Silicon Valley Frontlines

Financing Improved In The Fourth Quarter - And So Did Valuations And Deal Terms

In my recent blog I noted that the volume of venture financing completed in the fourth quarter of last year improved somewhat - at least compared to the experience of the previous 9 - 12 months. [I also said that my next post would be on some of the gathering clouds in the Valley funding picture - I'm deferring that for a moment while I fill in some other fourth-quarter details first].

Perhaps even more encouragingly than the simple volume of financings, the terms under which the fourth-quarter deals were completed also showed significant improvement, according to a report from law firm Cooley Godward. For example, the median Series A round was done at an average valuation of $6.15 million - an improvement from the average $5.0 million in the first three quarters and moving back towards the average $7.0 million seen in the prior three years. Similar improvements were seen in Series B and higher rounds as well. Notably, however, in 2009 there were only 11 deals done a at a pre-money valuation of more than $100 million - far fewer, not surprisingly, than the 188 such deals done in the three years 2006 through 2008.

It’s also encouraging to see that the percentage of up-rounds [rounds completed with an increase in valuation from the prior round] improved to 45% in the fourth quarter compared to just 26% in the prior three quarters. While this is still short of the 60 to 80% up-round versus down-round ratio seen in prior years, things have clearly stabilized and improved.

Liquidation preferences continue to be done largely at 1x, although in the fourth quarter was a slight increase in the proportion of series A deals done with between a 1x and a 2x preference. [In simple terms the liquidation preference represents the multiple of the money put in that an investor gets back at a liquidity event, such as a sale of the company or an IPO]. These liquidation preference multiples are still far better than the 3x or more that we used to see in 2002 through 2004 after the dotcom implosion. 58% of the deals done in the fourth quarter included fully participating preferred-which is pretty much the same level as we've seen in the last four years. In simple terms participation means the ability of preferred stock to share in the liquidity proceeds alongside common stock, after the payment of their liquidation preferences.

In non-financial terms, the number of deals with pay-to-play provisions declined in the fourth quarter compared to recent history, while there was a continued increase in the proportion of deals done with drag-along provisions. [Pay-to-play provisions are typically used to motivate investors to participate fully in their pro-rata percentage of subsequent financing rounds, while drag-along provisions are employed to insure that a majority of investors may force a reluctant minority to pursue a liquidity event, for example].

There are various other items worth looking at in this report, so I’ve attached a full copy. Enjoy!

Download Cooley Godward Q4 2009 Venture Financing Terms

The State of Play in Silicon Valley Venture Funding - Clouds on the Horizon?

I went to a session the other day to get the update on PriceWaterhouse Coopers quarterly "MoneyTree" VC funding trend report and thought you'd be interested in some of the observations. If you're in the Valley and likely to be raising money you need to know what's going on out there. So here's the update for Q4 2009 and the year as a whole:

• In Q4 about $5.0Bn was invested in almost 800 deals - a dollar amount in line with Q3 and about 100 more deals being done.
• For the year 2009 a total of $17.7Bn was invested in startups by VC's - the lowest since 1997 and $10Bn less than in 2008.
• 38% of the Q4 number, and 40% of the full year, was invested in Silicon Valley companies, with an additional 15% and 10% respectively in the rest of California. So CA-based businesses account for about half of all U.S. VC investing. By comparison in 2009 just 8% was invested in the NY Metro area and 12% in New England (Boston).
• The number of Valley deals done in Q4 was around 260 - better than any quarter since Q3 2008 and on a par with the rate of deals getting done in 2006
• Early stage (Series A rounds) bounced back in the Valley in Q4 after a dry Q2 and Q3 - good news for newer startups.

Despite the efforts of many regions to create startup hubs and try and replicate the Valley, the share of funding taken by startups in Silicon Valley has been increasing steadily from 23% in 1995 to the 40% mentioned above in 2009. 

