There was a very interesting article in the Wall Street Journal recently talking about how the gap between the venture capital invested in firms and the amount they are getting sold for is narrowing.
"According to data from Dow Jones VentureSource, the median acquisition value of a venture-backed company in 2009 was $26 million, which is 1.3 times the median amount of venture capital - $19.8 million - that these companies raised in their lifetimes. That’s less than the 1.5x multiple in 2008, and well below the 3.6x experienced in 2007. In fact, it’s the smallest gap since the dark times of 2003 when the multiple sat just above 1."
The service focused firms which includes social media, dotcom and retail as well as the business and financial services focused companies haven't fared as badly but even for them the multiples are drastically down from their heydays.
Why does this matter?
It is a generally known fact that VCs do not expect block-buster deals for every one of their investments. Even they are aware that 40% will bomb, 50% will return the investment and 10% will be the super duper deals that they will be remembered for. It's the average multiple for all these transactions that is being referred to above. Hence, if the sector is only returning a 1.3x over an average investment period of 5 years, that's an IRR of about 5%, which certainly does take the venture capital industry closer to an existential crisis.
An interesting article from Nic Brisbourne today on convertible debt. It leads to a few thoughts and comments:
An emerging business may raise convertible debt either:
1. As an initial investment, when putting a valuation number on the table is a tough ask
2. As an investment by an existing investor when the previous round was raised a while back and they are looking at new money to put a valuation number on the table
3. As an investment by an existing investor who doesn't want their holding percentage to exceed a certain level for regulatory requirements, government incentives etc.
The conversion price in the first case may be a discount to the price of subsequent investments. The price in the second and third case could be the same as previous rounds or subsequent rounds.
Of course, convertible debt does have an interest component with it as well. In some cases, the interest may get adjusted as shares as well rather than a cash output.
It's also possible to have an interest component rather than a discount to the share price compared to the earlier or previous rounds.
So, as an entrepreneur, when should one opt for convertible debt?
1. When there is sufficient confidence in the business opportunity but that belief is not reflected by the investor e.g. the term sheet on the table is talking about £1 million for a 50% holding in the firm, convertible debt may be the way to go.
2. When the entrepreneur is looking at a simplified process perhaps without advisors. The costs attached to raising convertible debt are generally lower and less complex than raising equity. There has been a lot of discussion around standardizing term sheets to make the process simpler for entrepreneurs. But I think there are too many stakeholders in this process to let such an initiative go through.
A very interesting post from Steve Blank capturing the difference between business plans and business models. I think it should be prescribed reading for all entrepreneurs and certainly deserves recording for posterity on this blog.
In summary the business plan helps clarity of thought on market, strategy, sales approach, financial targets. Recording all these thoughts will help the entrepreneur with his/her approach. But keep it short....I think it comes into play more as the firm develops.
The business model, on the other hand, is more flexible. Who are the initial targets, what is the way to market, what is the sale price. It can be tweaked and restructured as the startup develops and gets more feedback from the market.
Continuing with our Wednesday term sheet focus, one of the clauses which received quite some attention in the term sheets I saw last year was the liquidity preference.
To explain that with an example, let’s assume a venture capital investor invested £5 million in a firm with a post-money valuation of £20 million and received preference shares with a 2x liquidity preference. Two years later, the firm has a buyer for a sale price of £50 million and management decides to exit. The investor will now receive an upfront £10 million before the rest of the proceeds are shared between the remaining participants.
If the VC in question had participating preference shares, they will also participate in the distribution of the remaining proceeds in proportion with their share holding.
In some cases, the VC holds what are called capped participating preference shares. These generally kick in when the exit is exceptionally high. In this case, the liquidity preference may be capped between 3x-5x. However instead of going the pref route, the VC may stand to gain more if they convert their preferred to common shares and have all the proceeds distributed across the shareholders according to their respective holdings.
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