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Kernel column: Falling share prices at leading tech companies don’t mean the end of the world

By | The Kernel, Uncategorized, Venture Capital | One Comment

My latest column for the Kernel. It was published on Wednesday.

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Nic Brisbourne on why the technology start-up ecosystem will remain an important part of the global economy, despite some recent missteps.

You can see from the chart below that the share prices of high-profile internet companies Facebook, Groupon, and Zynga are down 48-60 per cent over the last three months.

This comes on top of a lot of other negative news, including leading investors selling shares in the companies above at minimal profits, and CalPERS, traditionally one of the largest investors in venture capital, announcing that they have made a terrible 0.0 per cent return on venture over the last ten years.

As a result, commentators like Alan Patrick are asking whether we are seeing the end of Silicon Valley as we know it. I think that is an over-reaction. Here’s why.

Firstly, the fundamentals for start-ups are stronger than ever: innovation is still required, the cost of innovation continues to fall, the pace of change continues to increase, and the best people increasingly want to work in start-ups.

Secondly, many of the problems are limited to one aspect of the start-up ecosystem: late-stage funding for some consumer internet companies. LinkedIn, and numerous SaaS companies, are still doing fine on the public markets.

That said, I think the problems indicated by the graphs above are very real. The reality is that we have been dealing with a market failure to provide liquidity to investors in late-stage companies for most of the time since the internet bubble burst in March 2000.

M&A has existed at a reasonable level for much of that period, but IPOs have been thin on the ground, and while small funds can make a decent return focusing on M&A, larger funds need the higher valuations you get from public markets to make their models work. This is one of the reasons that CalPERS returns have been so poor for the last ten years.

For the last couple of years, it looked like specialist late-stage funds like DST, private exchanges like Second Market, and latterly dedicated growth funds from traditional VCs like Kleiner Perkins were stepping into the void. These funders were providing liquidity to early investors and additional capital for growth, just like the IPO markets used to. The market thought it had found a solution to its failure.

The investment thesis for these specialist late-stage investors was to pay high valuations and then drive share price appreciation via revenue growth and hype, leading to an IPO. That worked for a while, but following recent losses for IPO investors I suspect those days are over.

Pinterest is a great company and a great service, and I’ve written about them admiringly in the past, but now they have become interesting as a case study of a deal that made sense a few months ago, but would be harder to understand now. They are rumoured to have recently rasied $100 million at a $1.5 billion valuation. That worked when comparable companies like Groupon and Zynga were worth $10 billion+, but looks chunky now they are at $2-3 billion.

With its $1.5 billion price tag, Pinterest will have a lot of work to do to get to the point where they can go public and deliver a venture return to their recent investors, and they have a valuation now which puts them out of reach for acquisition for all but a handful of massive tech companies.

So these sorts of deals will dry up, and we will be back to the situation we had before DST stepped onto the scene.

Fortunately, capitalism is a resilient beast and I’m sure we will find a new solution to the market failure. This time round, I think it might be that a different type of investor steps into the IPO void, one that is focused on the fundamentals of profits and cash flow as the drivers of value.

That will mean lower exit valuations for successful companies and less cash around to fund acqui-hires – which in turn will mean that angels and venture investors will need to reduce their valuations if they are to make a profit on their investments, probably leading to smaller rounds and smaller funds.

But this doesn’t mean that the ecosystem is broken. It will still be possible for entrepreneurs and their investors to make good money. But it will take a little longer, be a little harder and the payout will be a little less.

It may be a painful transition, but the tech start-up ecosystem can and must remain an important and thriving part of the global economy.

Kernel column: The LP update meeting

By | The Kernel | One Comment

My latest column for The Kernel. It was published last Thursday.

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The LP Update Meeting

Everybody answers to somebody, Nic Brisbourne reminds us. What happens when VCs are hauled into the boardroom to justify their investment decisions?

I’m just back from our semi-annual update to the LPs in one of our funds, and I thought I would share the experience with you all. As a reminder, LPs, or limited partners, are the investors in venture capital funds. They are typically pension funds, insurance companies or specialist investment houses known as FOFs (“fund of funds”).

