A number of you have been wondering if I am still alive or have given up blogging. Life has been busy to say the least and a 36 hour day would certainly help on getting the posts out. Several companies of mine are selling, financing or working on strategic partnerships. This combined with travel soccer tournament season with the kids and I am no longer master of my life.

That said, as many of you saw on Friday, Google formally announced its acquisition of FeedBurner. I wanted to take this opportunity to thank the founders (Dick, Eric, Steve & Matt) as well as the rest of the management team (Charley, Rick, Brent, Joe, Chris, Don, Eric, Traci & crew) for a great ride. Usually, in the venture world, investments hit near death experiences before sky-rocketing to success. (some also jump into longer-term death status). FeedBurner came out of the shoots on fire and never looked back. In addition to being one of the best financial deals we have ever done, the FB team was one of the most enjoyable to work with. They were always proactive in identifying both opportunity and issues as well as laying out well-thought through solutions. Other words that come to mind are ethical, open, thoughtful and efficient. The community of users and commentators also seemed to share the same enthusiasm for the team and its approach. This drove much of the viral spread of the business. Note to other entrepreneurs: create a better product, iterate frequently to stay ahead, reach out actively & be responsive to your user base and don’t be arrogant asses.

Gang…I’m gonna miss our monthly board meetings but thanks for a great ride!

This post is directed equally towards 1) entrepreneurs trying to figure out how we value companies and 2) regulators, auditors and such trying to get true market pricing for our assets.

I was recently talking with Eric Nath who is one of the more forward thinking appraisers. We were discussing the mess that all of the new regs and guidances have created in some of the more illiquid asset classes. As discussed in recent posts, the venture industry has an issue on its hands because it is an imprecise world being forced to use precise valuation tools. Many would say that it is about time that we came out of the stone age and accepted more responsible, transparent methods. Furthermore, our industry group, NVCA, has embraced the new valuation recommendations.

So, if we are to join the 21st century on valuation, we need to do two things…determine the discount rate and apply it to our expected cash flows. We should be able to use CAPM to determine our discount rate. However, I don’t know of any public segments that enjoy 50% failure rates and 10% wins in the 8-10x range. I am certain that there is a beta hidden in there, but efforts to bake this into Black-Scholes models have resulted in both divergent and surreal results. So, CAPM has generally been ignored for early stage VC. Next, groups have tried to replicate how VC’s think and back into rates. Early Stage VC’s target 10x return on capital in 3-7 years and Late Stage VC’s target 3-5x in 2-3 years. However, you get massively different IRR’s depending on your scenario (timing & multiple) that look like:

        * Early Stage VC is 10x in 3-7 years
            — at 3 years, this is a 115% IRR
            — at 7 years, this is a 39% IRR
        * Late Stage VC is 3-5x in 2-3 years
            — at 2 years with 5x, this is a 124% IRR
            — at 3 years with 3x, this is a 44% IRR

So, if you average these out, you get roughly an 80% IRR for early stage deals and an 84% IRR for late stage deals. This is a pretty high discount rate and a pretty large range for the IRR’s. Furthermore, if you ask most Late Stage VC’s, few will tell you that they are targeting an 85% IRR. So, I am not certain how you use even our own words to back into the discount rate.

Let’s say that we have figured out what discount rate to use (80%???). All we need to do is apply it to our cash flows to get a present value. The good news is that late stage VC’s should have enough history and profitability in their deals that they could look out 2-3 years and have some confidence that they are in the ballpark. However, their early stage brethren are not so lucky. I don’t know any of our early stage companies that can accurately predict revenue (or CF) more than two quarters out let alone guessing at 2-3 years. Most plans we get from entrepreneurs show massive hockey sticks that rocket to $100m+ in revenue by year 5. Most companies are fighting to get over $20m by year 5. Furthermore, if you formally tracked the accuracy of these five year forecasts, you could drive a truck through them. For the 50% of deals that die, revenue might never get above $2m and for the breakout deal, revenue could be north of $100m or it could get its valuation based on number of members, subscribers, etc but only have revenue below $20m. Either way, the gap is tremendous with year 3 cash flow swinging from -$12m to $15m (or more in either direction). Two companies could look like:

Cash Flow                               Year 1        Year 2        Year 3
Company One                        -$10m        -$12m        -$15m  (increasing due to scaling costs but poor revenue)
Company Two                        -$2m           $2m         $10m (linear traction and growth)

If you apply any discount rate to Company One, you get a negative value and if you apply 40% versus 120% to Company Two, you get a huge different in value.

So, you see the magnitude of the issue. Even by our own standards, the applied discount rate range is enormous due to uncertainly around the timing of the exit. You can use an average, but the standard deviation is massive and would lead to massive mis-pricing for everything other than in the middle of the bell curve. We also have significant uncertainty around the actual cash flows.

It is possible that I am overlooking some clear analogy that would result in a straight forward methodology. In fact, I would pay significant money to any appraiser or regulatory who could help us get visibility around future financials. I don’t enjoy reporting bad news to my partners any more than accountants like imprecise methods. This would save us tremendous heartache post-investing. You have my email above and the comments section below…our phone banks are open and awaiting your calls.

I posted last week about the consolidation of the venture capital industry. Whitney Tilson recently pointed out that this is also happening in the hedge fund world. LP’s will increasingly gravitate towards brand where they also have the added benefit of being able to deploy larger sums into larger funds  (versus a lot of smaller allocations). This creates an interesting barrier to entry for new, emerging managers.

Big Hedge Funds Get Bigger, Leaving Less for Small Rivals
By GREGORY ZUCKERMAN
April 19, 2007; Page C1
The largest and best-known hedge funds are elbowing out their smaller and newer rivals for the cash pouring into the business.

The change is making it harder for smaller funds to attract deep-pocketed investors and is reducing the temptation for some Wall Street stars to leave to start their own funds.

Firms like D.E. Shaw & Co., Fortress Investment Group LLC, Farallon Capital Management LLC, Och-Ziff Capital Management Group, Tudor Investment Corp. and Citadel Investment Group LLC now manage between $13 billion and $31 billion each. At the beginning of 2004, each of these firms had less than $10 billion.

The 100-largest hedge funds now control about 70% of the money in the hedge-fund world, up from less than 50% at the end of 2003, according to Morgan Stanley’s prime-brokerage unit, which caters to funds. And the 300 hedge funds with $1 billion or more control about 85% of all the money in the business.

Many of the biggest hedge funds are examining public offerings of their stock, hiring employees from smaller firms and taking steps to try to transform themselves into organizations that can rival Wall Street’s investment banks. But despite a deluge of cash that continues to come into the business, many smaller funds — even those with top pedigrees and enviable track records — are finding the environment more challenging. Last year, new hedge funds raised $10.5 billion, well below the $18.7 billion they were hoping to bring in, according to Morgan Stanley.

"Larger, longer-established funds are increasingly capturing capital — squeezing smaller funds and making it difficult for new start-ups to raise capital," says Robert Discolo, managing director at AIG Global Investment Group, a unit of insurer American International Group Inc. that invests about $8 billion in hedge funds.

As recently as five years ago, the largest funds didn’t attract that much more money each year than their smaller competitors. Instead they usually relied on stellar returns to expand their firms. Investors are moving to bigger funds because their bulk often can create advantages like lower trading fees and financing costs and better risk management. These funds also are providing investors with a variety of trading strategies, becoming one-stop shops. Some of the biggest funds also are expanding because they have been able to generate enviable returns.

For example, funds managed by Citadel, Farallon and Fortress generated returns of 20% or more last year, according to investors.

But blowups at huge funds, such as last year’s heavy losses at Amaranth Advisors, a multistrategy fund handling $9.2 billion at its height, are reminders that big doesn’t always mean best.

