The Venture Capital “Reset” – We Were Expecting You
Venture capital fundraising declined in 2015, with total money raised down more than 9 percent and a 13 percent decrease in the number of fund closings. And Q4 2015 brought a loud message, with funding down 30 percent and deal counts down 13 percent versus the previous quarter, falling to a level not seen since the beginning of 2013. About one-third of the new funds were first-time funds, comparable to previous years. As most predicted based on second-half 2015 trends, venture capitalists invested more money in fewer but larger deals, which continued a trend we’ve seen in the past few quarters. Of course, this “reset” is familiar ground to seasoned entrepreneurs building startups, and once again they will have to reduce spending, cut staff and focus on the bottom line. http://www.bloomberg.comd/news/articles/2016-01-12/tech-funding-slowdown-hits-venture-capital-firms. Late-stage companies continue to take the lion’s share of venture dollars (although, as discussed below, late-stage funding should decline), and early-stage companies will feel the crunch (although, also as discussed below, perhaps early-stage deals will become a larger piece of the venture capital pie during the expected slowdown). Venture funds will likely get more favorable valuations and terms in light of liquidity concerns, and they will certainly do more due diligence on companies.
All said, venture capital will continue to be a popular investment category, but venture capital deal numbers and dollars have likely peaked, if not plateaued. Despite the dominance of large venture funds and mega deals, the resilience of angels, angel groups and other seed investors has continued to be noteworthy. Pitchbook suggests that “the pre-seed and seed financing market has diversified and deepened, with a surge in competitors looking to put money to work ... while seed investors are likely to dial back their investment paces more in 2016, so activity should diminish by a fair amount.” Pitchbook Data, Inc., VC Valuations + Trends, 2015 Annual Report. It remains to be seen how much seed and Series A financings could decline in 2016, but certainly the competition for dollars and pressure to distinguish one’s company from the field will intensify.
We have frequently observed the unprecedented impact of “tourist” VCs, including corporate venture arms, hedge funds and mutual funds. The latter two are already pulling back, but it seems unlikely that corporate venture arms will, given their non-financial, R&D-oriented investment objectives. Pitchbook Data, Inc., VC Valuations + Trends, 2015 Annual Report.
“So what will 2016 bring? Discontinuity, as old trends die. And new beginnings: more than ever, entrepreneurs and investors will need to look at a broader field of industries and business models and discard received wisdom to capture the emerging opportunities. One thing is clear: lather/rinse/repeat is not promising .”http://www.forbes.com/sites/toddhixon/2016/01/04/the-venture-investment-outlook-for-2016-discontinuity-and-new-beginnings/#f59eb6843cbf.
Campbell Soup Launches Food Startup Fund – New Corporate Model?
Campbell Soup Co. is starting a venture capital fund, Acre Venture Partners, to invest in food startups. A Campbell subsidiary will be the sole limited partner of the fund and the fund will be managed by an outside partner. This is a different model from the typical internal division, corporate-controlled venture arms, including those formed by other food and beverage industry companies such as General Mills Inc. and Coca-Cola Co.
Venture capital funding for food-related startups has exploded, with $4.6 billion invested in agriculture technology in 2015, up 95 percent over 2014. Niche consumer markets have helped, from organic, sustainably grown, local, and farm-to-table solutions, to allergy-friendly and antibiotic-free products.
Healthtech Investor on a “Mission” – Neither VC Fund Nor Corporate VC
Ascension Ventures is a subsidiary of Ascension, the nation’s largest nonprofit and largest Catholic health system, which operates more than 130 hospitals. Ascension Ventures was created 15 years ago, driven to help transform healthcare during a time of regulatory and reimbursement changes in the industry. AV has eight health systems as limited partners, investment in more than 50 companies, and $550 million in assets under management across three funds.
Ascension is “mission-” as well as return-oriented, as it and its limited partners are nonprofit health systems dedicated to helping their communities. We have often discussed the critical importance of an investor’s knowing the verticals in which it invests. Ascension gets to see healthtech companies in action and in real time, as many of them serve its hospitals. It should be more astute than a financial investor at identifying companies whose products and services improve patient treatment and outcomes while bringing healthcare costs down through enhanced efficiencies.
Ascension’s portfolio companies include Syapse, a provider of clinical decision-support and workflow tools to community hospitals, and Zipnosis, a telemedicine company.