These meetings are the equivalent of board meetings for our portfolio companies. We have around a dozen LP update meetings a year across our four funds and they are the most important moments of contact we have with our investors.

My hope is that the following description of the meeting will help explain the information we request from startups and the pressures we sometimes find ourselves under which we then have to pass on to our portfolio companies.

The agenda at the meeting today was similar to the usual agenda and I’ll go through each of the four items.

Manager update

We see our LPs relatively infrequently; they each look after interests in a large number of venture capital and private equity funds, and they occasionally shift responsibility for looking after our fund to new people, so we always begin by reminding them of who we are, why we are special, and our investment strategy.

Then we update them on how we are doing compared with our peers and on any changes to personnel and our funds under management.

Market update

Having set the scene about us, we go on to provide data on the market as context for the performance of our funds. One of our slides today showed VC exits over $100 million since 1996, split between the US and Europe. The data shows that there were over 150 such exits for US companies, up from around 100 per year in the previous peak in 2005-2007, whereas Europe has yet to exceed the 40 or so deals at this level we were seeing at that time.

We were seeking to make the point that our recent good run of exits was impressive, given that we are based in Europe, and that the high level of US deals last year bodes well for Europe going forward, provided the macro-economic picture holds.

Another slide showed venture investments in Europe by sector, and provided the basis for a discussion about our sector strategy. (Our mission is to back the best entrepreneurs wherever they are, so compared to our peers we expect to be overweight in some less fashionable sectors.)

Portfolio update

This is the longest and most important agenda item. We present the performance of the overall fund and comment on changes since last time, with a particular focus on changes to the value at which we are holding our investments.

Then we talk through the key portfolio companies in some detail. We typically focus on the top half-dozen by holding value and the partner responsible for each of these assets presents a couple of slides covering what the business does, why it is important, how the company has been performing and the likely timing and value of the exit.

Having been pretty quiet for the first couple of agenda items, the LPs typically spring to life with questions during the portfolio update. They are keen to make sure they fully understand any changes in fund performance and our plans for the key assets.

They are on the look-out for discrepancies with what we have presented previously, whether we have sufficient reserves, and any signs that we are too bullish about our valuations or exit projections. (One of the unfortunate legacies of the poor performance of most of Europe’s VCs in recent years is that LPs have become a cynical bunch.)

There are strong parallels between the way we present our portfolio and the way our portfolio companies present their revenue projections and pipeline at board meetings. It is during these sessions that confidence in the future is built or destroyed, and credibility as a manager is won or lost.

They are hugely important for us, as the LPs in our current fund are the best prospects we have to be LPs in our next fund. We are therefore prudent about setting expectations, including for individual portfolio companies, but having set expectations it becomes very important that we meet or exceed them.

Summary

In this section we discuss any pending changes to the firm that our LPs need to be aware of – and, in some cases, approve. For example DFJ Esprit’s merger with Tempo Capital that was, by coincidence, announced today, was discussed under this agenda item in a previous meeting. Fund extensions and annexes are also discussed here.

I hope this gives you some insight into a little talked-about aspect of life as a VC. In particular, I hope it comes across that VC partners have to stand up and make commitments about the performance of the companies they have invested in.

When working with portfolio companies our primary motivation is to help them be as successful as possible. The quality of data and the accuracy of projections that we report back to our LPs is an important secondary consideration, but, at the end of the day, it is results that count.

Kernel column: ADVISORS: THEY DON’T HELP VCS, BUT THEY CAN HELP START-UPS

By | Startup general interest, The Kernel, Venture Capital | One Comment

My latest column for The Kernel. It was published on Monday.

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Can, and should, advisers play a greater role in start-ups looking to raise funds, asks Nic Brisbourne?

What role do advisors play for start-ups? Advisors are typically small partnerships, or individuals, who help startups raise money from venture capitalists. They usually charge some form of retainer, and then a success fee of a percentage of funds raised and perhaps some options. Retainers normally range from £5,000 to £10,000 a month, the percentage of funds raised between three and five per cent, and options up to 0.5 per cent of the business. Larger fundraisings (£10 million to £15 million) are typically charged at the top of the retainer range and bottom of the success fee range, with smaller fundraisings the other way round. Most advisors won’t take on a fundraising of less than £2 million to £3 million because they can’t make enough money from it.

