The venture capital business is all about making risky bets on world-altering technologies. But when it comes to exit strategies, VCs are a conservative lot.
Two paths—a trade sale or a major market IPO—provide the lion’s share of returns. While their brethren in the private equity industry fiddle with financial engineering and leveraged debt, venture capitalists have historically banked more on disruptive technologies than creative liquidity techniques.
Trouble is, conventional exits aren’t providing the returns investors expected. Although the technology IPO market has recovered somewhat this year, most startups fall short of Wall Street’s criteria for profits and earnings predictability. Corporate acquirers, meanwhile, absorb only a fraction of venture-funded companies. So funds are left with fat portfolios of maturing startups they’re eagerly looking to unload.
Today, VCs are making up for the IPO and trade sale shortfall with a wave of inventive exit techniques. They are concocting elaborate buyout transactions, spinning off portfolio company divisions, orchestrating reverse mergers and—when all else fails—quietly selling stakes at a discount to secondary investors. Timing is the critical driver. As funds founded on the eve of the Internet bubble near the end of their 10-year lifespan, venture investors face stepped-up pressure from limited partners.
“The problem we have as venture capitalists is it’s really tough for us to hang on to anything more than about 10 years,” says Drew Lanza, a partner at Morgenthaler Venture Partners. “We’re getting to the point where the LPs are saying: ‘I gave you that money seven or eight years ago. I really need to see some returns.”’
Limited partners can take some comfort in the fact that avenues are opening up, helped by flush debt flow and the willingness of venture capitalists to apply their talents for out-of-the-box thinking to exit strategies.
Here, then, are five strategies VCs are using to jolt returns from their portfolios:
1. Stick it in reverse
Frustrated with the high cost of complying with Sarbanes-Oxley for new issues, more venture firms are avoiding the hassle altogether. They’re skipping the IPO registration process by taking portfolio companies public through reverse mergers and raising money through private stock sales. (See sidebar: “Reversal of fortune.”)
That was the exit path selected by Athersys, a Cleveland drug developer that had raised more than $90 million since 1996 from more than a dozen venture investors. The company sought to raise $115 million through an IPO in 2000, but withdrew the offering due to “market conditions.” Six years later, backers were still awaiting an exit.
In June, Athersys completed an acquisition of BTHC VI, a publicly traded shell company formed for the purpose of merging with an established business. As part of the transaction, BTHC sold 13 million shares of common stock at $5 per share to accredited investors. The stock was recently trading at $8.
We’re getting to the point where the LPs are saying: ‘I gave you that money seven or eight years ago. I really need to see some returns.’”
Drew Lanza, Partner, Morgenthaler Venture Partners
Athersys is one of at least a half-dozen venture-backed companies that have carried out a reverse merger since last year. Others include Jamba Juice, Kreido Biofuels and ETrials Worldwide. Offerings are usually done in combination with a private investment in public equity (PIPE) deal to raise capital. While the sums raised are smaller than in a conventional IPO—and shares tend to be lightly traded—investors can enjoy the benefit of a rapidly rising stock price should a company’s earnings accelerate.
“It’s small-cap land and it’s sort of high risk/high reward,” says David Feldman, a securities attorney and author of Reverse Mergers: Taking a Company Public Without an IPO. “But when the rewards come, it can be extraordinary.”
Before you scoff at the notion, you should be aware that companies that have gone public using a reverse merger include Berkshire Hathaway and Turner Broadcasting. Warren and Ted haven’t done too poorly, have they?
2. Sell to a peer
Some venture funds are finding liquidity by selling portfolio companies to their private equity brethren. In these cases, venture capitalists don’t even have to go looking. More often than not, it’s the buyout shops who seek out the VCs.
By now, just about every venture firm has been approached by at least one private equity firm about buying a portfolio company, says Dixon Doll, general partner at DCM, which sold portfolio company eDreams, an Internet travel site, to a buyout fund last year.
Some VCs who have been exploring IPO prospects say they’re getting referred instead to the buyout industry. “Every company that gets to break even, you talk about exits,” says Kate Mitchell, managing director at Scale Venture Partners. “And every banker you talk to is going to put buyout candidates on that list.”
The trend marks a turnaround in relations between the venture and buyout industries. Buyout investors are known for targeting mature companies with cash flow to cover the cost of the debt incurred in purchasing them. For that reason, VC-backed companies—which tend to be barely profitable at best when they seek an exit—haven’t been popular buyout targets.