The Nation’s Capital of VC: Silicon Valley
In our previous “VC Hubs” segments we have endeavored to showcase venture capital activity outside of the Silicon Valley. But we think it’s high time to acknowledge the dominance of the Valley and its importance in predicting trends and shifts in venture capital fundraising and investing.
In light of the apparent venture capital downturn, we read The Silicon Valley Venture Capitalist Confidence Index, a quarterly survey of San Francisco Bay Area/Silicon Valley venture capitalists authored by University of San Francisco School of Management professor Mark Cannice. The survey reports the opinions of venture capitalists about the venture entrepreneurial environment in the Bay Area. In the Fourth Quarter – 2015 installment of the Index, Cannice reported that the index indicated a Q4 2015 improvement in optimism over the prior quarter, after three quarters of declines. However, the report acknowledged that the index was still low in terms of historical averages, due primarily to value and public market concerns.
Among the quotes from several high-profile respondents:
“We will see a pullback in late stage financings and even some layoffs, but the long-term value proposition of technology driven change remains intact. Caution ahead!” − Venky Ganesan of Menlo Ventures
“Still, there is plenty of room for creating real value and building great companies. We just need to adjust expectations.” − Bill Reichert of Garage Technology Ventures
“The explosion of research, corporate investment, partnering and innovation relating to connected/autonomous vehicles (drones, cars, trucks, factory automation, etc.) will continue to stimulate and broaden venture investment in Silicon Valley.” − Mark Platshon of Birchmere Ventures
“Eplatforming of IT to cloud, mobile and big data solutions will continue to lead to a major shift in market cap from the legacy vendors to a new generation of platform leaders and creating tremendous opportunity for startups. The Bay Area remains the epicenter of this activity where the most talented engineers and executives around the world continue to gravitate. There is pressure on later stage valuations and capital excess which we believe will lead to a return to focus on more capital efficient models of funding startups which aligns interests and will lead to more positive exit alternatives.” − Jeb Miller of Icon Ventures
A new down cycle in venture capital investing will certainly not impact Silicon Valley’s place atop the VC Hub hill. In fact, the U.S. venture capital industry will, once again, rely on Silicon Valley to guide it through a VC “reset” and continue improving the VC investment model. We are especially glad to read that some Silicon Valley players predict the Unicorn and mega-deal excesses, and decline in late-stage VC, may actually move money to the early stage.
With Apologies – Cybersecurity, Part 2
Cybersecurity was the focus of our last “VC Verticals” and we could not resist showcasing it again. As compared with other VC darlings, from software, to mobile and digital healthcare, and even food and edtech, companies selling cybersecurity solutions are addressing what many view as the biggest threat to our safety, our infrastructure and even our national security – cyber attacks.
Last summer, CB Insights identified the major venture capital investors driving early-, mid- and late-stage investment in cybersecurity, and the numbers are incredible. Intel Capital is an active mid- to late-stage cyber investor. Accel Partners is the second-most active investor in cyber startups. Kleiner Perkins is the most active mid-stage cyber investor. Sequoia Capital and Andressen Horowitz are also cited by CB Insights as among the top five most active investors in the space.
Big VC fund plays within a vertical usually result in the creation of more startups and more investors. Cybersecurity companies should be natural strategic targets for large technology companies, thus making their exit prospects good even when the IPO market is closed. Like addressing the complex needs of the energy industry, defending against cyber attacks will be a never-ending task demanding an “all of the above” response. As a result, new innovations will create new startup companies, many of which will have low-cost operating models. Competition and innovation in this critical sector should make it a new VC darling going forward, perhaps overtaking some of the old favorites.
Investor Due Diligence: Make it an Asset for Raising Capital and Maximizing Your Valuation
Most of our VC Tips discuss planning steps that can benefit company founders, management and friends and family investors by avoiding legal troubles or tax problems. But attention to legal details can also be the difference between raising capital at a fair valuation or failing to do so at all. Too often, cash-strapped startup companies cut corners or put legal housekeeping off until cash flows will help pay the legal bills. But many best practices in legal housekeeping can be more cheaply addressed sooner rather than later. More important, a company that prepares in advance for investor due diligence – the dreaded “look under the hood” that follows the term sheet – will best position itself to close a financing at a fair valuation. Call it “dressing your company for success” – if the investor is impressed with your company’s attention to detail and your investment of time and attention in putting your legal house in order, you will more likely close, and more likely close more quickly, and at a higher valuation.
