Two years and eight 14-hour plane rides. That’s what it took for Richard Wong to convince Australian software tool maker Atlassian to accept a $60 million growth investment from Accel Partners.
With more early stage venture capitalists showing interest in growth investments these days, they may be tempted to think these sorts of deals are easier to do. But in some ways they are harder. For starters, most of the companies worth investing in don’t need the money. Atlassian, for example, has 20,000 customers, $59 million in sales and is in the black.
Profitable companies typically must be convinced that it is in their best interest to raise venture capital. And that takes time. Accel’s two-year courtship of Atlassian was a particularly long dating period, but it isn’t abnormal, and many growth stage deals take more than a year to close, Wong notes.
It’s fair to ask, then, if these sorts of deals are worth the effort. The numbers say yes. Over the last five years, late stage VC investments have vastly outperformed early stage investments. Late stage VC posted a five-year return of 11.5%, with growth equity close behind at 7.4% and early stage VC returning just 3.1%, according to Cambridge Associates and the National Venture Capital Association (NVCA).
Those performance numbers helped Institutional Venture Partners (IVP), a prominent late stage and growth investor, raise the biggest fund in the firm’s history in late August: a $750 million vehicle. “Limited partners are more interested because they’ve come to recognize that good later stage companies can put capital to work effectively,” says Steve Harrick, a general partner at IVP. “Conventional wisdom once held that early stage was where you want to be, but then the numbers came home to roost.”
Lovin’ Late Stage
LPs have backed a number of growth stage funds from traditional early stage firms over the past few years. Sequoia Capital has been at it for a while, raising about $930 million for its fourth U.S. growth fund in 2008. That same year, two other early stage firms raised their first growth funds: Accel closed on $480 million for a traditional growth fund and Kleiner Perkins Caufield & Byers raised $764 for a cleantech-focused growth fund. A couple of years earlier, Draper Fisher Jurvetson (DFJ) raised $290 million for its first growth fund.
And those are just dedicated growth funds. Some early stage investors with sizable funds have started making growth investments from their core funds. For example, Greylock Partners, an early backer of LinkedIn and Facebook, has signaled its intentions to invest in more mature tech companies out of its latest $575 million fund.
And multi-stage firm Norwest Venture Partners is making growth investments in addition to early stage deals from the $1.2 billion fund it raised last year. “In the ‘90s, you could expect to get to a liquidity event within five years, but now it’s more like eight or 10 years,” says Promod Haque, managing partner at Norwest. “With the extended liquidity time frame, growth stage reserves are needed more than ever.”
Backed by solid returns, later stage deal making is on the upswing. Expansion stage dollars increased 48% from the first quarter to the second quarter of this year, with $2.7 billion going into 277 deals. Meanwhile, the number of investments in later stage deals climbed 14% in Q2 from the prior quarter, rising to 200 transactions, according to the MoneyTree Report by PricewaterhouseCoopers and the NVCA based on data from Thomson Reuters (publisher of VCJ).
LPs don’t want to wait nine years to get some liquidity. So, newer funds are trying to roll more late stage deals into their portfolios.”
Harrison Miller, a managing director at growth equity firm Summit Partners, says his firm has committed $770 million in capital to growth stage investments so far this year, an increase of about 40% from last year. One big reason for the uptick, Miller says, is that growth stage companies were reluctant to take money during the heart of the recession, when comparable valuations hit rock bottom. Since the stock market has largely recovered and stabilized, those companies are now more willing to consider a deal.
Summit’s most recent deal was a $100 million investment in Avast Software, a European developer of antivirus software. The investment could help the profitable company become a billion-dollar business, Miller says. Another recent investment was a $5 million infusion in Wildfire Interactive, a maker of social media marketing software. Just 2 years old, Wildfire is already profitable, but it teamed with Summit to more quickly expand its product offering.
Miller acknowledges there is increased competition in the market, but he believes his firm, as a pure-play growth equity investor, has some distinct advantages over other players. Primarily, it has the infrastructure to source deals. Unlike early stage companies, which almost always come knocking on a VC’s door, growth stage companies must be courted.
Tale of the T-Shirt
Atlassian, for instance raised its first capital eight years after the company’s founding, a wait its founders say provided them an extra dose of autonomy in building corporate culture. Founders Mike Cannon-Brookes and Scott Farquhar rejected offers from a small army of VCs before settling on Accel, whose $60 million minority investment marks the firm’s largest round ever in a software company. Accel also wooed with a display of corporate culture solidarity. One of Atlassian’s oft-repeated value statements is “Don’t F*** the Customer,” or DFTC. Accel printed its own t-shirts stating its partnership’s No. 1 value: DFTPC, or “Don’t F*** the Portfolio Company.”
At Avast, CEO Vince Steckler says the company decided, in lieu of funding, to use a “freemium” model of offering free basic service plus subscription charges for premium offerings to grow revenues without requiring extensive investment in sales and marketing.
