The occasion of the annual 409A/123R (short for Internal Revenue Code Section 409A and Accounting Standards Code 718/Statement of Financial Accounting Standards 123R, Share-Based Payment) valuation exercise is likely a less coveted experience. Often seen as a necessary evil, it is full of rules and methodologies that were developed with the aspiration of transparency, but are often less approachable for the typical user. Similarly, purchase price allocation studies (i.e. valuations of intangible assets for ASC 805/SFAS141R, Business Combinations) come with a surprising complexity even for small acquisitions.

In order to shed some light into the world of start-up valuations, The Brenner Group is hosting a seminar for executive management, financial professionals, corporate counsel, and investors to prepare for the valuation process, understand valuation reports, and assess the impact of preferred equity terms on common stock valuation.

Topics Include:

• Taxman v. Auditor:

Commonalities and differences between IRC 409A and SFAS 123R (ASC718), as well as fair market value under IRS regulations and fair value under accounting standards

• How it’s done:

Overview of the valuation process, the common methods for enterprise valuations, and the subsequent allocation between different classes of securities, including the Current Value Method, the Option Pricing Method, and the Probability Weighted Expected Return Method

• What does it mean to me:

Impact of different terms of preferred equity on the valuation of common shares

• Accounting for Acquisitions:

Overview of the assumptions and issues regarding valuation of intangible assets intangible assets in a purchase price allocation for SFAS 141R (ASC 805)

Thursday, July 29, 2010 8:00am Breakfast & Registration 8:30 – 10:00am Session

For in person attendance please register by July 27, 2010 to rsvp@thebrennergroup.com

For webinar register by July 27, 2020 via GoToMeeting for Demystifying Valuations for Venture Backed Companies

For more information: Demystifying Valuations for Venture Backed Companies

Gunther Hofmann is a Vice President of The Brenner Group and has done extensive work in valuations, M&A, venture capital, and corporate finance with significant international experience in small firms as well as global corporations. Gunther earned a Masters Degree in Electrical Engineering and Business Administration from Darmstadt University of Technology in Germany, and was a Visiting Scholar at UC Berkeley. He is a holder of the Chartered Financial Analyst designation, and a member of the National Association of Certified Valuation Analysts. Gunther is Chairman of the Software/IT Industry Group of the German American Business Association (GABA).

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The acquisition will provide discussion fodder for months if not years to come, and we will see if HP can turn Palm into a serious competitor for the iPhones, Androids and Blackberries of the world.

In this post, I will stay clear of any strategic speculation, but rather focus on the process of the transaction.

The proxy statement recently sent out to the shareholders provides some interesting turn-by-turn insights into the transaction. A number of lessons can be learned that are equally applicable to smaller transactions.

How events unfolded

The story starts with a meeting of the Palm Board of Directors on February 17, 2010, where they reviewed operational results. Anticipated revenues for the quarter ending 2/26/2010 were 25% below plan. Anticipated revenues for the quarter ending 5/28/2010 were 63% below plan.

That has to hurt.

The Board channeled its pain into an “assessment of strategic alternatives”, also known as “raise money, license the IP, or sell the Company”. Bring in the investment bankers – in this case Goldman Sachs and Frank Quattrone’s Qatalyst Partners.

At this point, the share price hovers around $9.62 – down but not out from its recent high of $17.46 in September 2009.

On February 25 the Company officially revised its revenue guidance downwards for the current quarter and the current fiscal year. The stock closes at $6.53 the following day and erodes further in the coming weeks to $3.85 on April 6, the day before takeover rumors start.

The bankers and management draw up a list of 24 strategic partners. Between the end of February and beginning of April a total of 16 companies are contacted of which 6 sign a nondisclosure agreement to take a look under the hood. Three of them (“Company A”, “Company B”, and the ultimate acquirer, HP) are invited at the end of March to submit preliminary proposals for a transaction. Two more hover about the fringes (“Company C” and “Company D”).

HP submits its first offer at $4.75 per share on April 13, below the public market share price of $5.16.

Company A came in with a cash offer of $600 million which after preferences would have returned little or nothing to the common shareholders; Company B delivered an unspecified, drawn-out stock deal ; while Company C proposed a cash offer in the range of $6.00 – $7.00 per share with the promise of a fast close. But after taking a closer look, Company C later revised its offer down to $5.50 per share.