Circumstances have changed, however, and that’s drawing venture and buyout firms closer together. The vast sums flowing into the buyout sector over the past two years have pushed up prices for their usual acquisition targets. And venture-backed companies—many of which have matured into viable businesses while waiting for the IPO window to open—are looking more attractive.
Still, they’re not always obvious matches. Mitchell says when Scale began exploring exit prospects for a health care company in its portfolio company last year, she and her partners weren’t thinking of a buyout fund. Ten-year-old U.S. Healthworks, which runs clinics for treating workplace injuries, was posting annual revenue in the $100 million range and seemed like a solid IPO candidate.
You have all these companies formed in the late 1990s to 2000 that are good companies. You’re not losing sleep over these companies, but you’re not delivering an exit either. That’s why putting it in the hands of a buyout fund is an alternative way to monetize the value.”
Kate Mitchell, Managing Director, Scale Venture Partners
In the end, Scale decided a buyout would provide a more reliable return. U.S. Healthworks was acquired in December by a group that included health buyout fund Altaris Capital Partners and Dynamic Healthcare Solutions in a transaction valued at around $185 million. Two of U.S. Healthworks’ four backers, Scale and Richland Ventures, exited the investment, while Salix Ventures and Three Arch Partners opted to keep their stakes in the company, which had raised close to $100 million between 1996 and 2006.
It’s difficult to determine the extent to which VCs are profiting through sales to buyout funds. Such exits are apt to be less profitable than an IPO, says Lanza, who has met with several buyout investors in recent months about purchasing portfolio companies. Valuations set by private equity and buyout funds are usually higher than what venture firms offer in late stage rounds, he says.
In some recent cases, companies have been bought for sums far exceeding cumulative venture investments. In March, buyout firm TA Associates paid $175 million for Alere Medical, a provider of Internet medical monitoring systems. Flagship Ventures, Institutional Venture Partners and S.R. One, among others, had invested more than $45 million in Alere over nine rounds, according to Thomson Financial.
VCs saw an even better exit from the sale of Barcelona-based online travel agency eDreams. TA Associates paid $195 million for the 8-year-old company last October. Venture investors, including Apax Partners, Atlas Venture, DCM and Net Capital Partners, had put about $35 million into eDreams over three rounds.
DCM General Partner David Chao says gross proceeds from the sale of eDreams will return about 40% of the committed capital to its DCM I fund. Chao calls the deal “the largest ever e-commerce LBO in Southern Europe and the largest VC outcome of an Internet company based in Spain.”
3. Sell in pieces
Private equity funds are also increasingly serving as an alternative for companies looking to sell stakes or raise capital without the “full glare of the public markets” upon them, says H. Raymond Bingham, managing director at PE firm General Atlantic.
Since Bingham joined the firm to head its Palo Alto, Calif., office late last year, General Atlantic made two investments in the San Francisco area, buying 80% and 20% stakes. In both cases, Bingham told attendees at a June venture capital conference, “The founding venture investors were looking for some kind of liquidity.”
In January, General Atlantic paid $66 million for a minority stake in ServiceSource, an outsourcing provider for hardware, software and health care companies that had previously raised $10 million from Benchmark Capital, according to Thomson Financial. In March, General Atlantic made an investment of an undisclosed amount in AKQA, an online marketing company backed by Accenture Technology Ventures and Francisco Partners.
Bingham projects that the media sector will be a hot area for private equity transactions, although he notes that “there’s an awful lot of money chasing deals in every sector.” And private equity funds aren’t expecting bargain prices.
It’s small-cap land and it’s sort of high risk/high reward. But when the rewards come, it can be extraordinary.”
David Feldman, author of “Reverse Mergers: Taking a Company Public Without an IPO.”
“This is a well-informed market, and people have a very good idea of what their trade comparables are,” Bingham says. “If you don’t go in with something serious, albeit on the low end of the serious range, you simply won’t be treated as credible.”
Some secondary investors hope to lower the acquisition cost per company by purchasing whole portfolios. Older venture funds are a prime source of deal flow, says Ken Sawyer, managing director of San Francisco-based secondary investor Saints Capital. He estimates that almost 30% of all companies backed by a 1997-vintage VC fund are still private and independent today, and “that’s a big factor driving a need for an alternative form of liquidity.”
Saints acquired stakes in more than 60 companies last year. What has driven the deal-making pace to a large extent, Sawyer says, is the lengthening timeline to liquidity from first venture money to exit.
In addition to buying limited partner stakes, Saints purchases portfolios from venture funds, as in the case of Amerindo Internet Fund, which it bought last year with Greenwich, Conn.-based secondary investor Willowridge Inc.
