You Gotta Know When To Hold em –

After a long period of lackluster merger and acquisition results for venture-backed companies, venture capitalists were popping the champagne after the release of first quarter 2004 M&A statistics. On the surface, it looked like our industry had turned the corner, with a median transaction gain of $22 million representing a 2.5 times cash-on-cash return.

During the dark days of 2002 and 2003, VCs were lucky to recoup invested capital through a sale. By sharp contrast, a $22 million gain per investment seemed miraculous, leading VCs to conclude that strategic buyers must be back with their check books open. But a deeper analysis of the industry coupled with second quarter 2004 data suggests that the first quarter may not be indicative of things to come.

We believe there are four critical factors that may dampen the momentum seen in the first quarter of 2004 and drive down M&A valuations over the next 12-18 months:

* Excessive Capital Investment. Due to the recession in 2001-03, too much capital was invested in the companies that VCs are trying to exit today. Current issues in the venture industry and stock market may result in lower M&A valuations than in the first quarter 2004, preventing venture investors from obtaining successful returns.

* The Bubble Overhang. More companies were funded during the bubble than in the history of the private equity markets. The majority of the companies funded during the bubble, a staggering 71%, are still operating and remain privately held. This overhang will depress M&A valuations until supply and demand are more balanced.

* The Venture Funding Cycle. According to the National Venture Capital Association, over 50% of VC firms plan to fund-raise this year and next. Venture investors need liquidity in their portfolios-which has been largely unavailable for the past three years-to entice new investment. This natural incentive to liquidate investments may contribute to the M&A supply/demand imbalance.

* Uncertain Macroeconomic Influences. Current and expected macroeconomic influences point toward an unfavorable M&A environment in the near term.

Excessive Capital

As shown in Figure 1, most companies being sold today were initially funded 3-5 years ago, and therefore, subjected to the economic recession of 2001-2003.

During the recession, most VC-backed companies were unable to meet growth projections as capital spending on everything from software to services to equipment was slashed. This forced VCs to hold onto companies longer than originally anticipated and invest more capital to keep the opportunities alive. As a result, venture-backed companies that survived the economic debacle to reach an exit had on average of 3-4 times more invested capital than comparable companies in the mid 1990s.

Unfortunately, at the same time, the market normalized after the “bubble” era and M&A valuations returned to the levels of the mid 1990s-around $20 million to $30 million per deal. In 1994 and 1995 these valuations generated healthy 4-5 times cash-on-cash gains. In contrast, in 2002 and 2003, these same valuation levels resulted in capital gains of only $2 million to $6 million per transaction due to the large amount of invested capital (on average $18 million to $24 million) per company. Figure 2 depicts these trends by showing the median gains obtained by venture backed companies through M&A activity from 1994-2003.

The best way for VCs to obtain successful returns in this market is for strategic buyers to pay significantly more than $20 million to $30 million per transaction. In early 2004, it seemed buyers might be willing to do just that. Of the 77 companies sold during the first quarter, 44 reported both the sales price and the amount of invested capital prior to liquidity. The median sales price was $47 million-a significant increase over the $30 million paid in 2003. This resulted in a median gain of $22 million per transaction, representing a 2.5 times cash on cash return. Notably, eight companies were sold for gains in excess of $100 million, with the top transaction realizing a $600 million gain. Further, just 10 of the 44 reporting companies were sold for a loss. This was great news for the venture industry.

But then second quarter 2004 results were released. This time, 86 companies were acquired or merged during the quarter. Yet, the median gain per transaction reported was nearly half that of the first quarter, or only $12 million. Further analysis showed significant cause for concern in the information technology sector. Of the 47 companies reporting M&A data, 39 were IT related. The median gain on these transactions was only $4 million as compared to $18 million in the first quarter. In addition, in the second quarter, 18 of the 47 reporting companies were sold for a loss-almost twice as many as the first quarter.

We believe that the positive M&A results we saw in the first quarter 2004 were largely due to the three years of pent-up demand by VC sellers and strategic buyers. VCs entered 2004 ready to sell their top portfolio companies, and strategic buyers entered 2004 with the view that acquisitions would be the best way to jump-start growth. These factors combined to encourage buyers to provide generous valuations. However, an excess supply of venture-backed companies available for sale combined with a deteriorating economy resulted in disappointing second quarter results. This is a trend that we expect to continue through 2005.

Bubble Overhang

Over 8,400 new portfolio companies were funded during the glory years of 1998-2001. On a normalized level, based upon pre- and post-bubble data, there would have been only 3,000 companies funded during that period. Of these 8,400 bubble companies, 71% (or 6,060) remain privately held today. Thus, there are a greater number of bubble companies seeking an exit today than should have been funded in the first place. This represents an unprecedented supply of companies for the M&A market over the next several years. Due to the sheer number of companies funded during the bubble, many have “me too” business plans. These factors have combined to give today’s acquirers more bargaining power and alternatives than ever before. As a result, we believe the venture industry will see a drag on M&A valuations until these companies are worked through the system.

Funding Cycle

Approximately 50% of U.S. venture firms plan to raise new funds in 2004 and 2005, according to a survey conducted by the National Venture Capital Association. As a result, general partners have a strong incentive to create liquidity, particularly newer firms raising their second or third funds. Given that the companies being sold today have a median age of 4-plus years, current investment track records will largely be based upon the 8,400 companies funded during the bubble. Of those, only 1,005 achieved M&A exits through June 30, with most recording marginal gains at best.

While well-established venture firms may be able to raise new funds based upon historical track records, newer and less established firms will feel pressure to generate liquidity for fund-raising purposes. Since the number of venture firms increased 93% from 1996 to 2003, one can assume that a significant number of firms seeking to fund-raise today are relatively new.

These VCs need to obtain liquidity immediately from their share of the 6,060 privately held companies remaining from the bubble period in order to be most successful in fund-raising. Thus, we believe the selling pressure over the next 18 months, combined with the significant over-supply of companies, could create a strong buyer’s market that depresses valuations.


Most of the transactions in the first and second quarters of 2004 were cash based, suggesting that strategic buyers considered their stock too undervalued to use as an acquisition currency. Since the beginning of 2004, we have seen an 8.4% decrease in the NASDAQ composite index and a 3% decrease in the Dow Jones Industrial Average.

We believe higher valuations will only be achieved on a sustained basis when positive stock market performance resumes such that buyers are incented to use their stock as acquisition currency. Therefore, we expect to see strategic buyers restraining valuations over the next 12-18 months, potentially resulting in losses for VCs forced to exit in this environment.

In addition to the stock market performance, other macroeconomic influences-such as the continuation of violence in Iraq, worldwide terrorism, all-time high oil prices and increasing interest rates-point toward a softening M&A market for the remainder of 2004 and 2005.

Until strategic buyers feel more certain about the economy, the stock market and consumer confidence, they are unlikely to aggressively pursue acquisitions.

With the dynamics of the M&A market working against VCs seeking liquidity, we believe that venture firms that aren’t required to raise funds in 2004 or 2005 would be wise to hold onto their portfolios and continue to build value. The patient venture capitalist will be rewarded with a less crowded M&A market when the current supply-demand imbalance is corrected.

Stephanie Smeltzer McCoy is a vice president with Meritage Private Equity Funds, a Denver-based communications oriented venture capital firm. McCoy has more than 14 years of international finance, investment banking, consulting and accounting experience. Previously, she specialized in M&A work with The Wallach Company and co-founded the corporate finance practice of Arthur Andersen in Moscow, Russia. She is a member of the AICPA and serves on the boards of directors of Exabyte Corp. and Trillion Partners, a company she co-founded. She may be reached at