Bird in hand, Palm’s CEO and advisors communicate on April 24 to HP and its advisors that, “to remain in the process, HP must improve its offer significantly and immediately”, which they promptly did, increasing their offer to $5.70 per share on the same day.

In the end, Company C did not match that offer, but proposed an alternative transaction under which it would acquire certain patents and take a nonexclusive license to Palm webOS in exchange for a one-time cash payment of $800 million. The Board eventually dismissed the licensing agreement as too dilutive to the value of the overall Company.

The deal with HP at $5.70 per share was announced on April 28.  Prior to the announcement, the shares were trading at $4.63.  The $1.2B offer represents a 23% premium over the price on the previous trading day, and a premium of almost 50% over the price before any rumors of a transaction started to circle.

Unfortunately it also represents a discount of 41% from the time the M&A process was initiated and before the devastating results were announced; and a discount of 67% from the last high in September 2009.

Several lessons can be learned from the process:

1. Start your M&A process early

There are a number of reasons to start the process early, especially in a situation where the company is strategically stalled, as in Palm’s case. Usually the runway is limited, and any delay also restricts strategic options. For Palm, the option to license out webOS turned out to be an inadequate non-starter. Once the bad news is out, share prices fall quickly and any transaction is perceived as a “fire-sale”. Missing the revenue target by over 60% one quarter out qualifies as VERY bad news. So bring in the bankers before you run out of options.

2. The more the merrier

Not all bidders may be the ideal candidate, and any auction in such an environment will inevitably attract bottom-feeders. But a healthy number of participants will keep the auction competitive, make the ideal candidate pay up, and generally force a transaction in a timely manner on the best available terms.

3. Keep key employees motivated

Once a company is on the auction block, employees will consider their options too. It is important to retain  key employees to effectuate a transaction as well as maintain the value of the company. This is especially true for technology companies, where most of the value is intellectual property that is embedded in the workforce. Palm’s Board recognized this early on and approved a Retention Bonus Plan for certain employees on April 1.

4. Cash is king

Somewhat obvious, but in a situation such as Palm’s it is hard for any Board to accept and consider the complexity and value of a stock deal. Not surprisingly, Company B’s proposal was not pursued further, in part because of the ambiguity and uncertainty of a stock deal.

5. Keep the options open

A straight sale is not always the best option, and Palm’s Board considered a range of different strategic options. Although the ultimate transaction was a sale of the whole Company, this open option approach helped to attract more and diverse potential interested parties. In this case, a straight sale was the easiest to evaluate for the seller, and – as indicated above – as the game moved to later innings, the less viable options were retired.

6. Elephants can dance

This one is probably less obvious. The deal was pulled off on a very abbreviated time line. This is exceptional from the seller’s perspective, but even more from the buyer’s. Palm certainly was motivated by a dwindling cash balance, deteriorating fundamentals, and the inability to double-down on its webOS roll-out in light of the weak initial market success. HP had its strategic reasons to buy into the deal, but the speed of execution was forced by the competitive nature of the auction that did not leave much room for delay.

Now, if only HP and Palm do their post-merger integration at the same speed as they did the transaction, we should see some new and exciting products in the marketplace fairly soon.

Gunther Hofmann is a Vice President of The Brenner Group and has done extensive work in valuations, M&A, venture capital, and corporate finance with significant international experience in small firms as well as global corporations. Gunther earned a Masters Degree in Electrical Engineering and Business Administration from Darmstadt University of Technology in Germany, and was a Visiting Scholar at UC Berkeley. He is a holder of the Chartered Financial Analyst designation, and is an Accredited Valuation Analyst (NACVA). Gunther is Treasurer and a Member of the Board of Directors of the the German American Business Association (GABA)

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This is true in general, but can become a prerequisite in connection with securities laws[i].

Many of our clients are venture-backed technology companies. Most of the capital that they raise comes from accredited investors, if not institutional venture capital funds. Some of their money may come from unaccredited investors, and virtually all venture-backed companies issue stock options to employees that are sooner or later exercised. Most of the employees of course are not accredited investors. An annual income of at least $200 thousand or net worth of at least $1.0 million renders you an accredited investor[ii] .

As IPOs continue to be the exception, the exit route of choice for most companies is a sale to another company in an M&A transaction.

And as cash comes at a premium these days, the acquiring company often pays with its own stock – and that’s where some sophistication goes a long way.