The downside for a VC selling a portfolio is that it may have some hidden gems. Amerindo learned that lesson the hard way. The portfolio it parted with included voice-enabled application developer Tellme Networks, which was acquired earlier this year by Microsoft in a deal rumored to be valued at more than $800 million.
Other exits by Saints portfolio companies include CyberTrust, which was sold to Verizon, and Scene7, which sold to Adobe. In addition, three portfolio companies it bought from VCs completed IPOs this year: Cavium Networks, Mellanox Technologies and Opnext.
4. Spin out
When there’s no ready buyer for a company, venture firms are getting some ROI by selling portions of startups. For example, SOA Software, a Los Angeles enterprise application developer, sold its professional services business in May for $25 million to Zensar Technologies of Pune, India. SOA said it spun off the unit to concentrate on its enterprise business. Whatever the reason, the sale provided some cash to the VCs who have invested $60 million in SOA since 1996, including Draper Fisher Jurvetson, Mellon Ventures, Paladin Capital Management, Redpoint Ventures, Palisades Ventures and Trident Capital.
Spinouts can also work for companies planning to go public. That was the strategy taken by Glu Mobile, a venture-backed mobile entertainment company. Before it went public on the Nasdaq in March, it determined that one of its divisions, UK-based mobile game distribution service ProvisionX, no longer fit with its core strategy, says Dave DeRuff, managing partner of EastPeak Advisors, which assisted in finding a buyer. In January, Glu sold ProvisionX for an undisclosed sum to Wmode, a provider of mobile content services.
The proceeds from the ProvisionX sale had to have been welcomed by Glu’s backers, who did well—but not great—when the company went public. For their total investment of $57 million, Globespan, New Enterprise Associates, Scale and Sienna Ventures collectively owned 10.7 million shares of Glu worth about $155 million as of June 20.
Nearly 30% of all companies backed by a 1997-vintage VC fund are still private and independent today, and that’s a big factor driving a need for an alternative form of liquidity.”
Ken Sawyer, Managing Director, Saints Capital
DeRuff predicts that the number of carve-out deals involving venture-backed companies will rise in the next few years as more funds seek to wring value from older portfolio companies. Waiting for the IPO window to open takes too long these days, he says. The average age of a VC-backed company that went public last year was 9.4 years old, up from an average of 8.14 years old in 2005, according to Thomson Financial.
(The median age for VC-backed companies that went public in 2006 was 8.10 years old, up from a median age of 6.13 years in 2005, according to TF. Age data were unavailable for VC-backed companies that were acquired.)
“We see so many venture funds shutting down smaller companies; I think that’s a shame,” DeRuff says. “There’s more market there for many of these private companies than is commonly realized.”
5. Try a new exchange
Some venture firms are finding new markets on lightly regulated alternative exchanges. Although few U.S. venture-backed companies have gone public on London’s Alternative Investment Market, AIM has emerged in the past two years as a popular exit route for European startups and for companies seeking to raise financing from institutional investors. (See sidebar: “Alternate route.”)
Now Nasdaq is entering the fray with an exchange built for institutional investors. Nasdaq Portal, set to debut this summer, will be an exchange for privately held equities and debt. Securities may be bought and sold by qualified institutional buyers, who must have least $100 million under management.
While it won’t take the place of a traditional IPO, Portal offers a route to partial liquidity for venture capitalists and their portfolio companies, says John Jacobs, Nasdaq executive vice president in charge of the Portal effort. The other advantage: no quarterly earnings reports or Sarbanes-Oxley compliance costs.
With more venture capital dollars being spent outside the United States, VCs are also increasingly open to taking foreign companies public in their home markets. For companies in developing countries, this was an unpopular tactic years ago. But with stock exchanges in India, China and other fast-growing economies up sharply in the past two years, VCs are rethinking old biases. The change of heart is aided by examples of lucrative exits, such as Info Edge (aka Naukri.com). The India-based employment website, which is backed by Kleiner Perkins Caufield & Byers, held a very successful IPO in India last year.
Looking ahead, Gary Morgenthaler, a general partner at Morgenthaler Venture Partners, envisions buyout funds and overseas markets emerging as the key factors driving new liquidity for venture investors. Granted, U.S. VCs don’t have a lot of experience orchestrating offerings on faraway exchanges. But if new venues are opening up, it won’t be long before venture investors are lining up at the exit doors.
“The venture industry is pretty clever when it comes to that,” Morgenthaler says. “When there’s money to be made, we find a way to get there.”