Is the Venture Capital Market’ Real? –

When participants talk about “market terms” for a venture capital deal, they are saying much more than they imagine. They are expressing the implied view that a market for venture capital operates and that there is commonality of terms. How many times have the readers of this article used the phrase “that’s market” to defend to a founder the requirement for vesting of shares, or why two demand registration rights are appropriate for a 30% holder? We all do it. Does this conduct support the view that there is a market and market terms? Or, is the reference to “market terms” something that venture capitalists and their allies use to justify their conduct?

Of VCs and Rugs

An economist would describe a market as the nexus of connection between buyers and sellers, a location where individual actors exchange things of value. Anyone who has ever been in a commodity-trading pit is probably forever seared with a clear visual image of a market, as are visitors to rug bazaars in Istanbul. The overall image many carry is a chaotic melee of individuals shouting at each other in the language of commerce. An economist would also tell you that out of these shouts of supply and demand come an agreed price of exchange, and as exchanges occur consensus on price occurs (at least from moment to moment). The economist does not attribute any sense of fairness to these negotiations: The assumption is that individuals acting in selfish interest reach a common ground (i.e., a “market” price).

A further assumption economists make is that markets work better when buyers and sellers feel comfortable that they share access to information equally. “Fairness” is not in the price agreed, but found in the process of negotiating the price. Implicit is the expectation that if participants believe that they are not being subjected to unfair treatment, they will participate in the market willingly and actively. This underlying assumption of “fairness” is at the root of much of our securities market regulation, for example. It’s also an important underlying concept in what would commonly be called “business morality.” If you’ve ever negotiated a price and agreed to “split the difference” you’ve seen the effect of this societal norm.

If one applies an economist’s view of a market to venture capital finance, things get a bit murky. Definitionally, venture capital transactions are privately negotiated transactions, but can they really be described as occurring in a market? Is there information symmetry between participants? Can there be a “market” for venture capital?

As a venture capital lawyer I have been fortunate to work with some very smart and decent investors throughout the United States. Each of these participants believed that there was a market for venture capital. At some point in each negotiation, they pointed to a particular requested term or condition and stated that it was “customary” or “market.” They really were saying that the term was the equivalent of price consensus in a market bazaar. They clearly acted as if there was in the venture market an equivalent to a stock exchange trading floor. But where is it? And, is there any support for the rationale that customary or consensus terms are reached in the venture market?

My firm recently compared certain common terms for venture financings in a national survey that covers the major venture markets in the United States (with thanks to Fenwick & West, whose data on Bay Area venture financings was also used). These quarterly surveys provide some interesting insight into transactional terms and shed light on the question as to whether a market exists, albeit in a different form than commonly imagined.

Check the Data

One of the most interesting things to come out of the studies is that over time terms do tend to coalesce in patterns. For example, over the last 18 months, in the San Francisco Bay Area the percentage of down rounds, as an overall portion of venture financings, has fallen from 68% to 45%, and the prevalence of certain protective terms, such as full ratchet antidilution protection and recapitalization transactions (i.e., modifying existing securities and negotiating new terms), has also fallen, from 18% of all deals to 9% in the case of full ratchet protection and from 19% to 11% in the case of recapitalization transactions.

Although we only have data for a shorter measurement period, terms have had similar movement in the Mid-Atlantic market. Over the last six months down rounds have fallen from 79% to 52% of all deals, full ratchet protection has fallen from 50% to 21% of all deals and recapitalizations fell from 15% to 6% of all deals during the same period.

Examining the data suggests that terms tend to move rationally: If market conditions support upward movements in valuation then provisions that protect the down side (such as full ratchet antidilution protection or restructurings) become less prevalent.

Further signs of the non-randomness of terms exist in regional differences between certain deal terms. Market participants often remark that there are often significant differences between East Coast and West Coast deals, suggesting that East Coast deals often contain more onerous terms for financed companies. The two examples most often pointed to are occurrences of redemption rights and full ratchet antidilution protection. The data support this suggestion. In the fourth quarter of 2003, investors in the Mid-Atlantic required redemption in 74% of deals, and investors in New England required redemption in 90% of deals. Meanwhile, investors in Southern California required redemption in only 42% of deals and in the Bay Area only 32% of deals required redemption during the same period.