Exempt Transactions

Most often, the stock of the acquiring company is not registered with the SEC, either because the acquirer is a public company that uses newly issued shares that are pending registration, or because the acquirer itself is a private company with restricted stock. Thus, such a stock offering would need to use one of the exemptions provided under Regulation D of the 1933 Securities Act – known as “Reg D Offerings [iii].

Usually, the issuance is exempt under Rule 506 of Regulation D, which allows for unlimited amounts of capital raised (Rule 504 limits the sale of securities to $1 million within a 12-month period; Rule 505 limits the raise to $5 million, also within a 12-month period).

Rule 506 also allows the sale to a maximum of 35 non-accredited investors; however, these investors need to be “sophisticated”.

What is “sophisticated”?

In the eyes of the Security Act, “sophisticated” means someone who has “either alone or with his purchaser representative(s) such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment.”

So you can get some help on the way to “sophistication” by retaining a purchaser representative.

What now is a “purchaser representative”?

The purchaser representative is defined in Rule 501 of the Securities Act.

Apart from not being an affiliate of the issuer and being acknowledged by the purchaser, the purchaser representative “has such knowledge and experience in financial and business matters that he is capable of evaluating, alone, or together with other purchaser representatives of the purchaser, or together with the purchaser, the merits and risks of the prospective investment”.

In other words, the purchaser representative is a shortcut to “sophistication” and the path around unaccredited status.

The Brenner Group regularly acts as purchaser representative, enjoying the opportunity to spread “sophistication” and help unaccredited investors to navigate and understand sometimes complex transactions with hundreds of pages of agreements in a multitude of disclosure documents that today’s mergers produce in the interest of compliance …….. and informing investors.

[i] This blog post does not constitute legal or investment advice.

[ii] California provides for some similar provisions regarding a “qualified purchaser”.

[iii] For very small transactions including only buyers (and seller) in the same states, companies may be able to take advantage of some of the state exemptions, such as California Corporations Code Section 25012.

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My favorite quote: “But in a bust, having a lot of cash can be a huge competitive advantage because you can use that cash to put enormous pressure on your underfunded competitors.” Amen to that.

Fred Wilson from Union Square Ventures picked up the gauntlet and countered with The Case For The Lean Startup: “I have never, not once, been successful with an investment in a company that raised a boatload of money before it found traction and product–market-fit with its primary product.”

Which prompted The Revenge of the Fat Guy with some more clarification on why big is beautiful, and some cleaning up of common myths about that elusive product-market-fit.

The dogfight has elicited a slew of reactions throughout the blogosphere, my preferred one is making the not-so-obvious connection to Dr. Seuss’Lorax.

With so much body weight being tossed around, the questions remain: (1) who’s right and (2) what does that mean for your startup?

Who’s right?

Both, of course.

Ben Horowitz walked the walk and spent his way to success with Opsware. Arguably, this was before Opsware had found its sweet spot and dominance in the data center automation segment. Now one successful fat start-up does not a prescription for success make, and for every successful fat start-up there are plenty of failures (remember WebVan?). But the same can be said for the lean start-up. The lack of money does not predict success. Arguably, there are more dead lean start-ups than fat ones; although not necessarily by choice.

Fred Wilson has invested in about 100 web companies, and has yet to see success in doling out too much money too early.

What does it prove? If somebody gives you a boatload of money, and you spend it wisely, you can be successful; conversely, if they don’t give you so much money, but you spend it wisely, you may still be successful. Chances are, however, that you’ll build it and they won’t come.

What does that mean for your startup?

I surmise to say “it doesn’t matter”. Investors just aren’t giving out those boatloads of money anymore, so you might as well get used to the low-carb diet.

The other aspect that’s not so clear in either post is what’s good for the company and positioning the product may not be good for the founders or investors.

Boatloads of money usually come with boatloads of dilution; unless a company can prove quickly significant traction in its market. Dilution for the founders and dilution for the investors. Now it is true that 1% of McDonalds’ pie is worth more than 100% of the burger joint next door, but things are not so rosy after the second re-structuring, wash-out, and reverse split.

Boatloads of money also significantly increase the benchmark for success. Once a company burns through $30+ million, it’s hard to make everybody happy with an exit of less than $100 million. These days, most exits aren’t above $100 million, so most investors aren’t happy. What happens often enough is that with new funding, a viable strategy to get the company to an exit of $50 million is ditched in favor of a high risk, “swing-for-the-fences” strategy to get the company to the magic $1 billion exit. But this evolves from a structural issue within the venture capital industry at large, covered in two earlier posts (Bigger isn’t better Part 1 and Part 2).

