Friday, September 12, 2008

Values suffer as VCs focus funds inside

By Christopher Calnan

It’s taking venture capitalists longer to cash out of startups, causing firms to invest more in their own portfolio companies than in new deals, data shows.

The increased use of so-called inside rounds, in which no new investors join in a private equity funding, not only means less capital for entrepreneurs seeking first-time funding, but also means tech startups are having a harder time determining a current valuation because a company’s valuation is often recalibrated as new investors join an investment round.

Experts say a vicious circle is being created as a result: An accurate valuation is critical in making a merger or acquisition deal happen, but with no new investors, most potential acquirers are taking a harder line on what a potential acquisition is truly worth — and that is slowing M&A deals, industry experts say.

By midyear, the number of financings of New England-based venture-backed companies completed as inside rounds had risen 5 percentage points (to 31 percent) since 2002, according to Dow Jones VentureSource. At the same time, the median time to liquidity (either initial public offering or M&A) for venture-backed companies nationally hit a record-level seven years as of the first half of 2008. And the median amount of capital raised by companies before an M&A reached $22.2 million versus $14.9 million in 2001.

Such conditions are creating a chasm between buyers and sellers, said Jonathan Karis, chairman of Boston law firm Nixon Peabody LLP’s venture and emerging growth company practice. He’s seen five M&A deals fall apart this year after opposing sides couldn’t agree upon a price.

“Big (acquisitive) companies know there are not a lot of options,” Karis said. “They’re able to hang tough on evaluations.”

Inside’s upside?
Of course, the lack of new investors in such deals avoids early-round VC investments from being diluted. But they also prevent portfolio companies from getting the highest prices possible for limited partners, said Mike Fitzgerald, general partner of Waltham-based Commonwealth Capital.

“It has a huge implication on returns,” he said.

And losing out on a current valuation with an inside round is worth the long term gain of getting the company ready for a higher valuation in a future funding, said Bob Iacono, who until July held both the COO and CFO positions for nearly five years at Sepaton Inc.

“It’s very much a trade-off,” Iacono said.

In July, the Marlborough-based tapeless backup developer completed a $6 million add-on round of investment to supplement a $22 million Series E funding it closed in 2007. Boston-based HarbourVest Partners LLC led the inside round of financing, just as it did with last year’s funding.

The financing was completed to fuel the company through the release of a new product. And doing it without new investors made it faster and less disruptive to Sepaton’s management team, HarbourVest vice president Ian Lane said.

But Lane acknowledged that outside investors are an important part of the process. “To get an objective valuation,” Lane said, “you need a new (investing) party.”

In addition to affecting the valuation process, inside rounds may be affecting the life of fund reserve accounts, or the capital set aside for follow-on financings, industry observers said. Such funds are running low on capital as the time it takes for investors to cash out of deals grows longer.

Eight years ago, it took less time — and less capital — to bring a startup to the point where investors were able to cash out. Investors need to adjust to a new way of investing, observers say.
“Being a VC is totally different than it was 10 years ago,” said Peter Falvey, managing director of Revolution Partners, a Boston-based investment bank. “There’s a lot of anxiety out there.”