At, networking equipment maker Gigamon, which was self-funded by founders for nearly six years, CEO Ted Ho found that when the time came to raise a growth round, he could afford to be choosy. “I had seven term sheets in a six-month period,” Ho says. “We rejected the original five.” He adds that the company “didn’t want to just get money.” Gigamon was also looking for an investor with experience helping companies scale, and that was the key reason he went with Highland Capital Partners for a $22.8 million round that closed early this year.
Executives of growth-stage companies commonly cite a preference for investors with expertise in that stage, a seemingly sensible demand as the skill sets of early and late stage investors are often diametrically opposed. Whereas early stage investing is more about trusting your gut instinct, late stage investing is about imposing strict financial discipline and making decisions based on almost purely quantitative rationale. There’s also an ego aspect involved. Early stage investors like to be in charge, but that doesn’t work with more mature companies. “We often target entrepreneurs who are leery of outside investors,” says Miller. “They need to know that their investors will not come in with the expectation of grabbing the wheel.”
To secure initial funding rounds in mature startups, says Summit Managing Director Scott Collins says, it’s also key to convince management teams how one can be helpful. That includes everything from marketing advice to help in recruiting key personnel to introductions to potential acquirers and investment bankers. “These are companies with a lot of options,” Collins says. “They certainly don’t need the money to keep the lights on.”
Ryan Sweeney, a former Summit partner who now heads up growth investing at Accel, says he is wired for the growth stage. He admits he never wants to be in a position where he’s losing money on an investment. He’s more than happy to reap smaller rewards if it means less risk. For him, the thrill comes from finding that one great company that has been overlooked by others, despite being profitable and loaded with potential.
As a growth investor, you can’t just write the check anymore and ride it out for three to five years. You have to roll up your sleeves, recruit great talent and help your companies get international.”
Sweeney also believes Accel’s new growth fund makes perfect sense for the firm. He says over the last few years Accel was seeing many opportunities in its core industries that were becoming bigger and bigger. But the firm was hamstrung because those deals did not fit its traditional venture funding criteria. At the same time, the cost of starting a company has declined, which means more technology startups are reaching the growth stage sooner.
Growth Dollars Needed Sooner
Take social media, for instance. It is still a relatively new category, but many companies in the space are now ready for growth stage capital. And that speaks to the changing nature of growth capital in general. “Young entrepreneurs are getting to the growth stage a lot earlier,” says Sweeney. “But they still need help building a team and getting to that next level. As a growth investor, you can’t just write the check anymore and ride it out for three to five years. You have to roll up your sleeves, recruit great talent and help your companies get international.”
To date, Accel has done 10 growth deals. Besides Atlassian, it has made late stage investments in Facebook, discount shopping site GroupOn and ModCloth, an online retailer of indie and vintage fashions.
For DFJ, a growth fund was seen as the best way to broaden the firm’s reach and deliver returns to limited partners. “Our growth initiative was born out of our belief that is was complementary to our early stage investing, and enabled us to take advantage of companies that were at later stages than we normally invest in,” says Jennifer Fonstad, a DFJ managing partner.
One such example is Silver Spring Networks, which was already a rapidly growing cleantech company when DFJ invested in 2009. This was a deal that the firm could not have easily made from its early stage fund because of the revenue Silver Spring was already generating and because of its high valuation. “We wanted a fund that was focused on investing systematically in growth stage companies, not just one-off opportunities, so we could do deals just like Silver Spring,” says Fonstad.
Growth deals can also look good on the books because they are more likely to realize a quicker exit. That’s what happened with DFJ’s investment in AdMob. The company raised $12.5 million in growth capital led by DFJ in January 2009, and was then acquired less than a year later by Google for $750 million. “That turned out to be a very good investment and a very good return,” says Fonstad. (AdMob was principally backed by Accel and Sequoia, with Sequoia leading the startup’s 2006 Series A round. DFJ teamed with Northgate Capital Group last year to do the $12.5 million Series C, which valued AdMob at $211.1 million, according to Thomson Reuters.)
The quick return for DFJ on AdMob explains why more early stage VCs are trying to get in on growth investments: liquidity pressure. “LPs don’t want to wait nine years to get some liquidity,” says IVP’s Harrick. “So, newer funds are trying to roll more late stage deals into their portfolios.”
DFJ, for one, is also using its growth fund to help some of its promising early stage investments, such as Tesla Motors and Solar City, which require more capital to get to exit. As a result, the firm is also increasing its stake in those companies as they expand and commercialize.
Some investors, however, see potential for conflict when a firm starts using a late stage fund to support its earlier investments. That’s because the venture business depends on the validation of new investors for later rounds. If the same firm is leading the investment at every stage, it’s hard to know whether the company is truly progressing and whether the valuation is accurate.
We wanted a fund that was focused on investing systematically in growth stage companies, not just one-off opportunities, so we could do deals just like Silver Spring.”