Like Black Jack, doubling-down doesn’t always double your payout, but often enough leaves you with the loosing hand. Unless of course, you count the cards very, very carefully – as Ben did at Opsware.

Gunther Hofmann is a Vice President of The Brenner Group and has done extensive work in valuations, M&A, venture capital, and corporate finance with significant international experience in small firms as well as global corporations. Gunther earned a Masters Degree in Electrical Engineering and Business Administration from Darmstadt University of Technology in Germany, and was a Visiting Scholar at UC Berkeley. He is a holder of the Chartered Financial Analyst designation, and a member of the National Association of Certified Valuation Analysts. Gunther is Chairman of the Software/IT Industry Group of the German American Business Association (GABA).

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Strategic buyers’ interest

Strategic buyers are usually mostly interested in the product and the market. In the sense that patents support a competitive advantage, and this is reflected in premium margins, they add considerable value. In some industries, such as life-sciences, patents are indispensable. In other industries, patents only play a supporting role. Some strategic buyers will be interested in patents for defensive purposes: either they have a product or they intend to develop a product that may infringe on the intellectual property of the seller.

Strategies of non-operating entities

Most of the non-operating entities will eventually try to find targets that license the technologies (or collect damage awards through litigation). Some will act for operating companies as a direct or indirect front to take intellectual property off the market and prevent others from enforcing the rights aggressively.

How does all of this affect start-ups?

1. Broad Strategy

From the outset, the patent strategy should be as broad as practically possible. This means being cognizant of other applications for the technologies, even if there are no current plans to pursue them. These areas can lead to additional license revenue and make the intellectual property more attractive to a wider range of potential buyers and licensees (strategic and non-operating alike).

2. More isn’t always better

Many companies are trying to amass as many patents as possible in support of a very specific product concept. It might be more cost effective to have fewer, but stronger/blocking patents, that also extend into adjacent application areas.

3. Who’s infringing. Today and tomorrow

It pays off to be aware of anybody currently infringing or on the trajectory to infringing on the company’s intellectual property. Any such instance – even if small and in different markets, will help to make the patents more marketable and may lead to higher income now or later.

4. Enforce the patent rights yourself, or have a “friend” enforce

Which leads to the question what to do if there actually is somebody infringing upon the patents. If the perpetrator is a direct competitor, it certainly makes sense to enforce the patent rights oneself. If the infringement happens at the margins of ones application, or is not worth the effort, or if the necessary funds aren’t there for a drawn-out legal battle, then there are plenty of non-operating entities that may take on such a case without the company itself acting as the bull in the China shop. Usual arrangements involve a sell-and-license-back agreement with the acquiring entity.

5. Geographies matter

Sometimes it pays to patent one’s intellectual property not only in the more obvious jurisdictions where the company intends to do business, but also in others, where potential acquirers reside. Some international non-operating entities will not be interested in US-only patents, but rather look for international scope.

This gives just an overview of some of the considerations for technology start-ups and their patent strategy. Beauty is in the eye of the beholder, and often start-ups are too narrow in the pursuit of patent protection and miss some of the beauty that others may see.

Gunther Hofmann is a Vice President of The Brenner Group and has done extensive work in valuations, M&A, venture capital, and corporate finance with significant international experience in small firms as well as global corporations. Gunther earned a Masters Degree in Electrical Engineering and Business Administration from Darmstadt University of Technology in Germany, and was a Visiting Scholar at UC Berkeley. He is a holder of the Chartered Financial Analyst (CFA) designation and an Accredited Valuation Analyst (AVA/NACVA). Gunther is a Member of the Board of the German American Business Association (GABA).

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The project reminded me of how much the landscape of acquirers of IP has changed in recent years as the market for buying, selling, and licensing IP becomes more mature. There are a host of different players with very distinct interests and operating models.

In this first of two blogs, I will describe some of the main types of participants in more detail. In a second post, I will touch on the implications for the patent strategies of high-tech start ups.

Who’s out there?

In a broad sense, potential buyers of IP assets can be divided into operating and non-operating entities. Operating companies intend to use the patents to support (or defend) their operating business; non-operating entities are companies with no substantial operations other than enforcing intellectual property claims. They acquire patents for offensive (trying to license the IP or receive damage awards from infringers) or defensive purposes (trying to prevent others from seeking damage awards).

