billion invested in all of 2004.

For the period products and services showed growth with 77 deals with a median value about $6 M.  The number of deals is similar to 2004 however twice the dollars were invested this last quarter compared to same period last year.  Health care deals declined relatively but still 122 events with about $ 1.4 B.  IT deals were off in terms of numbers and dollars - 16 % and 18% respectively to 300 deals and $ 2.8 B invested during the period compared to last year's 2nd quarter.

For the southern California area PwC, Thompson and NVCA are reporting that Los Angeles based  firms secured almost $260 M during the 2nd quarter, up over 14% from last year.  San Diego is still the preferred locale for funding with 36 companies gathering over $390 M, up 25% from the 2nd quarter of last year.  And the OC had over $240 M,  a four-fold increase.  The above figures were reported by the Los Angeles Business Journal - Venture Funding in LA County Jumps.