There was a similar disparity in the treatment of full ratchet antidilution protection. In the Mid-Atlantic 21% of all deals in the fourth quarter of 2003 had full ratchet protection and in New England 26% of all deals had such protection. Comparatively, 13% of Southern California deals had full ratchet protection and only 9% of Bay Area deals had this protection.

The non-randomness of term data suggests some level of consensus among market participants. For example, in a random world, liquidation preferences could vary widely, as each deal was negotiated independently. Yet, in the fourth quarter of 2003, 1X liquidation preferences occurred in 80% of all deals nationally. Why not distributed 50/50 with 2X deals? Why isn’t 3X the standard term? Didn’t someone somewhere think that he was entitled to a 5X return on his preferred stock?

Where Is It?

So, if there is order in chaos, or a consensus being reached as to what constitutes a “fair” deal in a venture financing, how is this occurring? Where’s the market?

It’s often remarked that venture capital is a local business. Venture capitalists tend to like to invest in businesses that are close to home so that they can influence outcomes and mentor companies. Capital tends to congregate in regions where innovation occurs predictably and continually, in regions where there is a corresponding concentration of intellectual capital and academic and physical infrastructure. The cycle perpetuates itself; entrepreneurs locate their companies in regions that have the ecosystem to support their goals. And capital concentrates where repetitive and successful entrepreneurship occurs.

Where these concentrations occur, whether in Silicon Valley or Northern Virginia, at their most fundamental level they are concentrations of people. Where people congregate in a common enterprise, they tend to talk about what matters to them the most; they talk about what binds them together. In the case of the successful technology clusters, the prime topic of conversation, the thing that binds these communities is entrepreneurship. For many, that entrepreneurship is manifest in the establishment and growth of new companies. And, new companies require a few things to grow: smart people, real estate, an endless supply of coffee and money-lots and lots of money. The place where most of these expanding businesses look for money is the office of your friendly local venture capitalist.

Unlike the market bazaar, or the floor of a commodity exchange, the exchange of information among buyers and sellers in the venture market occurs through anecdotal information and indirect communications. Consider the venture capitalist on a board call who remarks when asked about the proposed terms of a Series B that the “last three deals he did all had similar terms;” or the experienced venture lawyer who tells a founder that like it or not, every deal he’s done over the last three years had founder stock vesting, so the chances of the founder having unvested stock is pretty small.

It also happens when the founder’s financial advisor argues against the requirement for a drag along right, and is chided by the venture capitalist for his inexperience. There are as many examples as there are interactions, but the underlying activity is the same: Everyone is looking to understand what is customary or what is “fair”. And in regions where venture capital transactions are commonplace, information symmetry and fairness are accomplished through repetition and shared experiences.

What is interesting to consider is how efficient the communications of market conditions appear to be. Without a central informational exchange or single location to obtain data, market participants in hundreds of independently negotiated transactions appear to move in concert and evaluate transactions similarly.

Local Not National

However, while there is support for concluding that regional market terms exist, there does not appear to be a truly “national” market for venture capital. There are significant regional differences in deal terms; venture capital investment is still a regional activity. Even the funds we work with regularly that have East Coast and West Coast operations, which could be seen as national funds, will negotiate transactions differently depending upon the “market” in which they are investing. Rather than transcending regions and creating a “national” market practice, these firms are following local conventions.

A number of years ago I asked my grandfather how a telephone worked. He replied: “Who knows, but who cares? I can get pizza when I want it.” It would be easy to have a similar attitude about the process of obtaining venture capital. However, if the market exists among those who are informed, there is in this an important lesson for the entrepreneur or would-be venture capitalist: Never stop listening to those around you and seek out the well-connected. Market terms aren’t shouted across a room, they are whispered at a Starbucks.

Jonathan Aberman, is an Equity Principal in Fish & Richardson P.C. He is the co-author with David Dutil of the “Summary of Venture Capital Terms,” published by Fish & Richardson on a quarterly basis and available at www.fr.com. Mr. Aberman can be reached at aberman@fr.com.