In the last decade, there has been a lot of development in the area of non-operating entities. The category may have started out as the derogatory “patent trolls”, but at this point has matured into an industry with a number of players with distinctly different strategies:

- Enforcing Entities: these companies seek to offensively enforce their patent rights vis-à-vis current or potential users that may have an interest in licensing the IP or are suspected of infringing upon the rights. These entities can be structured in a range of ways: some are structured as a fund; some were formerly operating entities that sold off the operating business to focus on patent right enforcement; and others started out as individual inventors with a successful track record of enforcing their prior inventions.

- Defensive Trusts: these entities are a relatively recent development. Large, operating companies band together to form trusts that acquire patent rights for defensive purposes. The rights will be licensed to some or all of the member companies as a “protective shield”. Depending on the trust, the patents may be sold after the initial round of internal member licensing to provide cash flow back to the trust as well as to keep the threat of litigation alive with non-members.

- Aggregators: whereas Enforcing Entities usually aim for an immediate and targeted activity, aggregators take a broader and more patient approach: Their aim is to amass a large patent portfolio in certain areas that will represent a critical mass for later enforcement.

- IP Development Companies: as public and private research organizations have become more skilled in their efforts to monetize their inventions, they have also become more active in seeking to round out their own IP portfolio through acquisitions. Some will have their own enforcement activities, while others may license a more complete set of IP to third parties.

- Buy-side, sell-side brokers: as the players in the intellectual property get more specialized and mature, so do the related intermediaries. A lot of operating companies and several non-operating companies do not want to openly engage in IP transactions, but rather do so indirectly through third parties. This preserves confidentiality for competitive and pricing considerations. By keeping the “need” for certain IP confidential, the buyer also does not provide any clues about their strategy, or legal Achilles’ heel.

Each of these entities may have its own focus on certain industries and may have its own process with its own timeline. For example, defensive trusts will necessarily focus on the industries of their member firms, and will likely only bid on a patent portfolio once they receive interest from their member firms. This may take a while and they may not be as responsive as other entities capable of making faster decisions.

Knowledge of the different strategies is essential in executing a successful IP sale. However, an awareness of the different strategies of these companies may also lead to a re-thinking of the IP strategy of start-up companies that intend to maximize the value of their intellectual property either in an ultimate sale, or in additional revenue from licensing agreements along the way.

Gunther Hofmann is a Vice President of The Brenner Group and has done extensive work in valuations, M&A, venture capital, and corporate finance with significant international experience in small firms as well as global corporations. Gunther earned a Masters Degree in Electrical Engineering and Business Administration from Darmstadt University of Technology in Germany, and was a Visiting Scholar at UC Berkeley. He is a holder of the Chartered Financial Analyst (CFA) designation and an Accredited Valuation Analyst (AVA/NACVA). Gunther is a Member of the Board of the German American Business Association (GABA).

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A recent Grant Thornton study digs a little deeper and identifies 1997 as the peak year for the total number of public companies in the US. Since then and through 2008 the number of listings has declined by almost 40%. This is especially remarkable as listings on other global stock exchanges have increased: the number of listed companies in Hong Kong has almost doubled.

Grant Thornton traces this development back to the advent of online brokerages in 1996 and introduction of new order handling rules in 1997. The decline in listings was already in full swing when the dot-com bubble peaked. The rate of decline has slowed somewhat since Sarbanes-Oxley (between 2004 and 2007: coinciding with the economic recovery), but accelerated again towards 2008.

Grant Thornton argues that the root cause of this depression in listings is not Sarbanes-Oxley, but an array of regulatory changes that were meant to advance low-cost trading (such as decimalizing spreads), but have had the unintended consequence of stripping economic support for the value components (quality sell-side research, capital commitment, and sales) that are needed to support markets, especially for smaller capitalization companies.

There likely is more to it:

The pace of smaller IPOs after the dot.com crash may have been much higher without Sarbanes-Oxley, or with a reasonable exception for small-cap companies. This has combined with decreased investor appetite for “public venture capital” in the US vis-à-vis emerging markets.

Is any of this likely to change?

Grant Thornton makes several recommendations to bridge to more traditional IPOs, such as the establishment of an alternative public market segment that supports a higher fee structure for market makers, as well as private markets with limited access, such as solely to qualified investors. IPOs might pick up in a recovery, but they are unlikely to reach the 360 new issues per year that are calculated as the equilibrium number to avert further erosion of total listings.