Some academic research suggests the best returns come from younger hedge funds.

Large funds often have to pass on certain prime opportunities, such as companies with low market values and illiquid debt, because they need to deploy big chunks of cash to create returns that make a difference for their funds.

Still, over the past year, funds with $1 billion that focus on stocks outperformed rivals with less than $500 million by almost 2%, according to Rick Pivirotto, Morgan Stanley’s head of capital introduction, largely because the big funds do a better job betting against stocks.

A new problem for smaller hedge funds: The Securities and Exchange Commission recently proposed changing its rules to require that investors in hedge funds have at least $2.5 million in investible assets, as opposed to $1 million in net worth.

That could reduce the universe of investors who might be interested in a smaller hedge fund.

At the same time, there are some indications that wealthy individuals, who often stick with smaller hedge funds, are becoming less enamored with the entire hedge-fund sector.

When Ralph Rosenberg, a former star at Goldman Sachs Group, launched a hedge fund, R6 Capital Management, last year, he was expected to raise billions of dollars. Even though the firm has generated impressive returns, R6 still manages only about $250 million.

Mr. Rosenberg had expressed hope to some investors that the firm would be bigger because he invested heavily in building the firm.

A person close to the firm says R6 is taking advantage of its size to focus on sometimes overlooked investments.

The biggest reason for the change: Pension plans, endowments and charities have been moving into hedge funds in recent years, and these investors favor funds with extensive rules-compliance and risk-management operations. And funds of hedge funds, which invest in a range of hedge funds and have themselves become much bigger, are focusing on larger funds.

"Today it is institutions that are going into hedge funds, and they’re looking for the biggest funds," says AIG’s Mr. Discolo.

A big, well-known hedge fund also can be seen as a safe choice for investors without much experience in the business.

But don’t shed tears for smaller hedge funds just yet. The generous fees charged by these private partnerships allow even small funds to do well if their performance is good. And while raising money has gotten harder, there are still more investors looking to get in compared with five years ago.

Mr. Discolo says AIG, which focuses on larger funds because it manages so much money, is spending more time lately finding up-and-coming hedge-fund managers at small firms, arguing that there is "more talent out there that is overlooked" as larger funds enamor investors. He argues that more investors could rediscover the attraction of smaller funds.

In fact, some hedge fund managers predict that institutions investing in brand-name hedge funds will move to smaller funds after they have developed sufficient knowledge of the business.

The shakeout and consolidation in the venture business continues forward at a strong pace. Brand and scale are increasingly driving success. The larger the venture firm, the greater the in-house domain expertise and the wider the breadth of deals in each vertical. In an effort to simplify the guessing involved with picking funds, institutional LP’s continue to flock to brand name funds. Just last year, Oak and NEA accounted, by themselves, for 20% of all capital raised.

In a recent San Jose Business Journal article, VC Funds Find Size Matters, they write:

"In the first three quarters of 2006, funds under $100 million captured
the least amount of capital in the 14 years that VentureOne of San
Francisco has collected such data. Once the norm, these investment
pools garnered just 29 percent of the $19.6 billion that has poured
into the asset class so far this year. In addition, the median fund
size has ballooned to nearly $200 million today, a far cry from a
decade ago when $81 million was the median."

This is not a surprise to me given that nearly every other asset class has seen a number of major Brands arise at the top end, an array of focused boutique firms on the low end and the middle market generally getting squeezed out of the business. This has happened in mutual funds, brokerage firms, insurance and is starting in Buyouts and Hedge Funds.

 

My father-in-law was on Wall Street for over 30 years. He once showed me a tombstone page from the late 1960’s with over 65 different small or mid-sized brokerage firms. This number winnowed down during the 1970’s and 1980’s. Globalization hit and firms were forced to merge to get international scale. Today, you have a handful of brand name firms like Goldman, Merrill and such as well as an array of boutiques.

