The pace of business today is much faster than it was five years ago or even a year ago, and seems to accelerate daily. In the current environment, companies, particularly those focused on Internet infrastructure, regularly obtain financing concurrently with their founding. Financing transactions move forward in an environment in which the time from introduction to term sheet to closing is measured in days, not weeks. Some companies have moved from launch to initial public offering in a matter of months, not years. Entrepreneurs have enjoyed breakaway success at ever younger ages. Company valuations have risen and dropped by 50% in a single trading day. Communication is instantaneous and global.
The accelerated pace of investment and company development in the new economy has challenged many time tested investment criteria, such as profitability, the need for a seasoned management team and the need for a proven business model. Periodic corrections in the market for Internet and technology stocks, such as the market drop on April 14, are likely to dampen some of these excesses and speculation and will delay IPOs for many companies. But the trend toward a real-time environment for launching and financing companies in the technology/Internet sector is not likely to reverse. This change has important implications for investors, entrepreneurs and professional service providers alike. This article looks at some of the factors that have caused and enabled the overall acceleration of the process of financing and building companies and the challenges and opportunities this acceleration presents.
Venture capital investors in the 1970’s and 1980’s helped build companies at a relatively measured, gradual pace. Entrepreneurs financed their ideas and dreams initially with their own capital and capital from close associates. Venture capital investors then provided successive rounds of growth capital, sometimes over a period of years. The due diligence and related processes associated with making an investment unfolded fairly slowly, sometimes over a period of months. By the time of the IPO, the business model and management team were well established and profitability had been demonstrated, or was attainable. Venture capital returns in this environment did not significantly outpace or were below returns from later stage private equity investments.
Today companies are financed and grow at a pace that makes the model of the 1970’s and 1980’s seem glacial by comparison. For example, Akamai Technologies, developer of the world’s largest fault tolerant server network for distributing Web content, received $8.4 million of financing from venture capital investors in November 1998. The company raised a second round of financing from venture capital and strategic investors in May 1999, added strategic investors in June and August 1999 and went public in October 1999 at a market capitalization of approximately $2.3 billion, which has since risen substantially. Andover.net Inc. converted to an Internet/Linux-based business model in the spring of 1999, raised a round of private equity financing in September 1999, went public in December 1999 and announced a sale to VA Linux in February 2000.
These and similar companies have experienced substantial increases in equity value with relatively few rounds of private equity financing and have been able to go public without generating earnings, as public investors effectively have taken venture capital-like investment risk. In this environment, seasoned executives exit in waves from established companies, investment firms, professional service firms and government to participate in dynamic new start-ups. The venture capital industry reflects this dynamism, as it has become increasingly promotional with particular sectors and investment ideas (roll-ups, B2C, B2B, etc.) falling in and out of favor very rapidly.
Why has the pace of private equity investing and company growth accelerated so quickly? The causes are many, but several factors particularly drive the current need for speed. These include the pervasiveness of the Internet, the abundance of private equity capital, and the favorable investment and tax environment that exists. Multi-billion dollar markets are up for grabs and rewards in the stock market are unprecedented.
The Internet has fundamentally altered the private equity investment business. The Internet is at once a new channel, a new platform and an enabler of new applications. It permits an enterprise to enter and dominate large markets very quickly, principally by facilitating regular and real time interaction with large groups of customers and potential customers. At the same time, new technologies provide growing e-commerce enterprises with the infrastructure and tools they need to capitalize on available opportunities. Emerging “solutions” from companies such as Asera, Vignette, DoubleClick, Commerce One, BroadVision and the many incubators that have been formed enable start-ups to greatly reduce launch time and dramatically reduce development costs. These include instant B2B infrastructures, ASP services, service providers willing to “rent” experienced talent, non-core back-end systems and processes such as finance, human resources, public relations, legal and accounting, and rentable real estate that is “fully loaded” for e-commerce operations. Enterprises seeking to achieve a dominant position must utilize these resources to obtain market share ahead of their competitors and require substantial amounts of capital to do so. Companies that can garner this capital and execute their strategies quickly have been rewarded with remarkable market valuations. Speed of launch matters greatly to these companies.
