Survey says starting a company has gotten tougher

For the past two years, Foley & Lardner has conducted a survey of investors, advisors and emerging technology company executives to uncover trends and issues facing venture-backed emerging companies. In November 2005, we found that while capital was abundantly available, finding qualified managers was a pressing challenge and a top priority for investors. In December 2006, we surveyed over 150 top venture capital, private equity and emerging company executives to uncover the issues that are the top priorities entering into 2007.

Respondents told us that the current financial market conditions are not making it any easier to start and establish an emerging technology company. Consider that 41% of investors responding to our survey have raised capital within the past year and even more (71%) expect to do so again within the next two years. However, despite the plentiful amount of capital in the financial markets, nearly half (48%) of the executives surveyed believe they are having a more difficult time starting a company today than they had a decade ago.

This illustrates the Catch-22 facing emerging technology companies in today’s environment: The financial markets continue to overflow with available capital, but investors have increased their preference for management teams with proven track records, and later stage companies and enterprises. Investors have raised the bar significantly higher the past couple of years, making it clear that product-less, profit-less companies “need not apply.” At the early stages of development and funding, today’s investors have a lowered risk threshold and are looking for businesses that can begin generating revenues faster with less seed capital.

More competition

However, the search for attractive transactions and investments is creating increased competition amongst investors, as available financing is clearly outpacing attractive investment opportunities. As a result, deal valuations appear to be rising, especially in later-stage company transactions. Further, the pressure from limited partners to sustain strong returns continues to grow. As such, we believe that venture capital firms must enhance the breadth of their investment focus, and approach deal structures and the types of companies in which they invest with a wider net and increased flexibility. Ultimately, investors are seeking to continue to put their funds to work in an extremely competitive market.

Venture capitalists also need to take harder looks at their portfolio companies two or three years into a deal, as they must try to enhance value as much as possible. To make strong companies even stronger, investors are applying laser beam focus on operations, in some cases conducting audit-like analysis and review of the company’s product or service line, and performing detailed assessments of management’s performance.

Nearly half (48%) of the executives surveyed believe they are having a more difficult time starting a company today than they had a decade ago.”

Thomas A. Rosenbloom, Partner, Foley & Lardner LLP

To assess whether or not operational value can be derived from a company, investors need to be able to understand the heart of the organization in which they are investing. Do service/delivery or production and supply capabilities support the financial projections? Are the company’s systems working in an optimal fashion? Has management instituted proper financial checks, balances and controls? What are the strengths and weaknesses of middle management? How can the customer base be enhanced and revenue streams maximized? Through this focus and analysis, investors should continue to be prepared to make changes to management when milestones are not met on a consistent basis, and to take a more hands-on approach to their portfolio companies.

IP no

Our survey explored the various exit strategies currently available to emerging technology companies. Investors and executives responding to our survey are overwhelmingly planning exit strategies around a merger or sale, as 68% cited a merger or acquisition as their likely exit. An overwhelming percentage of respondents (80%) predicted a “robust” M&A market over the next two years.

Consistent with our 2005 data, only 6% of respondents cited an IPO as a likely exit strategy, and a significant number of respondents (10%) noted that they did not know what their likely exit strategy would be. This, in our opinion, is a reflection of two factors: one, continued uncertainty in the IPO market as organizations hope for reform of Sarbanes-Oxley, and, two, investors’ desire to explore options that provide higher valuations and greater returns. More than 74% of our respondents predicted a “stagnant” or “declining” IPO market for 2007.

We believe that the M&A market will continue on a feverish pace in 2007. Investors have shifted their exit preferences away from the IPO market, as we have seen heightened focus on sales transactions. Financial firepower continues to reign, as private equity buyers blazed through a spectacular string of expensive transactions in 2006, yet barely making a dent in the mega-billions of capital they have available. We are confident that the trend will be bolstered by the private equity firms seeking to put their vast amount of capital to work through “club” deals, which should continue to become more prevalent.

Flush with cash

Only 6% of respondents cited an IPO as a likely exit strategy, and a significant number of respondents (10%) noted that they did not know what their likely exit strategy would be.”

Thomas A. Rosenbloom, Partner, Foley & Lardner LLP

If this isn’t enough, lenders and other debt market forces are eager to loan plentiful amounts of funds to augment a financial buyer’s wherewithal. On the strategic buyer side, corporations are coming to the table with strong balance sheets and unprecedented sums of available cash, with the option of using their shares as acquisition currency, thanks to the sustained strength of the stock market.

In fact, M&A experts suggest that a principal deal driver in 2007 may be a more aggressive approach by strategic buyers who are under intensifying pressure to channel uncommitted cash into growth-oriented strategies, such as acquisitions.

While our survey indicates that the IPO is most likely not the expected or preferred exit in 2007, recent reports and market activity may point to a more optimistic view of the IPO market in the years ahead. Investors’ expectations have steadied and companies are being maintained in a portfolio for longer periods, and, as such, they are becoming more mature and stronger. This could mean that companies available to go public will have a more solid foundation on which to achieve positive results after an IPO.

In the last quarter of 2006, public offerings showed a modest increase, with 89 IPOs accounting for more than a third of the 228 completed for the whole year. With more patience and a willingness to wait for the opportune time to go public, companies and their investors may return to public equity to help spur continued growth.

Overall, we believe that venture capital investors will face numerous challenges in 2007, including significant competition for viable investment opportunities, increased pressure to deploy capital, the need to be more flexible in the types of companies and transactions they will back, taking a hands-on, in-depth approach to their investments, and being prepared to be patient for the right exit.

Thomas A. Rosenbloom is a partner and member of the Private Equity and Venture Capital Practice and Emerging Technologies Industry Team at Foley & Lardner LLP. The survey was conducted in December 2006 and is based on 155 responses. A full report on the survey results can be accessed at