Humans are creatures of habit and tend to drift to Brand. If in doubt, go with the brand that you know or have heard of…Fidelity mutual funds, Merrill Lynch Private Banking or AIG insurance. If you are an entrepreneur, there are a handful of funds that most will put on their list such as Sequoia, Kleiner, Benchmark, DFJ and such. They then add to the list other groups that they may have heard about from publications or from associates. Likewise, if you asked most institutional investors what funds were on their approved hit list, you would often see the same 20-30 names come up time and again. As a result, these funds are oversubscribed time and time again.

Scale plays a key role in the venture business. With more partners and more deals in the portfolio, a larger fund will have a deeper array of resources and domain expertise to draw from. They can also write big checks and play lead regardless of raise amounts…this puts them in the Alpha Dog role. If a group has had two or three successes in a given vertical, they not only get a reputation for their actitivity in that sector, but they also have access (or know where) to more resources, teams and companies in it. They know the scuttlebutt in the industry, are plugged into its inner circles and have "alumni" CEO’s from past deals that are at the heart of these sectors. Entrepreneurs like being backed by the investor(s) behind XYZ Corp (say Google)…call it guilt by association.

These firms are now raising $500-800m funds with the later stage guys (TCV, Menlo, etc) raising $1-2B funds. You also have new funds spinning out from these brand groups raising $150-300m funds. LP’s view them as an extension of the mother fund they spun out of. Because many of the LP’s also have the 10/10 or 20/10 rule (need to put out at least $10m and don’t want more than 10% of the fund), they are limited to $100+m funds and $300-500m is even better since they can get more money deployed while also having more co-investors in the boat (how can this fund be bad if there are 20 other major LP’s…right?).

However, the sub-$100m fund is getting squeezed. You have either $30-50m high networth funds or possibly $75-100m specialized funds, but by and large, LP’s are focused higher up.

Ironically, the larger funds have not historically performed as well as their smaller brethren. Large funds need to deploy larger sums per deal. However, if anything, the exit valuations have been contracting due to the weak IPO market.

"Historically, these firms, which typically do seed rounds and A rounds,
have outperformed large funds. At 10- and 20-year horizons, early/seed
stage VCs returned at 36.9 percent and 20.5 percent respectively,
according to data from NVCA and Thomson Financial. By comparison, later
stage VCs, typically bigger, returned at 9.5 percent at year 10 and
13.7 percent at year 20."

So, consolidation will continue in the industry while returns will compress. Many funds will be forced to move later stage or out (Summit started as a VC firm and is now predominantly a buyout/late stage shop). New fund groups will arise on the lower end to target the "abandoned" seed stage, but the total dollars there will continue to be dwarfed by the bigger fund efforts.

Google announced this morning that it would acquire DoubleClick for $3.1B. This is quite a windfall for Hellman & Friedman who took the company private in 2005 for $1.1B. DoubleClick has always been one of the premier assets on the internet and after it went public, saw its fortunes decline due to poor management. I always thought that it would be a classic buyout opportunity given its franchise and cash flow combined with a need for rational management to take over. Well, H&F righted the ship and enjoyed an online advertising bonanza which lead to a very nice exit for them. These days, while their bubble inflates, the buyout guys have it coming and going (even in the tech world).

"Something wicked this way comes…"
  — Ray Bradbury

We have just survived our annual audit season and it is clear to me that things are going to get increasingly murky, confusing and ugly for valuations in the venture capital world. For those of you not well versed in the intimacies of the portfolio company valuation methodologies, I’ll give you a quick overview.

