Silicon Valley Frontlines

New Dynamics Emerging in Early Stage Funding ...

Start-ups have been through a dreadfully dry funding period over the last 9 months or so as VC's, angels and other investors have retrenched following the financial market collapse. It does seem as if there is a thaw starting to happen now, driven by an improvement in exit prospects (IPO or M&A) and a returning confidence now that we appear to have avoided a second great depression. And frankly there are some very interesting ideas out there like UsTrendy, a start-up with which I'm working, that in a slowly normalizing market deserve funding to drive to the next level. So what's happening out there now?

We know valuations are down - maybe half of what they would have been a year or more ago, even for start-ups that have made good business progress over that timeframe. While no-one likes a down round, if you raised money a year ago just be happy that you sold less of the company then than you would now to raise the same amount - and that hopefully the cash kept you in business during this downturn. 

However now we're also seeing the amounts raised go down as well. In fact your traditional Series A round is now looking more like a seed funding - perhaps a $0.5m to $2.0m raise versus the more traditional $2m to $6m. Despite valuations being down this is also translating into selling less of the company in the fundraising - maybe 20% to 40% versus 30% to 50%. The reality of many start-ups today is that they can do a lot with less money anyway. People are cheaper, and with the tools, technologies and techniques available today (eg: building cloud-based apps as opposed to complex software applications from scratch) developing the business is faster and a lot less expensive that it used to be.

What we see now is a class of micro-VC's emerging and filling the space occupied previously by angel investors, along with larger VC's getting in earlier with smaller amounts. In the micro-VC class are funds like Come Lague's $20m Nueva Ventures, Fruition Ventures, Capybara Ventures and all the way up to the new Andreessen-Horowitz fund which with $300m is not micro in size but many of the deals, in which they plan to invest from $50,000 and up, are definitely at the seed/early stage. New firms like Javelin Venture Partners, with two partners and a $75m fund are also emerging. Meanwhile established firms like Matrix Partners just closed a new fund in part focused on new seed/early stage investments (this is a marked shift from their typically bigger, later-stage investments) and Draper Fisher with a $7m (miniscule for them) seed stage fund focused on Plug and Play TechCenter startups. 

The reality for VC's is that their limited partners put money in their hands to invest and get better-than-average returns (around 20% per annum as noted in my recent post) for higher-than-average risk. VC's don't accomplish that by sitting on their hands. If anything, logic says the dynamics of great ideas, cheaper costs of execution and lower valuations should be encouraging more investment right now. And I think this trend of micro-VC with micro-investments in micro-startups is going to be the key funding growth area for the future in terms of number of deals being done. That said, there is also a good argument to say don't raise any true VC money if you can get where you need to go with friends and family, angels and a little seed money.

Which brings up the next question - as an entrepreneur, what kind of terms do you want/expect to get for this species of money these days? See my next blog shortly!

Economic Outlook in the Valley Improving ... But Where Will There Be Jobs?

The large accounting and consulting firm KPMG just announced the results of it's latest survey of key executives in various industries and I'm glad to see the technology sector optimism, which bodes well for the near future in the Valley. I also note that "only a very small percentage of the respondents say they are considering or planning further headcount reductions". Given that 65% of the surveyed execs (not just tech) implemented headcount reductions as their major reaction to the recent economic turmoil, this is particularly good news. An extract from the survey is below the chart.

For those not paying attention, the Valley unemployment rate (San Jose metro area in the chart below) has soared to almost 12% in the last month, and is now well above the 9% or so rate we experienced in the aftermath of the dotcom implosion. History - and "jobless recovery" prognostications - suggest it will stay up there for a while. That 12% has hit people pretty hard. Here's a headline from The Daily Telegraph in the U.K:

"In California's Santa Clara county, the local food bank served 17pc more people in the year to May than it did in the previous 12 months. That month (May) alone, Second Harvest Food Bank's food connection hotline experienced a 71pc surge in first-time callers."

Silver lining: I'd suggest that, as cash starts to flow again into startups, new job creation will occur there all the way up through Facebook and Google, while the dinosaurs - the HP's of the Valley - continue to shave away the layers. And for start-ups the people can be had for less base cash (though you'd better offer performance incentives in the way of bonuses and equity in exchange).

Here's an extract from the KPMG press release:

Technology: Leading the Recovery

Two-thirds of technology executives in the survey believe their industry will recover more quickly than the national economy. Silicon Valley-based executives were even more bullish, with 77 percent of them saying their recovery would outpace the U.S. one.