Given investor interest in overseas markets compounded by an increase in domestic M&A activity and bankruptcies, a further decline in listings in the US is much more likely until a new equilibrium is found.

Gunther Hofmann is a Vice President of The Brenner Group and has done extensive work in valuations, M&A, venture capital, and corporate finance with significant international experience in small firms as well as global corporations. Gunther earned a Masters Degree in Electrical Engineering and Business Administration from Darmstadt University of Technology in Germany, and was a Visiting Scholar at UC Berkeley. He is a holder of the Chartered Financial Analyst designation, and a member of the National Association of Certified Valuation Analysts. Gunther is Chairman of the Software/IT Industry Group of the German American Business Association (GABA).

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Whereas the timing of a transaction (up-market, down-market, hot technology space, etc.) is certainly of importance to the general consideration of whether or when to sell, the execution time from when the decision to sell has been made until the transaction closes is relevant in any market.

Obviously, there is a time value of money, and one dollar in a couple of weeks is worth more than one dollar in six or nine months. The simple compounding effect gets amplified for companies with a high cost of capital – such as venture capital.

Getting stale

But more than that, once deals are marketed they tend to have a limited shelf-life before they become stale. Interest in the company may be waning, and the economic situation of the company as well as the larger economy can change negatively as time drags on. Any potential acquirer will do a “make or buy” analysis. The assessment can change over time as the deal lingers on.

It is a crucial condition to a successful transaction that a sense of urgency among the buyers be constantly stoked. This holds true for a sale in an auction as well as for negotiated sales.

Confidentiality is another consideration: the longer the deal process lingers, the higher the likelihood that word gets out. This may be an advantage if the company is selling its assets and wants to target the largest possible universe of buyers, but it can be detrimental if it keeps customers from buying its products pending a transaction, or employees start to become nervous over the outcome of the transaction, or competitors start taking dead aim in the marketplace.

Auction 90TM

The Brenner Group has developed a formulated process for the sale of a company: Auction 90™ . As the name implies, in its purest form it takes 90 days from the start of the engagement until a buyer is contracted.

The process has been designed in an auction setting and can be executed as an open auction (where the goal is to maximize exposure) or a limited auction (where a limited number of bidders are corralled along a pre-defined process to expedite the transaction.

Timing

There are several factors that influence the execution time:

1. Asset sale versus stock sale

As the name implies, a company sells only its assets (or a sub-set of its assets) in a piecemeal manner. Any proceeds to the company will then be distributed to debt- and equity holders. In a stock sale, the owners of the company sell their stock to the acquirer, thereby disposing of the company in a single transaction. The assets (and liabilities) will continue to be owned by the company. Usually, asset sales can be executed faster than stock sales, in part because stock sales require more analysis and due diligence by the buyer.

2. Complex due diligence

Obviously, the more there is to a company, the more due diligence there is to do, and the longer it takes for a transaction to close. Complex technology, employees, overseas offices, and contractual relationships all take time to analyze. The further a company is along in terms of customer buy-in, product development, and actual sales, the easier it is for an acquirer to do due diligence.

3. Economic and industry environment

Obviously, deals will take longer in times when everybody is hunkering down and trying to cut costs. There are exceptions to the rule – if companies provide technology or products deemed “mission critical”, deals will still be done expeditiously. For example, Electronic Arts acquired online game company Playfish for $375 million at the same time EA announced layoffs of about 1,500 employees from its core staff.

4. Cash deal, share deal, merger

If the acquirer pays in cash, there is little to analyze. A transaction where the acquirer pays with shares needs additional scrutiny: are the shares registered, or restricted, or readily marketable, what is the trading volume, etc. The more weight on deferred payment, the higher the risk for the seller; especially as the seller has little control over the acquiring company’s operations going forward.

5. Auction, negotiated deal, limited exposure auction

Usually, an auction will lead to a speedier close, as it keeps all participants focused on a deadline. While a negotiated sale for a highly sought-after company can proceed swiftly, undue urgency may not leave the seller the necessary time to investigate other strategic options that could result in a higher price. Read more about auctions in my previous post Going…going…GONE!

Ideally, technology companies are bought, not sold. Employing the right sale strategy ensures an optimum transaction value.

Gunther Hofmann is a Vice President of The Brenner Group and has done extensive work in valuations, M&A, venture capital, and corporate finance with significant international experience in small firms as well as global corporations. Gunther earned a Masters Degree in Electrical Engineering and Business Administration from Darmstadt University of Technology in Germany, and was a Visiting Scholar at UC Berkeley. He is a holder of the Chartered Financial Analyst designation, and a member of the National Association of Certified Valuation Analysts. Gunther is Chairman of the Software/IT Industry Group of the German American Business Association (GABA).