More often than not, it’s better to get it right the first time. We’ve seen countless situations where a startup cuts corners in its initial go around − documenting stock issuances with founders and service providers, addressing tax issues relating to equity awards, and the like − only to have to spend much more money later on to clean things up. Or, worse yet, being unable to secure venture financing because of investor concerns over poor documentation of equity holdings or failure to address tax issues. We’re often reminded of the Midas Mufflers commercial: “Pay me now or pay me later.”
Here is a sample of the areas in which you should clean things up now and be better prepared to raise money, especially in a more challenging venture capital market.
- Cap Table and Supporting Legal Documents. Consider how you can clean up your ownership records and capitalization table, which should list all stockholders or members, all option and warrant holders, and all convertible note or debt holders. It may make sense to get rid of the notes or debt, perhaps by requesting that the holders convert to equity. But it is equally important that all stockholders and option holders have signed stockholder, subscription, option and other appropriate agreements with which an investor will be comfortable. Attention to detail is critical – have all stockholders and option holders signed appropriate documents? Are they consistent with the cap table? Is the current cap table optimal in terms of raising capital, or should there be changes to make the company more appealing to an investor?
- IP Minimums. Register your company’s trade name and logo as a trademark if it has market value. Have all employees and, more important, independent contractors, developers and consultants sign appropriate inventions assignment agreements. Your company’s trade secrets and other intellectual property are protected by trade secret laws only if you have taken reasonable steps to protect them. Make confidentiality, use of personal computers and devices, and protection of customer and other company information a core part of your company’s culture, from the top down. Registration of trademarks and patents will depend on your company’s business, but employee and contractor agreements and a stated policy regarding confidentiality and data privacy have become the minimum standard for all businesses, and investors care.
- The New Due Diligence Priorities: Data Privacy and Security and Foreign Customers. For most technology companies, but especially for SaaS and other companies that may possess personal customer information − including credit card, personal and healthcare information − we now live in a world where data breaches can kill a company. Sophisticated investors, especially those investing in companies that accept credit card information, healthcare information and other personal information in the conduct of their business, are very concerned about data security risks. If your company develops a data security policy and establishes supporting procedures and systems to protect personal information, and it educates itself about both U.S. and foreign country laws governing data privacy and security, you will not only reduce the risk of data breaches, but will impress investors that you know what you are doing. Many SaaS companies may also need to insure compliance with laws and regulations governing exports and restrictions on doing business with certain foreign countries. We have encountered this with most SaaS companies with which we have worked.
Expect a due diligence request list from sophisticated investors that asks many questions. What types of data does the company collect from customers and what is its purpose? Do you have a data privacy and security, and an information security, policy? Does the company have an access control policy, use encryption and have an incident response program? If applicable, please provide a summary of all HIPAA compliance requirements and processes for such compliance, as well as copies of all business associate agreements related to HIPAA compliance. These questions will be the tip of the iceberg. So ask your counsel to provide you with a comprehensive data security due diligence checklist so that you can be prepared for the new world!
- Human Resources. Make sure your employee manual is up to date and in compliance with applicable law. Confirm that your payroll and employee benefit plans are properly administered by people who understand the laws relating to withholding taxes, overtime and welfare and retirement benefits. Review your classification of any personnel or service providers as independent contractors versus employees. Many startup companies incorrectly classify employees as contractors. If you have non-U.S. citizen personnel, obviously you need to confirm that your immigration law house is in order. The consequences can be expensive.
- Is Your Software a Big Component of Your Value? So many companies are essentially SaaS companies. And they are favorites of venture investors due to their lost-cap-ex and infinitely scalable business models. But the development and contents of your software can truly come back to haunt you when raising venture capital or selling your company. Venture capital investors are focused on what the ultimate buyer of your company, and their legal counsel, will investigate as part of their later due diligence. Perhaps the most significant part of an investor or buyer’s due diligence of a SaaS company, after basic business and financial due diligence, is a deep-dive analysis of the company’s software to confirm that it does not present legal risks associated with the use of open source software in development or otherwise. Many investors and buyers will have a third-party software audit firm like Black Duck do an intensive review of the software to verify the quality, functionality and proprietary ownership of the source code. The smartest founders will seriously consider having such an audit, at least as to open source and related risks, conducted before an investor’s due diligence begins. This can save significant time and, again, will impress the investor that company management knows what it is doing.