The increase in demand for capital has coincided with a surge in capital supply. Investors have continued to allocate increasing levels of capital to venture capital investments, with over $48.3 billion (representing over 3,600 deals) invested in 1999 as compared with $19.2 billion (representing over 2,900 deals) in 1998, based on data from Venture Economics. Technology-based companies (including Internet-related businesses) accounted for over 90% of all venture investments in 1999. This convergence of supply and demand has resulted in more and ever larger funds – there are now at least 18 venture capital funds with more than $1 billion of committed capital and larger private equity funds increasingly focus on earlier stage, venture-like investments. At the point where supply and demand meet, capital and investor confidence abounds, competition for high quality deals, ideas and people is fierce, deal sizes grow, and private company valuations remain high even as public valuations plummet. From the perspective of a promising start-up company operating in this marketplace, speed to closing is a key differentiator. From the perspective of an investor, the availability of capital and the prospect of extraordinary returns can justify making a large investment at a high valuation when a good investment opportunity is identified from among the many available opportunities.
Investing in Real Time: Challenges and Opportunities
The pace of investments in the Internet and technology sectors present important challenges and opportunities for market participants. The most significant, perhaps, is the way in which the emphasis on speed has altered and compressed the very process of screening, analyzing and making investments. The second set of challenges and opportunities relates to managing and capitalizing on market dynamism and volatility. These challenges and opportunities arise in the areas of transaction structuring, implementation of liquidity strategies, and management of risk. In each of these areas, the objective is to understand and adapt existing processes and rules in the context of a speedier environment.
Investment firms operating in the current environment must be able to commit capital and close transactions very quickly. This has placed a premium on technical expertise and business experience, as firms need to introduce decision makers and conduct high quality diligence and assessment of technology, management, company strategy, risks and market opportunity within a limited window of opportunity. In some respects, the nature of diligence has changed – business case due diligence can yield marginal results because of the speed with which many business plans change as companies grow. Similarly, traditional market analysis may be less relevant because many entrepreneurs use the results of the business launch as the best and cheapest way of gauging market reaction. But in any case the pace of e-commerce investing has required investors to adapt, change and accelerate their traditional investment process by making it more focused.
Some firms have launched funds with a specific focus (e.g., technology, B2B) to help provide this focus. Investment success has tended to breed further success, as private equity firms with strong track records and brand names can rely upon high quality deal flow, access to reliable references to corroborate investment decisions and access to familiar management teams with strong track records to commit capital quickly and with confidence. Partnering arrangements frequently occur, as investors work in tandem with other investors and strategic partners to spread the work of the evaluation process, add different perspectives and skill sets and diversify investment risk. Investors increasingly favor collaboration and emphasis on working with familiar partners and advisers, often resulting in multi-party transactions.
The pace of e-commerce transactions presents similar challenges for the professionals who work with growing companies. The creative process of evaluating a company and structuring a transaction that used to occur over a period of weeks now occurs in a much shorter time frame. The process can work effectively within this time frame, and indeed can be more efficient than a longer process, provided experienced personnel, high quality data and good systems are available. Firms must have the ability to adapt and scale their processes to meet differing transaction sizes and timelines without sacrificing excellence. To do this, service firms operating in the current market environment must implement creative, forward thinking programs for retaining and promoting their best personnel.
