No sooner did we complete our three-installment piece on “Lessons Learned in the Bubble” than we realized our analysis was premature. We incorrectly believed that the introspection phase of the post-bubble era would continue for at least a few more years as we continue to recover from the technology depression of 2001-2003.
We were wrong.
In fact, looking back over the last 90 days, a mini-bubble has clearly emerged and the introspection period, as the following examples show, is clearly over, apparently to nobody’s chagrin.
The year got off to a sleepy start. With many investors still licking their wounds from the excesses of the last cycle, we expected caution to prevail. As one of our pre-revenue portfolio companies, KeyEye Communications (a 10GB fabless semiconductor company) was preparing for a Series B financing, we gave the management team the traditional “post-bubble” expectations regarding fund-raising: It would take six to nine months, be an extremely difficult and challenging process, take 30 or 40 first visits to build a funnel of five to six interested VC firms, and valuation should be the last thing in their minds while raising money. Valuation, after all, is set by the buyers, not the sellers, of stock.
In early March, the KeyEye team started the week with a dry-run presentation to the Blueprint Ventures’ partnership. As they endeavored to raise $10 million we bade them farewell with a final bit of advice, “Don’t lose confidence if the first couple of meetings don’t go well. After all, this will take a few months to get done.” The next day, two major venture firms called us. Their message was clear, “We met with KeyEye earlier today and are interested in moving forward immediately. What are your valuation expectations?”
Over the next three weeks of fund-raising, KeyEye’s management team visited with about two dozen groups, often canceling first-time meetings as some of the first groups moved rapidly through their process.
By the third week, we stopped arranging first-time meetings because we predicted the deal might get done before the meetings actually took place. Six weeks and multiple term sheets after our dry run, the company signed a Series B term sheet at a healthy up-round valuation. The lead Series B investor sought no syndicate and desired nothing but a guarantee that it could invest $10 million, driving up the size of the financing to approximately $15 million.
The point of this story is not to describe a phenomenally successful portfolio company, though clearly we believe KeyEye, like any VC’s portfolio company, is “top quartile.” We are obviously ecstatic with the financing. The point is to describe a financing environment that many of us have not seen since 1998. The KeyEye funding shows us that things are clearly heating up, but what really gets our attention is what is happening beyond this type of healthy activity.
We have been witness to this disturbing trend from the other side of the table. During the same 90-day period that KeyEye was raising its B round, several entrepreneurs canceled first-time meetings in our office-always on short-notice-because a term sheet was signed during the week between their initial contact with us and their scheduled meeting date.
Those of us old enough to remember 1998 recall deals being done in two or three weeks, with entrepreneurs walking out of conference rooms with the ink still drying on freshly minted term sheets. Those of us still showing up for work in 2001 and 2002 remember regretting the speed at which some of those deals got done. Some said we forgot how to do our due diligence. Well, judging by the first few months of the year, we may have once again forgotten.
Earlier this year, and after several months of technical evaluation, we submitted a term sheet to an innovative wireless technology startup. Deep in our exit projections-which regular readers of this column will know seldom exceed $100 million to $200 million-we submitted a fair single-digit valuation that we thought adequately protected the entrepreneur while rewarding the investors for their risk. We backed our term-sheet with a formidable Sand Hill Road syndicate and a talented CEO who was ready to join the company with the welcoming support of its founders.
Take a Number
One day later we received notice that the company would not accept our term sheet because the valuation was too low. Instead, they opted for another term sheet.
The competing term sheet, as we later learned, valued the company about 30% higher. It did not, however, provide a syndicate (the lead firm took the entire round) and it did not provide a CEO. The company believed that it could recruit a CEO while the competing VC completed its due diligence process. After the deal closed, the company spent approximately three months searching for a CEO.
Once again, for those too young to remember, this type of price-based, non-syndicated deal competition went out of style sometime in 2001. Today, with little rationale, price and time-based competition are alive and kicking once again.
Who Needs Capital Efficiency?
On another recent deal we saw the deal valuation and metrics spiral upward before a syndicate could even be assembled. The company, led by a well-known, proven and successful wireless CEO, successfully negotiated its valuation upward by 300% from where the deal structure originally started. This time, in an if-you-can’t-beat-them-join-them approach, we relentlessly pursued the deal, agreeing to invest less capital at the final valuation than we sought on the original deal terms (our goal remaining IRR rather than cash-at-work).
The striking element of this deal was how successfully the entrepreneur negotiated valuation with a single syndicate. In other words, there was no actual competition in the deal, simply a feeling by the current syndicate, ourselves included, that the deal could garner a higher valuation elsewhere. In a structure once again reminiscent of the 1998 market, the founders and common shareholders retained an unprecedented level of equity and control in the company. We reluctantly agreed, rationalizing our Series A investment with a trust in the management team, which we had backed before, and a smaller investment amount.
The More Things Change
Why the sudden mini-bubble? What fundamentals have changed to give venture investors the elan they have shown since the beginning of the year? The answer? None. Most VCs will readily acknowledge that exit valuations have not gotten richer. Some will argue that an exit window is beginning to show if not open. That is clearly the impetus behind the mini-bubble of 2004. Unfortunately the numbers do not support the premise. Certainly the number of exits has grown, but their valuation is built on revenue and cash flow that most venture-backed companies have failed to grow. If that sounds familiar, it should.
One last prediction: If this dot-com flashback keeps up, look for the price of sock puppets to soar on eBay.
Bart Schachter and George Hoyem are managing partners with Blueprint Ventures. Blueprint is an early- stage venture firm with two funds under management. Schachter focuses on communications and IT infrastructure, wireless technologies, nanoelectronics, software, and communications semiconductors. Bart may be reached at email@example.com. Hoyem’s investment focus is software, wireless, security, and other IT and communications infrastructure companies. George may be reached at firstname.lastname@example.org.
Top 10 Signs of a Mini-Bubble
1. Multiple competing term sheets.
2. Term sheets without site visits.
3. Financing in 6 weeks vs. 6 months.
4. $15M Series A financings.
5. $500M+ exit assumptions.
6. Pre-revenue Series B financings.
7. Pre-profitability IPO filings.
8. Wave investing.
9. Terms swinging to entrepreneurs.
10. The sock puppet is back!