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It is based on an exhaustive survey of commercial bankers, asset-based lenders, mezzanine capital investors, private equity sponsors and venture capitalists. It provides insights into everything from the critical ratios commercial banks expect when extending credit to the average closing fees charged by mezzanine investors.

Rates of Return – what VCs want

What caught my attention and gave this post its title is the calculation of implied expected rates of return of venture investments.

Investors were asked about their expected sales multiple (target sales prices to total venture investment ratio). As can be expected, the average ratio decreases from 8.2x for a “Stage 1” company (Two guys in a garage, or more formally according to AICPA: “No product revenue, limited expense history, incomplete management team with an idea, plan, and possibly some initial product development”) to 3.9x for a “Stage 6” company (“Established financial history of profitable operations or generation of positive cash flows”).

So far so good.

Respondents were then asked about their anticipated time to a liquidity event. Again, as expected, the timeline shortens from an average of 6.2 years for a Stage 1 company to 3.8 years for a Stage 6 company.

With both numbers in hand, the authors then calculated the implied rate of return.

The average implied expected rate of return actually increases from 40.5% for a Stage 1 company to 43.3% for a Stage 6 company.

In other words, this would mean that VCs require a higher rate of return from an investment in a company with lower risk. This does not quite conform to financial theory.

How come?

1. Black Swan Hunting

First, VCs aren’t really going for an average return, but they are looking for the outlier that will carry the return for the portfolio. In essence, they’re “black swan hunting”. The 6.2 year estimate for the time to exit of a Stage 1 company may be a realistic average. But the 8.2x exit multiple might be better understood as a hurdle ratio for a base case: An Early Stage VC investor is unlikely to invest in any company (or at a valuation) that does not have the potential to return such a multiple. In the end, of course, most investments don’t pan out that way. But hopefully, a select few in the portfolio will outpace that number by far.

2. No incentive to invest in early stage deals

Secondly, and questioning the viability of Early Stage Venture Capital investing on a more fundamental level: If above estimates are correct in reflecting the current reality that the expected returns from Early Stage investments aren’t significantly higher than Late Stage investments, who would want to invest in Early Stage deals? And indeed, for the second quarter 2009, an analysis of 89 financings conducted by law firm Fenwick and West pegs the percentage of Series A and Series B rounds at 35% of all financings, down from more than 50% in the third quarter of 2007.

And finally – coming back to the title of this post – I believe that respondents are underestimating the detrimental effect that compounding has on their rate of return: The additional time to exit chips away from a healthy return. I would yet want to meet the Early Stage VC who invests with an expected IRR as low as 40% on an individual investment.

The authors of the Private Capital Markets Report are planning to include actual return estimates for the different stages of investment in future editions of the survey. At that point we will be able to quantify exactly how bad VCs are at their math.

In the meantime, I encourage any investor to participate in the survey.

Read more about Silicon Valley news, trends, and commentary in The Brenner Banner

Original post permalink: http://banner.thebrennergroup.com/2009/11/12/are-VCs-bad-at-math/

If VC firms ought to be smaller, what does that say about the VC industry as a whole?

VCs have been investing more than $20 billion each year since 1998. In 1999/2000 investments shot up to over $20 billion per quarter, but went down sharply afterwards, then starting a slow upward trend to an annualized rate of about $30 billion at the end of 2008 when the current economic crisis kicked in.

A Kauffman Foundation report by business-blogger-at-large Paul Kedrosky (his blog: infectious greed) pegs the reasonable size of annual venture investments in the US at $12 billion (instead of the $30 billion rate we saw in 2008). He largely gets there from return-considerations, as well as using a fraction of overall GDP.

Further suggesting the vc industry is contracting Bill Gurley from Benchmark gives a very good summary of how venture capital will likely get caught in the asset allocation squeeze (or the “denominator effect”): a typical institutional investor may allocate 5% of all assets under management to venture capital. As the total assets shrink because the value of all other asset classes such as stocks and bonds shrink, so will the money available for venture capital. Exacerbating this trend – and making it a long-term effect – would be a lower relative allocation. Whereas institutional investors have increased their relative allocation to venture capital over time, now may be the time to reduce it, following dismal returns from the industry for much of the last decade. The 5% could very well be cut in half – along with the venture capital industry. Gurley’s outlook still trends towards a “stabilized market size of well over $15B a year”.

