Feature Story: Making an Exit – VCs Examine their Options –

During an argument between an old-timer and a young Turk over the merits of the forward pass versus the running game in football, the old-timer said: “Three things can happen when you throw the ball, and two of them aren’t good.”

While the risks taken by venture capitalists are higher than an incomplete pass or even an interception, in today’s market staring at a term sheet for a company with a distant exit strategy can feel like third and long.

At the risk of taking the anecdote too far, VCs have adopted a defensive focus, and the downturn in the public market has provided VCs with some much-needed reflection time. Most VC firms have spent the past few months reviewing and evaluating their portfolio companies, deciding where to place their bets and where to cut their losses.

The problem facing VCs is that they invested billions of dollars into thousands of companies over the past few years, but very few of these companies are able to successfully execute exit strategies in today’s down market – leading to somewhat of a backlog in their portfolio. The classic VC optimist says the market will change for the better, but even in last year’s market, positive exit opportunities may have been too few for the industry.

Knowing Your Options

In the afterglow of the so-called exuberance, tails of woe have commandeered the headlines. As an example, venture capital has become so unhip that Esquire magazine, in its April issue, lumped Red Herring’s Venture 2001 Conference with political satirist/piano man Mark Russell in the same category: “Things we won’t be covering in Esquire this month.”

Nobody issues press releases on their failures, and it is difficult to track the figures on the less-than-favorable exit strategies. But there’s no question, VCs are caught between a rock and a hard place in the current environment.

“Everybody is dealing with it, and nobody wants to talk about it,” says Doug Chertok, managing director and general counsel at Hudson Ventures. He adds that VCs have to be painfully honest about the prospects of these companies. Being careful not to panic prematurely, they owe it to everybody involved – investors, founders and employees – to “pull the plug” on struggling companies as soon as it becomes obvious that success is impossible.

Dana Callow, managing general partner of Boston Millennia Partners, says whereas 10% of a given firm’s portfolio may have needed attention one year ago, maybe half the companies demand attention now. He suspects that funds have experienced about a 10% closure rate of portfolio companies over the past six months.

Portfolio companies now have to prepare to operate for at least a year without any liquidity options, and companies are being forced to separate business strategies from financing strategies. An initial public offering can no longer be a requisite for operational success.

“If there’s no liquidity, you have to run a business differently,” he says.

Over the past few years, VCs have been very successful at attracting capital in support of the nation’s entrepreneurs. VCs raised $92.3 billion in 2000, which is a dramatic increase over the $11.7 billion raised in 1996.

In the last three years, 403 firms raised their first VC fund, and the more established VC firms have been raising new funds every 12 to 18 months, pumping billions into start-ups. This success has created an incredible backlog of portfolio companies that will need to reach an exit in the not-so-distant future.

Over the past five years, VCs have invested in 8,700 operating companies that are still privately-held today, according to our VentureXpert database. Those companies represent $164.8 billion in investments and include multiple funding rounds at various developmental stages.

This volume of private companies becomes significant, because even in the wide-open financing environment of 1999, only 485 venture-backed companies were acquired or held IPOs. In 2000, that number jumped slightly to 509 venture-backed companies.

“There’s simply not enough capacity to get those companies out, which means your loss ratio goes higher,” Callow says.

Depending on how the estimates are modeled, exits over the next five years might be half of the needed amount. Factoring in the current dip in the financing market and sideline money, the odds of success decrease.

When it comes to exiting a portfolio company investment, VCs have about six different options, and four of the options aren’t so good. In the ideal situation, VCs want to exit their investments through an outside financing activity at an increased valuation.

Short of an outside financing activity, a combination of less-than-favorable exit options face VCs. When the outlook becomes apparently bleak, some VCs cut off the cash infusions, challenging the companies to stop eating themselves alive. Since this strategy often ends in the dissolution of the company, other VCs have chosen instead to stop the bleeding early and redeem out any remaining assets. Other investors have taken a group of struggling companies from their portfolio and rolled them together in the hope that the whole is greater than the sum of the parts.

Elsewhere, a growing, quiet market for private sales of interests in private companies is available for VCs who want liquidity. Unfortunately, this liquidity may come at a price, because the buyer knows that a private secondary sale is not a preferred exit strategy in most cases. Investors in distressed companies and turnaround specialists will often facilitate these deals as will emerging private placement exchanges.

Many observers perceive IPOs to have greatly increased in the dusk of the 1990s, but the IPO market of 1999 and 2000 may not have been as big a story after all. According to VentureXpert, 257 venture-backed companies went public in 1999, and 232 went public in 2000.

Companies that held IPOs in 1999 and 2000 raised record amounts of money, but the number of venture-backed companies hitting the market was not as remarkable compared with the past 10 years. In 1996, 279 venture-backed companies held IPOs, while 204 held IPOs in 1995 and 223 in 1993.

