VC Seemed Strong; Reports of Q3 Slowdown Reveal Different Views
We’re in for some good news/bad news reporting here. The good news is we’re not going to inundate you with more election data. And the other good news is that Q3 2016 was the 11th consecutive quarter with more than $10 billion in VC investments. The downside here is, according to the MoneyTree ™ Report from PricewaterhouseCoopers LLC, total VC spend was down 32 percent and deal count down 11 percent compared to Q2 2016, and down 36 percent and 25 percent, respectively, compared to Q3 2015. $10.6 Billion in Venture Capital Deployed to Startup Ecosystem in Third Quarter, According to MoneyTree Report, https://www.pwcmoneytree.com/NewsFeed.
The report attributes the decline to a “normalization process that is expected after a quarter in which record-breaking investments dominated headlines.” Software and biotechnology are at the top of industry verticals receiving VC in Q3 2016, although the dollars and deal counts for each were down. The report notes that seed, early- and expansion-stage investments were also off, but late-stage investments were up, continuing past trends as investors hedge their bets on riskier startup companies. Another report agrees that VC investment has markedly decelerated, but also points out that 2016 is still on pace to be the second-most active year in the past decade.
A national downturn in VC activity hurts the cities that are strong during robust VC markets, but, as we’ll discuss below, does not necessarily hurt up-and-coming VC communities. Venture capital investing hits 99-year low in Maryland, http://www.baltimoresun.com/business/bs-bz-moneytree-report-20161013-story.html; Austin startups feel the chill as venture capital investments drop, http://www.512tech.com/technology/austin-startups-feel-the-chill-venture-capital.
Other reports are more bullish, suggesting that, while VC investment slowed in Q3 2016, “estimates reliant on data available at quarters’ end overstate the extent of early stage declines.” Crunch Network, Early stage VC holds up (even as late stage plunges), https://techcrunch.com/2016/10/24/early-stage-vc-holds-up-even-as-late-stage-plunges. That report suggests that seed-stage VC investment held up as compared with the last quarter and Q3 2015. Latest Data Show Venture Capital Industry on Pins and Needles, htty://www.xconomy.com/boston/2016/10/25/latest-data-show-venture-capital-industry-on-pins-and-needles.
So where does that leave us? Our experience is that venture capital investors continue to be active in the seed and early stages, particularly for promising startups in the internet and ed tech, fintech and healthcare arenas. So, perhaps some of the negative outlook could be based on premature data and overstating a drop in later investment while understating seed- and early-stage numbers. And maybe some of what we’re seeing is a healthy leveling, with some noting that “boards and management teams recognize it’s not in the best interest to keep raising money at an unprecedented pace ... It’s time to actually get a return on equity.” Venture Financing in Early-Stage Deals Continues to Cool, http://www.law360.com/privateequity/articles/858607/venture-financing-in-early-stage-deals-continues-to-cool.
An Underrated Startup Company Advantage: The Second-Time Founder
Much of the data on VC activity comes from polls of institutional investors. But many smaller seed- and early-stage venture capital deals are never reported. The beneficiaries of many of these investments seem to be companies founded by entrepreneurs who have already built at least one company in the same or a similar industry vertical. Examples include client startups in life sciences, healthcare information technology, education technology, financial technology and the industrial internet of things, with a common thread of companies that focus on collecting, interpreting and leveraging large amounts of data. Entrepreneurs who have already started, grown and exited companies with these attributes — particularly in heavily regulated spaces like healthcare, education, energy and financial services — are much more likely to raise a seed or Series A round.
Of course, strong business plans that show a clear path to profitability are also strong candidates for early financing. Early-stage angel and family-office investors particularly like those who can achieve goals without multiple financing rounds. Many founders of these companies wisely develop strategic partner and large-customer relationships early, primarily on the basis of the solution and cost-effectiveness provided by their products or solutions. Their biggest customer prospects quickly become potential follow-on investors and even company buyers. And the most intriguing startups find solutions for middle-market customers who cannot afford to build their own IT solutions.
Wall Street Journal: “New Silicon Cities” Attracting Techies
Consistent with one of our themes over the past few years, the Wall Street Journal recently reported that smart technology executives continue to move to university-based and quality-of-life towns. Take the example of a Mountain View, California, director of customer care and education of an online-gaming company who moved to Richmond, Virginia. He found that Richmond had a similar vibe to San Francisco and “little technology companies scattered throughout.”
The article notes that “tech jobs are multiplying across America, attracting executives and entrepreneurs drawn to lower living costs and a slower pace of life.” Examples include Eugene, Oregon; Manchester, New Hampshire; and Huntsville, Alabama. Most of these locales have startup communities supported by “regional offices of large tech firms and major universities or research centers.” Entrepreneurs in search of a better quality of life are starting to choose cities like Richmond, Virginia, over Washington, D.C.; Huntsville, Alabama, over Austin, Texas; or Manchester, New Hampshire, instead of Boston. Wall Street Journal, November 4, 2016, M1.
While the article emphasizes home costs, it is clear to us that a growing number of executives and entrepreneurs have figured out that the world is truly flat and that most of us can work virtually from anywhere in the country. VCs are following this young talent and are helping build VC infrastructures in Main Street college towns.