A firm doing both early and growth stage investments in the same company can also result in a misalignment of interest, with an investor ultimately owning too much of the company and effectively becoming a boss rather than partner, argues Harrick. “We are not believers in a full service model, where a venture firms supports the same company from seed to late stage,” he says. “When you try to do all things, it weakens your proposition to the entrepreneur.”
If growth stage is where the money is at, why doesn’t every firm do it? The simple answer is that they can’t. “I’m sure some smaller funds would like to do more late stage, but they don’t have the money,” says Norwest’s Haque. “The bigger funds are getting bigger and the smaller funds are getting smaller. That’s just the way the industry is moving.”
Additional reporting by Joanna Glasner and Lawrence AragonSIDEBAR:Never Too Old for Series ABy Joanna Glasner, Senior Editor
When Avast Software’s founders wrote the first program to remove a computer virus, the Iron Curtain was still up, and their home country, the Czech Republic, was still part of Czechoslovakia.
Viruses were so rare, that six months passed before Avast co-founder Pavel Baudis saw another one. Building a security software company seemed downright daring at the time, 1988. Seeking venture capital wasn’t even an option.
So, Avast’s co-founders did what entrepreneurs rarely do. They waited 22 years before raising outside capital. In the interim, they built a company with more than 120 million registered users and that adds about 3,000 new virus samples a day to its database.
Their first round, announced in August, made up in size for what it lacked in speed. The Prague-based company raised $100 million in growth financing from Summit Partners, which had been pursuing the company for years with offers to purchase a minority stake. Given that Avast has long been profitable without the help of venture capital, it wasn’t until the last year that executives—looking to accelerate growth and explore exit options—gave more serious consideration to outside investment, says Summit Managing Director Scott Collins.
While Avast may be an outlier in terms of how long it waited to raise VC, such stories of profitable private companies avoiding VC are par for the course in Collins’ corner of the investment universe. Although growth stage is usually associated with follow-on rounds in companies with significant venture backing already, there’s no reason the investment strategy can’t also work at Series A.
“There’s a whole world out there of companies that bootstrap themselves and do pretty well without venture capital,” Collins says. Just a month after funding Avast, Summit invested $12 million in another company that fit that description: Winshuttle. The Bothell, Wash.-based developer of software for integrating spreadsheets waited seven years before taking a venture investment. Earlier this year, Summit acquired a majority stake in another “old timer,” Ogone, a Brussels-based online payment service provider founded in the mid-1990s.
The appeal of later stage, unfunded startups is pretty broad, says Chris Sugden, managing partner at New Jersey-based Edison Venture Fund. You get a company with a proven business model and experienced, competent management, right at the time its growth curve is poised to hit a major inflection point.
With the extended liquidity time frame, growth stage reserves are needed more than ever.”
“There’s certainly less risk of capital risk and a lot more to evaluate when you can actually see a completed product or service,” he says.
The downside is that such companies rarely come knocking at VCs doors. It can take years of wooing to convince founders with years of experience turning down VCs to accept that now may finally be time to take the money. Edison, for instance, typically invests in a company nearly three years after making initial contact.
Coming in at a later stage, however, reduces downside risk, Sugden says. Since most companies already have an established customer base, it’s easier to perform in-depth diligence and it’s unlikely they’ll go belly-up, as happens all too often with early stage startups. A poor exit might be a bit less than getting their money back and writing down to zero isn’t likely to happen.
Why They Wait
It’s difficult to quantify whether venture-type companies overall are raising funding later in their lifecycle. Anecdotally, however, venture investors say they do appear to be seeing older startups seeking or securing initial funding.
The Great Recession had some impact in pushing companies to wait longer to try to raise VC. In other cases, companies just couldn’t attract VC at an earlier stage. That was the case for Gigamon, a 6-year-old maker of switches for network monitoring. Gigamon raised its first round of $22.8 million in late January from Highland Capital Partners. Ted Ho, CEO of the Milpitas, Calif.-based company, says Gigamon’s founders tried raising capital in 2004, but got shot down. So, they chipped in their own money to build a product.
More startups are also staying afloat through borrowing. That was a finding of a Kauffman Foundation study of nearly 5,000 startups founded in 2004. A survey showed that of the 2,606 startups that survived after four years, debt funding provided almost 67% of financing in 2008, up from 40% in 2004.
Additionally, particularly in the Internet and software sectors, it’s gotten much cheaper to launch and build a company, thanks to open source code, cloud computing, inexpensive offshore labor, reduced memory and processing costs, and myriad other innovations that enable entrepreneurs to do more with less.
Still, while there are companies that manage to reach scale on self-funding, VCs still expect most will need funding at the early stage.
“We do find companies that have bootstrapped themselves, but they’re the exception. They’re harder to find,” says Todd Chaffee, general partner at Institutional Venture Partners (IVP). He notes that most of the companies that have accepted growth stage capital from IVP have raised prior venture rounds. At the early stage, “generally if you’re a successful CEO, you’re going see to Kleiner and Benchmark and Accel and Sequoia,” he says.