While the VC industry has most definitely boomed over the past few years, the number of portfolio companies holding IPOs has remained relatively flat – an average of 192 venture-backed IPOs for 1991 through 2000.

The market fell considerably off the average in the first quarter of 2001, when only 11 venture-backed companies went public. Even Loudcloud Inc., with all the pieces of the IPO success formula of 15 months ago, stumbled at the starting gate after slashing offering prices twice.

George Nichols, a stock analyst for Morningstar Inc., calls this IPO market the worst in over a decade, and Linda Killian, the portfolio manager of Renaissance Capital’s IPO Plus Fund, counts back to the early 1970s before she can remember a colder market.

“Just today [April 4], three companies announced they were terminating their IPO efforts,” she says.

Prying Open the IPO Window

Public market investors have been burned by technology companies, and they aren’t ready for another beating quite yet. Just over a year ago, little old ladies in Missouri were pressuring their hometown brokers for a piece of the IPO action, but today the investment bankers cannot even sell these companies to the big institutional players.

Bill Burgess, vice chairman of global corporate finance at Deutsche Bank Alex.Brown, says two things have to happen before the IPO market will loosen up. First, he says investors have to feel comfortable with the public markets in general, which likely won’t happen until the markets slow their gyrations – particularly the negative ones.

Secondly, once the general markets have stabilized, one or two good deals historically have marked the turnaround from a bad financing environment. Strong, solid companies, like Octel Communications Corp. following the crash of 1987 and MBNA Corp. in the early 1990s, came to the market at good prices and retained their valuations. These companies restored investor confidence and gave them the courage to get back in the game.

Until that happens, the VC community will have to suffer through a dead public financing market, but even after the recovery, VCs can probably only count on IPOs to consume about 200 of their portfolio companies each year, according to past history.

An Acquiring Taste

Unlike the relatively flat growth level in the numbers of companies participating in the IPO market, the number of acquired venture-backed companies has steadily increased throughout the decade.

In 2000, acquirers gobbled up 277 venture-backed companies in deals totaling $68.9 billion, according to VentureXpert data, compared with a mere 16 acquisitions totaling $200.5 million in 1991.

Chertok says established companies are always looking for ways to boost their earnings, and they often seek acquisition targets offering new opportunities for revenue growth or new cost-cutting technologies. He points to the growth of corporate venture funds as evidence of this increased attention.

The acquisition has grown into an increasingly attractive exit alternative, especially in the current environment. Chertok says he evaluates potential deals based on their potential attractiveness to specific acquirers rather than just their IPO potential. Granted, the M&A deals don’t typically offer the additional pop a company can pick up after a public offering, but they theoretically don’t have as much possible downside, either.

As an added benefit in a cash M&A deal, the investors get out of the investment instantly. But even with the stock-based acquisitions common among technology companies, the investors often receive liquid securities.

Unfortunately, as much as the poor market performance of established technology companies has soured investors on the IPO market and the technology sector, the public companies’ falling stock prices have really hurt their ability to make acquisitions.

Companies find acquisition activity attractive when they can leverage an inflated stock price for greater purchasing power, but those deals don’t look so good anymore when it takes four or five times as many shares to reach the same purchase price. As evidence, preliminary VentureXpert figures show only three acquisitions in the first quarter of 2000, totaling $381.5 million.

Even if the acquiring companies’ stock prices rebound to acquisition levels, another pitfall could be the effect of an acquisition on earnings, since earnings statements impact market sentiment again. If this trend continues, another sideline issue could be the likely repeal of the pooling-of-interests acquisition method (VCJ March, page 40).

At press time, the accounting regulators had not yet made a final decision on the fate of the pooling method, through which an acquisition does not affect earnings as directly or negatively as the alternative accounting treatment. The final decision could go several ways, but if the pooling method is removed as an acquisition option (which it likely will be), acquired technology companies will not only cost the acquirers the acquisition price, but the acquirers will also probably be forced to take either a one-time or an annual earnings charge – and earnings charges are unacceptable in current market conditions.

A Few Good Deals

In light of the current financing environment, Callow says it’s time to restructure. “You sit down and talk to your entrepreneurs on an everyday basis,” he says. He recommends building a real relationship, working through the difficult issues and designing a path that will support their long-term growth efforts.

Across the board, VCs say that the dealflow has cleaned up and that they have been able to invest in companies at much more attractive valuations. Chertok points out that not only are these companies coming forth at greatly-reduced valuations, but he is seeing deals where other investors have already spent heavily to develop the company’s costly infrastructure. Of course, Chertok’s benefit is at the expense of another VC.

“There is not a lot of mindshare among VCs to talk about things that are going bad,” Chertok says. He proposes that if VCs talked about their struggles they might be able to work out better solutions. Maybe, they could even score a Hail Mary.