Investors and professionals who fail to adapt their investment processes to fast moving e-commerce situations may nonetheless succeed in investing substantial amounts of capital and closing many transactions. In fact, some investors may view the option value of Internet investments (and the opportunity cost of not investing) as sufficiently high to justify making bets on a number of Internet investments in the belief that several successes will counterbalance the failures. It is unclear, however, whether these investors will be able to achieve superior investment returns over the long-term. Investors are subject to standards of responsibility that were developed in a more genteel and slower moving time in our economic history, both in their capacities as general partners and as board members of portfolio companies. Professionals serving on, say, 15 to 20 boards across the country while managing multiple new transactions face pressures in meeting these standards. Should high speed investing result in a series of highly publicized failures, reputational damage could occur if the failures have been caused by careless due diligence, ignorance of obvious warning signs or sloppy documentation. Accordingly, the most successful firms will be those who can reengineer their work processes and systems and marshall the resources necessary to move at a very fast pace without sacrificing creativity, analysis or self restraint. Availability of human capital and the time constraints on professionals at private equity and other firms are perhaps the most significant challenges faced by these firms.
Structure, Liquidity and Risk
The structural challenges and opportunities of investing at e-speed arise principally in the areas of tax optimization and price protection. For investors and entrepreneurs alike, the initial focus should be on maximizing gains on an after-tax basis. In this regard, savvy entrepreneurs optimize their equity position by obtaining it early, when enterprise value is low, and requiring that it be structured as restricted stock (with so-called reverse vesting), a profits interest or options that are immediately exercisable and subject to forfeiture if the entrepreneur leaves the company. These techniques, unlike a traditional option package, will facilitate capital gain rather than ordinary income treatment. Experienced investors and entrepreneurs also have a long-term focus and acquire their equity stake in a manner that enhances their overall estate plan, taking advantage of opportunities that will evaporate as equity value grows. And experienced private equity investors provide these solutions to their entrepreneur partners because they know that doing so will help them recruit better managers in a market for managerial talent that is incredibly tight. These techniques are not new, but the window for implementing them in e-commerce situations is very narrow – investors and entrepreneurs will squander valuable opportunities if they do not seize them before equity value rises.
Investors also focus on price protection as well as after-tax returns in the current market environment. Investors often will agree to a lofty valuation but may insist that valuation be revisited if a liquidity event does not occur when envisioned or occurs at a valuation that does not meet a specified benchmark return (e.g., 3x). Traditional concerns in this area become magnified due to the potential volatility of equity value. Examples of techniques currently used to address these concerns include participation features, which scale down as equity value grows, warrant protection, a revival of full ratchet anti-dilution protection (at least for an initial period following the investment), and conversion adjustments tied to valuation in connection with subsequent private financings, an IPO or a sale.
Optimizing structure requires an understanding of how existing rules apply in the context of a speedier and more volatile environment. For example, if an IPO will quickly follow a private equity investment, care is required to avoid having the SEC’s six-month short swing profit rules preclude selling in the IPO if such sales otherwise would be consistent with the investor’s overall strategy. When early liquidity is available, investors face potential conflicts in deciding whether to sell before satisfaction of the one-year holding period requirement for long-term capital gains, an important benchmark for taxable investors and general partners but an irrelevancy for tax-exempt limited partners. Investors in e-commerce situations must be mindful that the SEC’s Rule 144 does not permit resales of restricted stock into the market until one year after the stock is acquired in a financing or acquisition (and does not permit liquidity under Rule 144(k) for two years), absent a registration, which can present volatility risk. Similarly, a five-year holding period requirement applies for preferential capital gains treatment for investments in qualified small businesses (i.e., those with assets of $50 million or less, among other requirements). Since five years is a relative eternity for many technology investments, investors in such companies have focused on development of programs to track the reinvestment of proceeds from investments in qualified small businesses, as permitted under applicable IRS regulations, in order to preserve the opportunity for preferential tax treatment.