Eight out of ten executives in technology expect business conditions in technology to improve next year, with 78 percent expecting stronger revenue and 72 percent expecting improved profitability.

"These results are in line with recent earnings reports in the technology sector," said Gary Matuszak, partner, global chair and U.S. leader for KPMG's Information, Communications and Entertainment practice. "While it's far from blue skies in the industry, the worst seems to be behind us."

via news.prnewswire.com

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• Silicon Valley gets a taste of the grapes of wrath (telegraph.co.uk)

The Case for Optimism - Plug and Play in BusinessWeek

For the last four months or so I've been working out of the Plug and Play Tech facility in Sunnyvale as an Executive-in-Residence. Not quite the same thing as the EIRs at venture capital firms who are typically executives of prior portfolio companies looking for their next portfolio company gig, and paid by the VC in the meantime. At Plug and Play I pay rent and get no salary - but I do get a great opportunity to develop relationships with many of the 200 or so start-ups based there, leading to potential consulting, interim or advisory roles, and perhaps the next full-time situation. Oh yes - and i have to pay Plug and Play a cut on any consulting with these companies. Costly? Yes. Worth it? Yes. Great place to be; very interesting opportunities and the chance to help companies who really need it. Good blog material too!

One thing I like about Plug and Play - it is a hotbed of optimism. Everyone here - even though struggling to raise cash and find customers in the current environment - is pursuing a vision or a dream and doing whatever they can to make it happen. You have to like the energy and drive and some of the ideas are terrific.

This week BusinessWeek has published a whole series of articles titled "The Case for Optimism" and Plug and Play is prominently featured in the segment "Keeping the Faith in Silicon Valley". Nice article with a good profile of Saeed Amidi, the founder of Plug and Play. The business is his brainchild and is primarily successful in its mission as a result of his energy, vision and networking. And its a lot of fun to be there and part of it.

Portfolio Returns - What VC's Are Looking For ...

Fund raising by VC's has been a difficult task recently, as we know. Which prompted me to do a little research on what expectations limited partners (the investors in the VC funds) have for their money. I'm indebted to views shared by Susan Mason at Onset Ventures at the SVASE event a couple of weeks ago, and Fred Wilson's blog, A VC, earlier this year (Fred is a partner at Union Square Ventures, an investor in Twitter and some other very interesting companies and one of the smartest investors out there)

In order to raise money VC's have to offer superior returns versus the investment alternatives for their limited partners. We know VC investing is risky and for a limited partner the money is in there for a long period of time (no, they can't pull it out when the market crashes or other misfortunes occur). So those returns need to be quite substantial to attract the billions that flow into this kind of investment vehicle and then have to wait it out.

As it turns out the returns needed are in the order of 20% per annum over the life of an investment in a specific fund - after the VC's get their cut in management fees and their "carry" (share of the portfolio). Put another way, over a typical fund life this turns out to be about 2.5x their original investment. If you invested $10m in a VC fund it would deliver $25m in returns (after the VC fees and carry) when the fund is liquidated after 10 years. Not shabby - if it happens.

On the VC side, then, how do the individual investments need to perform in a portfolio to deliver this kind of return? As an early stage investor Fred Wilson expects to lose all his money on 1/3 of his investments, get his money back or a little more on another 1/3 and make all of the fund returns on the remaining 1/3. Which means the latter have to do really well - about 7.5x the amount invested.
This in fact will range from maybe 2x to 15x per "successful" investment, but you get the picture. 

So in a $250m portfolio of maybe 25 investments, roughly 8 would have zero returns, another 8 might return $80 - $100m in total, and the remaining 9 would have to generate roughly $650m which would come in the range from $15m to $150m. That is not an insubstantial task. But then VC's are highly incented to make it happen!

Of course a VC takes a portfolio approach. An entrepreneur can't. So while a VC can be OK with doing well on one of every three investments, you as an individual need to make the one you're working on defy the odds stacked against you.

Life Returning to the Tech IPO Market?

In my blog on July 9th I talked about the recent survey focused on what worries VC's the most. Given that the answer, overwhelmingly, was "exits" (or rather, lack of them) its interesting to look at what's happened in the one month since my post.

In that period NASDAQ, the broadest indicator of tech market health, has gone from 1,756 to 1,992, or back to early October 2008 levels. That's an increase of 13% in one month. More focused tech indexes have done even better. Just as importantly it continues an improvement in the markets starting back in early March - NASDAQ bottomed at 1,268 and is now up 57% since then.