Sounds like we're turning the corner on the pace of investment and that the Valley continues to lead the geographical pack substantially. However, if you just pay attention to the dollars you miss a big theme - which is that the bulk of the money gets sucked up by the major capital-intensive segments in the Valley. These are Biotech, Medical Devices and Cleantech. If you're in those businesses you need lots of capital to develop products, gain regulatory approvals and so on - and the good news is that they were getting funded. The growth of these sectors is also a key element in the increasing SV share of funding I noted above. You don't have to go back far to remember the days when the number of companies in those sectors could be counted on the fingers of one hand - Genentech (now wholly-owned by Roche), Acuson (now Siemens) and a few others. And of course Cleantech, as such, didn't exist at all. The diversification of the Valley away from semiconductors, computer and then networking equipment manufacturing towards these newer, major segments has been a huge boon and, again, evidence of the ability of the Valley to reinvent itself time and again.

All that said, the software/internet space still had 177 companies funded in Q4 in the Valley for almost $1Bn (one third of the 2009 total) and the number was a 22% increase over Q3 of 2008. In 2009 as a whole the 619 software/internet companies funded was a 40% decrease vs. 2008. So Q4 was a good exit to the year in this segment. And its still clear that, despite the ease with which many startups in Internet, Social Media, Software etc can get started pretty much anywhere, the majority still get started and grow here, in Silicon Valley.

So where does that leave us? Well, things are definitely better than a year ago. However the panel discussing the results was largely gloomy about the outlook. And not just for this year, but particularly for 2011. In my next post I'll summarize the panel's opinions and add some of my own. Its enough to say that if you can get funded this year then take as much as you can while you can because the longer term has many clouds forming ...

Why Do Otherwise Sensible Companies Not Have CFO's?

The Canopy Financial fiasco (see my posts from late last year) highlights a very basic question (in that case, among many basic questions): "Why do so many fast growing startups not have a CFO?"

Here's an interesting table (I think it's from Ernst and Young, one of the Big 4 CPA firms, via the J. Robert Scott CompStudy):

As According to this only 17% of startups have a CFO when they have done one or fewer rounds of funding. In most cases this is probably appropriate - these companies tend to still be at the pre-revenue, product development stage and the business is pretty simple.

By the second and third rounds of funding, however, most of these companies are now generating some level of revenues and starting to grow and scale the business. Yet only 56% have a CFO. And only three-quarters of them have a CFO after 4 or more funding rounds.

To me this is bizarre. There are so many requirements piled on a business that need a dedicated CFO to help handle - revenue recognition, external audits (often a mandatory investor requirement as a condition of later-stage funding, though not always enforced), business planning and strategy, pricing, international structuring and tax planning, compensation structures, internal controls, economic models, budgeting, HR compliance etc...

So why do people not have them? I think its a combination of the following:

1. Lack of experience at the founder/CEO level. Not knowing what's important in managing the broader growth challanges of an early-stage business and the need for checks and balances, particularly in rapidly growing, multi-location companies. By the way, lack of experience doesn't just mean few years of experience. The challenge is also often true with an experienced sales or marketing executive turned into first-time CEO, for example.
2. Pressure to keep costs low and spending focused on product development and customer acquisition (sales and marketing). Unfortunately this is often encouraged by a company's Board - people who should know better about the need for checks and balances but often tend to be way too focused on minimizing unsightly or "unproductive" G&A overhead.

You have no idea how many companies I've seen over the years where some combination of these two factors has resulted in substantial problems later - restatements of financials (sometimes material enough to change an investor's view of the company's results), businesses with poor balance of resources, out-of-control compensation structures, untenable long-term economics, screwed-up equity structures, bad borrowing decisions, etc.

In the case of Canopy Financial they had, at some level, thought about the need and done some initial looking - as I know from my personal experience. But it clearly was not as high enough a priority as it should have been, and it took the appointment of new in-house legal counsel to blow the whistle on the problem. I guarantee you that a strong CFO hired a lot earlier would have discovered the problem before it escalated so significantly - and perhaps prevented it altogether.

So I know its self-serving to some extent but - please! - bring in the right CFO-level help at the right time. If its too early for a full-time person there are many well-qualified part-time people available. The cost of not doing so may be substantial - and not just the cost of fixing things. In the case of Canopy, it was disastrous.