The pace of company growth and the volatility of the markets make liquidity strategy a second major area of focus for new economy investors. In recent months there have been many examples of newly public issuers that have soared to great heights in the after market, only to fall to earth. Having the ability to exit at a favorable valuation (through a sale or distribution) is critical to investment return. Investors traditionally have used registration rights and stock distributions to limited partners as vehicles to achieve market liquidity. Investors in recent months have also focused on techniques for locking in gains, such as costless collars and similar instruments, and transaction documents often include provisions designed to assure that these techniques will be available. Some investors in the current environment mix liquidity strategy with reinvestment strategy by investing in IPO’s of their portfolio companies. Investors must exercise caution in this area, as recent SEC positions indicate that certain rights to invest in IPOs may violate prohibitions against “gun jumping” whereas having the right to invest and failing to exercise it may send a negative message to the market. Investors also should remain mindful that IPO reinvestment may not achieve target investment returns unless “trees grow to the sky.”
A third area of focus for investors in volatile markets is risk management. The appetite of public investors to finance high risk start-ups that was evident in 1999 and the first months of 2000 has provided the opportunity for breakaway returns. In this regard, early/seed-stage venture capital returns soared to 91.2% for the 12 months ended September 30, 1999 as contrasted with 15.2% for buyouts during the same period, based on data from Venture Economics. Unfortunately, markets that provide very high company valuations also create the prospect of disgruntled public investors should a company’s stock price drop precipitously and unexpectedly.
It is now clear that some e-commerce companies will not succeed, even though the overall economy and technology sector will continue to prosper. Thus, careful investors assure that defensive measures such as strong D&O indemnity and insurance protection are in place. While it is possible that the plaintiffs’ securities bar will ignore e-commerce failures due to the inherent (and fully disclosed) nature of the risks involved, it is also possible that this group will focus on e-commerce and technology failures as its next major business initiative. Any investor or entrepreneur who has been ensnared in securities class action litigation, having every communication and action scrutinized over months of depositions, knows that avoidance and defense are profit maximizing strategies.
Some of the problems presented by the ever quickening pace of commerce cannot, of course, be addressed by organizational advances, technology enhancements, or clever transaction structures. These include the challenges associated with mapping out a business career for one’s thirties, forties and fifties after achieving great success in one’s twenties (and the more difficult variant of dealing with the feeling of being left out if success fails to occur right away), and challenges associated with quick transitions, such as moving from e-speed to family speed at weekends or holidays, for example. It is hard to downshift at high speed, as any race car driver will observe. The e-commerce era is in its infancy, and it is hoped that a rich literature will emerge to mark, interpret and chronicle the social issues it presents, much as Man in the Grey Flannel Suit emerged from the 50’s and Bonfire of the Vanities and Liar’s Poker emerged from the mid and late 80’s. But problems such as these are beyond the scope of this article.
Where is it all heading? As noted, stock market corrections will inevitably temper the market excess and speculation that have recently occurred, and the easy access to the public securities markets that has existed for many companies is likely to become more difficult. Some Internet ideas will fail and profitability inevitably will become a criteria for success once again, as companies no longer pursue strategies focused on acquiring customers at any cost. But advances in technology, once made, rarely move backward. If documents can be delivered instantaneously, not overnight, they will be delivered instantaneously. If a high quality firm can commit capital and close in a prudent manner in weeks, not months, it will win more business than a firm that takes longer to commit its capital.
For companies, investors and professionals alike, maintaining high quality execution and delivery while moving at a fast pace, and building strong companies rather than a single minded pursuit of quick IPOs, should be paramount goals. Success in the new economy requires a nimble, opportunistic and streamlined approach to problem solving and market penetration. Some firms might opt not to focus in this area. Others will try to serve both new and old economy client bases, at the risk of creating competing internal cultures, each with its own economic model and risks and each with its own constituencies. In any case, understanding the application of old rules to new situations and devising processes to assure effectiveness at any speed will enable market participants to keep pace with or remain ahead of their clients and competitors.
Brian Conway is a Managing Director at TA Associates, Boston, Mass.
John LeClaire is co-chair of the Private Equity/Emerging Companies Group at Goodwin, Procter & Hoar LLP, Boston, Mass.
Terry Breen is the Managing Partner of the Dot.Com Consulting Practice at Andersen Consulting, Boston, MA