Advisors are highly geared towards the success fee. Their economics on a £5 million fundraising might be six months retainer at £5,000, totaling £30,000 and then a further £250,000 success fee if they get the deal away. Their business will be successful if they achieve a high hit rate, and the good ones turn away a lot of business. I was talking to one advisor recently whose success rate over the last three years is 100 per cent. That makes him just as picky as the VCs he is raising money from.

But my emotions are mixed when I see I have a deal from an advisor who I know and trust. On the one hand I can be sure that the deal will be at least half decent, particularly if the advisor is well known. On the other hand I know that it is likely that most every VC in London will see the same email and competition for deal will be fierce – or at least that is what we have to assume. We are often told that we are “one of only a small number of funds that have been introduced to the opportunity” but in my experience that is not always the truth. A few years ago we did quite a lot of work looking at a games company, and I had been repeatedly told that we were one of a select few VCs looking at the deal, but when the advisor inadvertently emailed me the spreadsheet he was using to track investor discussions there were over 60 investors on his list.

The challenge for VCs is that it is easy to spend a lot of time going nowhere on advised deals. Good advisors know that the way to reach the highest price is to keep investors guessing about whether they are going to win the deal. As a result there is usually at least one VC who invests a lot of resources and then loses. And when you lose a deal as a VC you are left with very little, and often precisely nothing, to show for your efforts.

I am much more excited, however, to see an email from someone I respect who is helping a company because he is on the board or board of advisors. I generally feel that my chances of success are much higher from this kind of introduction because it will be less widely shopped, and, ceteris paribus, it will get more attention than an advised deal.

Finally, when I get an email from an advisor I don’t know or don’t remember, I don’t feel anything at all. We have a process for looking at deals like this and we check them all out, but my expectations are very low and the chances of an investment happening are similar to if the email had been sent to our general company email address.

None the less, entrepreneurs need to understand when advisors can be useful. If you are going to use an advisor, then for heaven’s sake go for one who is well respected, well known, and has a wide network. Otherwise you might as well email the VCs yourself. If you are unsure check with a couple of VCs before you sign with them (I’m happy to help). Look beyond the VCs the advisor has raised money from in the past, to the live relationships they have today. Ask for names of individuals they will email about your company. Be careful. There are a lot of chancers out there who will take retainers from companies with little chance of raising venture. I even had one fairly well known adviser admit to me that was his business model.

Next, if you have a hot company that is already well known, using an advisor will probably allow you to reach a higher valuation. I think that is the best time to use an advisor, hence the title for this article.

For lesser-known companies, however, the logic for using an advisor is less clear. VCs who see an email from an advisor about a company they do not already know will most likely prioritise the opportunities they have from other sources. There, they have a better chance of closing a deal. So companies that are not super hot and which have alternative ways of putting themselves in front of VCs should consider whether an email from an advisor is the best route in – even if you still use an advisor to manage the fundraising process.

But for lesser known companies without good links to VCs, advisors can be really helpful though: they will help navigate through who does and does not have money and who is likely to be interested. They will generally take some of the misery out of engaging with investors. Additionally, good advisors have probably the widest network of potential investors and are well placed to help companies that might need to boil the ocean to secure funding. But if at all possible, you should start building relationships with VCs long before you need to raise money. You will benefit from early feedback on your company, and have a higher chance of success when you do come asking for cash.

Lastly, advisors are only really suitable for larger or later rounds. For decent advisors the economics do not work for a typical Series A fundraising, and if someone is offering to help you raise less than two or three million, you should really ask yourself why.

Good advisors can also add a lot of value in other ways. They spend a lot of time helping companies to cast their story in investor-friendly terms. This can be hugely valuable for entrepreneurs who have not worked with VCs before. They manage the investment process, which can be hugely valuable to resource-strapped start-ups. They will also advise on the complicated and lesser known aspects of raising venture capital, although that information is increasingly available on the web, not least on my blog.

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