There are a surprising number of tech companies that are substantial, fast-growing, profitable (or on their way to being) yet are still private. You can see them in numerous tech segments - equipment, internet, software etc. These are the ones that need to spring loose in the public markets and now is the time to start seeing some of them do it. Filing an IPO this month means a good chance of completing the process before the holiday season and hopefully taking advantage of recent market strength.

And its starting to happen. Today, Fortinet filed their S-1. (An S-1 is the basic IPO prospectus or offering document filed with the SEC at the start of the IPO process.) They're a manufacturer of network security appliances (an "appliance" in this context is a simple, server-type box where the core functionality is in the software rather than the hardware - the hardware is simply the container, if you will) that reported over $200m in revenues last year, up about 25% over the prior year, and was slightly profitable. This is the type of low risk, solid, easy to digest IPO that will do well in this market.

Also last week Ancestry.com, an internet company, filed it's S-1. Their mission is to "help everyone discover, preserve and share their family history". Now I'm one of those sceptics who wonders how this can possibly be a big business. Apparently I'm wrong because it did $197m in revenues last year - up from $166m the year before! They're not a Valley company, and in fact they've been around in some form or another for 20 years, but they are an interesting filing to follow as an internet play.

Two other tech IPO's priced (that is, they completed the IPO process) in the U.S. last week - Avago, the Singapore-based former semiconductor group of Avaya, the HP spin off some years ago, and CDC software our of Hong Kong. Both are substantial, particularly Avago with $1.7Bn in sales last year.

More importantly, for our purposes, I hope these are the first of the next wave of tech-related IPO's that will provide exits (or will develop warchests to acquire some of the promising start-ups out there), and therefore hope for future liquidity events from today's investments, and slowly increase the confidence in funding some of the good ideas out there.

Valley Update - Funding, Capital Efficiency, Planning and Areas of Investor Interest

Spent the evening yesterday at SVASE's "Raising Capital for Early-Stage Technology Startups" event and I thought it would be worth sharing some of the thoughts from the three panelists who shared some great insights! They were

• Susan Mason, General Partner, ONSET Ventures
• Matthew Price, Sr. Associate, Nth Power
• Carol Sands, Founder & Managing Member, The Angels’ Forum and The Halo Fund

In no particular order, some of the key takeaways - all of which make great sense:

• "Capital efficiency" is paramount in this market. Meaning that the less cash you have to raise to get to breakeven/cash flow positive the better it is for investors, founders, management and employees. And therefore the cash you have also needs to be managed in the most effective manner possible.
• Yes, lots of portfolio companies have been through significant restructurings and downsizings to make the cash last and become more capital efficient. In many cases this has been a great thing as it has forced people to look at their businesses much more critically. This has been very timely as we've seen startups finding the external market has caused them to fall 6 - 9 months behind on their plans, though many are now getting back on plan.
• There will be a big shakeout in the VC business, in particular with those who have not raised additional funds or capital in the last 2 - 3 years (to be clear, all the above HAVE raised capital and are not in this situation!). The ripple effect on their portfolio companies will be substantial and ugly.
• We're seeing a return to real "sweat equity" with startups - which is a good thing!
• Good VC firms are still investing. Many are also looking much harder at how that equity gets leveraged or enhanced - partnerships, channels, even grant and government monies (which Silicon Valley companies have traditionally ignored but I see many European companies pursuing quite successfully)
• Silicon Valley startups have also not traditionally sold to the government - rethink that!
• Your financial plan needs to assume that not everything goes perfectly. In fact it needs to presume that many things will not go according to plan. Therefore always take as much money as you can now because you never know. Your financial plan is not just about having gas in the tank, but about "de-risking" the business. When you have cash you have options and can manage things going wrong. When you don't you have no options. None.
• If you're very early stage look at pre-seed convertible loans and other creative financing strategies - a bridge loan to a syndicated financing round etc (but as I've said before, make sure its a bridge, not a pier!). Get your suppliers and customers to help finance the business. 

Susan Mason, particularly, also did a great job of pointing out some market areas and opportunities she thinks are very interesting for investors:

• Monetizing data real-time
• "Everything" as a service - SAAS, Cloud Computing, PAAS, etc
• Enterprise 3.0 - for example, free, ad-supported network management tools
• Security as a service
• Financial payments infrastructure
• Internet gambling - when it becomes (inevitably) legalized here as it is in many other countries
• Virtual goods-based companies
• Mesh sensor networks with recurring revenue models
• Medical devices that speed up diagnostics or provide custom or personal medical solutions via your genetics