As the SEC and accounting worlds continue to dig deeper into our post-SOX world, they are trying to find more appropriate ways to mark investments to market. Traditionally, VC’s have kept their investments at cost until a third party transaction (financing, sale, etc) has indicated a change in value. Conservatively, VC’s have marked investments down (say 50% of cost or $1) if they believed the investment was impaired. So, we pro-actively took write-downs and only took write-ups when a clear market transaction occurred (no guessing if something felt like it was worth more).  First the accountants targeted the publicly traded companies with their efforts in the hopes of avoiding the next Enron debacle from hidden factors. Then they started to look at privately held businesses owned by buyout shops. These firms usually have cash flows, predictability and clear public market comps. Now, they are turning their guns on the venture market and it is not going to be pretty.

In September, 2006, FASB published SFAS 157 (Statement of Financial Accounting Standards) with the goal of establishing a framework for measuring fair value. PWC drafted a nice 4 page summary (Please Welcome SFAS 157…). It defines fair value as:

"the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date."

Okay. How do you expect this to work for the venture world? They give more guidance…use one of three helpful approaches: market, income or cost. So let’s see how these work.

Market Approach: observable prices and information generated by market transactions. Huh?? So, three video sharing sites are launched. One gets a $75m pre-$ valuation because of some traction, brand name VC’s and such. Another gets a $20m valuation because it doesn’t seem to have the buzz of number one and a third one struggles to get a $2m valuation. You tell me which is the right comp. As I wrote in my post, The Black Art of Deal Pricing, valuation techniques for VC is art and has even alluded the academics who can’t get CAPM to work.

Income Approach: thank goodness. This one works well for PE deals. Figure out the profit/EBITDA, etc, determine market comps and voila, you have your answer. Wait, what do mean these companies don’t have earnings? What, you say many don’t even have revenue? And, the comps range from 10x EBITDA to 100+x EBITDA? What about DCF…can’t predict cash flow? Okay, let’s use Black-Scholes pricing…too volatile and no clear market comps?

Cost Approach: this one has to work. All you have to do is figure out replacement cost. Isn’t that just a couple of servers, some labor and a website? How could the VC’s possibly pay $25m pre-$ on this one when replacement was only about $1 million? Okay, these weren’t too helpful…maybe there is another way.

On top of the fact that none of the traditional valuation approaches work well here, you have the quantum issue with early stage companies. They are many different states concurrently at the same time depending on who is doing the looking and how much Coolaid is in the glass. Let’s say you have a company burning $300k/mo and has $600k left in the bank. What is that company worth? Well, if it can raise capital in time, it can close x, y & z deals, get to breakeven and you’re off to the races. However, if it can’t raise the capital, then you are selling servers and office furniture. This creates a rather boolean and Draconian gap in just the next two months. If you feel good about how things are going with the raise, then you are more likely to price closer to the likely term sheet valuation. If you aren’t, then you take it to a $1. Have any of you entrepreneurs ever been able to guess where your term sheet was eventually going to come in? Could be anywhere from $30-60m depending on how the senior partners are feeling that day at the partners’ meeting.

So, we get to sit down with our auditors and go through this drill for everyone of our companies. We have always said that we have no idea how the market will received certain developments or milestones. Is the sector hot (couple of big exits) and VC’s are climbing all over each other or is it stone cold? Does management wow investors or leave them unimpressed despite a solid underlying business? Has the market inflected or is it just a head fake? Does the technology scale or can we only make a couple million dollars worth?

Better yet, if the reporting date is December 31st, but your audit is April 10th, the auditors now want you to apply all information you know as of April towards figuring out December 31’s value. So, your company receives an acquisition offer in January or February. Clearly, the firm had much of that value in December as well. So, use the Feb acquisition price in December even though the deal might still fall through.

Please let the venture world go back to the old ways. They are more conservative. We subjectively mark down our assets and will only mark them up when we get a third party transaction. Don’t make us do mark-ups based on imperfect comps or implied future transactions. I remember my physics teacher saying: you can’t multiply an imprecise number with another imprecise number and get anything but a really imprecise result. And please do not make us do $10,000 appraisals on each of our companies each year ($200-300k cost per fund) just to check your SFAS 157 box…