Eventually, the influx of technology entrepreneurs to these smaller towns demands airport upgrades and higher home prices. Although quality of life is threatened by economic growth, that evolution provides economic opportunity for many who were left out of the prior century’s migration to San Francisco, New York and Boston. While VC downturns expectedly hurt San Francisco, New York and Boston the most, fortunately there are still pockets of good Q3 2016 news for other cities and states that are known for their VC presence. Less cash but more deals last quarter for venture capital in Illinois, http://www.chicagotribune.com/bluesky/originals/ct-chicago-venture-capital-third-quarter; Colorado Sees a Spike in Venture Capital for Third Quarter, http://www.27global.com/colorado-sees-spike-venture-capital-deals-third-quarter; The region’s companies raised nearly $300 million in venture capital in last quarter, https://www.washingtonpost.com/business/capitalbusiness/the-regions-companies-raised-; Venture capital investment rises sharply in Michigan in 3rd quarter, http://www.crainsdetroit.com/article/20161006/NEWS/161009870/venture-capital-investment; MoneyTree Report: Florida’s venture dollars on track to surpass 2015, http://www.sun-sential.com/business/carees/fl-money-tree-third-quarter-report-201610.
Healthcare IT Still Getting Attention
Healthcare information technology is perhaps the greatest example and beneficiary of the convergence of a critical, heavily regulated and costly industry vertical and IT. While VC investment in healthcare IT slowed in Q3 2016 along with VC investment generally, advances in the use of mobile devices in patient diagnoses and doctor-patient interactions continue to attract venture dollars. This is buoyed by the potential for “internet of things” solutions to help healthcare providers and payers better manage and analyze costs and patient outcomes. Healthcare IT solutions continue to enable samples to be taken and analyzed far from the lab, make medical devices smarter and more interactive, enable doctor-patient communication without an office visit, and allow hospitals and other providers to enhance quality of care and patient outcomes and reduce costs.
Healthcare IT is in its infancy and will increasingly compete with pure biotech and software companies for VC dollars. Venture capital investment in HIT remains strong in 2016, http://www.healthdatamangement.com/news/venture-capital-investment-in-hit-remains-strong. While “ed tech” and “fin tech” are similar examples of IT convergence within heavily regulated and data-dependent industries, the consumer, government and commercial markets for IT seem large and more diverse by comparison.
Getting VC Financing Term Sheets Right
Next to the “investor deck” or company executive summary, the term sheet for a VC round is a critical first impression in attracting investors. VC Experts has provided a good summary of the most important VC term sheet negotiating issues on its blog. That term sheet highlights the material terms to be included in the definitive notes or equity purchase agreement and expedites the fundraising process by allowing a startup to “soft circle” investors before significant legal fees are incurred. That said, in our experience, it is critical for the term sheet to be prepared or at least reviewed and revised by experienced venture capital counsel. Terms Sheets: Important Negotiating Issues, nttps://blog.vcexperts.com/2016/11/03/term-sheets-important-negotiating-issues.
Borrowing from the VC Experts blog list, the key areas covered by the term sheet usually include the following, and we provide our own thoughts on their significance:
Company Valuation. Company value is, of course, subjective in the startup stage. Other deal terms — preferred rights of the security being offered, investor preemptive rights, stock option pools, etc. — can be important to bridge that gap. As an alternative, the company can offer convertible notes instead of equity so company valuation and other terms can be deferred to a later date, when the company is receiving a larger funding. However, convertible notes can be especially dilutive of the founders’ ownership percentages if the first equity financing is raised at a lower-than-expected company valuation, if the investors demand a significant discount on the conversion, or the note investors insist on a company valuation cap in determining their conversion price.
Type of Security. Certainly most investors want some form of “preferred” equity that promises the return of their investment before the founders and common stockholders participate in company earnings or sales proceeds. Many investors also want upside, either in the form of the right to convert to common stock or a “double dip” or “participating” feature that entitles them to their money back and then a percentage of the upside on an “as-converted” basis. Startup companies should be mindful of the dilutive effect of “preferred returns” or special dividend accruals and the liquidity challenges of “redemption rights” permitting the investors to demand a repurchase of their preferred equity at some point in the future.
Governance Rights. Many investors will look for special “consent” or “veto” rights over major company transactions such as additional equity offerings or a sale of the company. Others will seek a right to appoint one or more members of the board of directors or at least “visitation” rights permitting the investor to send a representative to board meetings.
Founder Stock Strings. Investors at times insist that the founders’ current shares be subjected to new or additional “vesting” terms resulting in the forfeiture of those shares upon early retirement or termination.
Anti-Dilution Rights. Most preferred equity terms include provisions whereby the investors’ shares will convert into a higher number of common shares if, prior to such conversion, the company issues additional equity at a company valuation that is less than the valuation implied at the time of their investment. Startup companies should seek competent legal counsel regarding the differences between “weighted-average,” “full-ratchet” and “pay-to-play” anti-dilution rights.
Preemptive Rights. Investors usually expect the right to invest additional amounts in future company equity offerings to preserve their ownership percentage. This is usually considered an acceptable request. But care should be taken to exclude certain stock issuances from this right, including grants of employee incentive equity, stock issues in add-on acquisition deals, and issuances of warrants or equity to lenders and strategic partners.
Employment Agreements. Startup companies should seriously consider, prior to an equity raise, not only subjecting their and their fellow employees to stock vesting terms, but also having each employee enter into standard employment agreements, including terms or separate agreements relating to intellectual property ownership, confidentiality, non-solicitation and noncompetition. Having these protections in place not only protects each founder from the actions of other stockholders but also makes investors much more comfortable with their investment.
Liquidity Rights. Many investors will want “co-sale” or “tag-along” rights entitling them to sell proportionately with any founders who sell portions of their shares, as well as “registration” rights in the event of a company IPO.
These are only a few of the standard terms that investors may expect to see. The final terms will depend on the company’s attractiveness and stage of development, and the terms of the financing should be negotiated with future rounds of financing and the company’s exit alternatives in mind. Once struck, the terms of the company’s first “seed” or “Series A” financing can impact the terms of subsequent financings.