Eventually, funds disbursed by venture capital firms will follow what they’ve raised. And little did they raise indeed so far in 2009: A dismal $1.7 billion was raised by VC firms from limited partners in the second quarter of 2009. Hopefully, we’ll see some recovery from such low numbers: This would lead to a very small industry indeed.

Gunther Hofmann is a Vice President of The Brenner Group and has done extensive work in valuations, M&A, venture capital, and corporate finance with significant international experience in small firms as well as global corporations. Gunther earned a Masters Degree in Electrical Engineering and Business Administration from Darmstadt University of Technology in Germany, and was a Visiting Scholar at UC Berkeley. He is a holder of the Chartered Financial Analyst designation, and a member of the National Association of Certified Valuation Analysts. Gunther is Chairman of the Software/IT Industry Group of the German American Business Association (GABA).

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http://banner.thebrennergroup.com/2009/10/12/bigger-isnt-better2/

Veteran investor Alan Patrikof is musing in a recent piece in The New York Times about the “good old times” when venture funds were $100 million at most.

So why should VC-Firms be smaller?

1. It takes longer for VCs to reap their profits:

The time from VC-financing to M&A exit has grown substantially. From about 2 years in 2001 to over 7 years in 2007. And the time value of money comes at a high price to VCs: In order to realize a 50% IRR on an individual investment, it would have to yield a 17-fold return after 7 years, versus a 2 ½ -fold return after two years. Not that such returns aren’t possible, but given the substantial investments of large VC firms, those need to be some hefty exits, and:

2. There aren’t that many supersized exits out there:

The average (disclosed) M&A deal size has shrunk to about $50 million in the US in Q1 2009 (with Q2 faring somewhat better) according to Thomson Reuters and NVCA reports. Most M&A deals are not disclosed. Most undisclosed M&A deals are much smaller.

So if venture investors owned 50% of a company at the time of the M&A transaction, the proceeds would yield them $25 million. Which is exactly the average amount of VC investment prior to an M&A exit in Q1 2008. That doesn’t leave much room for any return on investment. And although there are some encouraging signs for technology IPOs, the vast majority of exits are currently in the form of M&A. Even discounting the financial crisis: IPOs these days are a large-bank affair: a company will need to provide sufficient float to attract an active market in its shares; in the order of at least $50 million; at valuations of north of $250 million.

Will any of this change?

We will certainly see more exit activity and better valuations at some point. But a return to the “small IPO” is unlikely. And to build a company with an exit value of $50 – $100 million, it shouldn’t take more than $5 million for the math to make sense – which would call for venture capital firms that can deploy these relatively small amounts of money efficiently.

Gunther Hofmann is a Vice President of The Brenner Group and has done extensive work in valuations, M&A, venture capital, and corporate finance with significant international experience in small firms as well as global corporations. Gunther earned a Masters Degree in Electrical Engineering and Business Administration from Darmstadt University of Technology in Germany, and was a Visiting Scholar at UC Berkeley. He is a holder of the Chartered Financial Analyst designation, and a member of the National Association of Certified Valuation Analysts. Gunther is a Member of the Board of the German American Business Association (GABA).

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http://banner.thebrennergroup.com/2009/09/29/bigger-isnt-better1/

Curiously, the Silicon Valley Venture Capitalist Confidence Index for the Q1/09 actually rose to 3.03 from 2.77 (with 5 indicating high confidence and 1 indicating low confidence). This is the first substantial uptick in eight quarters.

Is this a green shoot, a regional curiosity, or just a statistical oddity based on survivorship bias?

Venture capitalists of course have to be professional optimists, and for those funds with money to invest, things are looking up indeed: valuations may be down, but this makes for more upside once the economy recovers. The economy is still falling, but the free fall has slowed to a steep downhill: the feared total collapse of the financial system has given way to a recapitalization of financial institutions, deleveraging of the economy, and a somewhat orderly restructuring of the manufacturing sector. Some of the responding VCs see the downturn in the economy as an opportunity to build great companies, pointing to the talent now available and the necessity of capital-efficient business models.

Overall, the confidence index may be a leading indicator. Low valuations may not be likable to entrepreneurs, and companies still face an uncertain or even non-existent exit market, but buying low was never bad for investors.

Gunther Hofmann is a Vice President of The Brenner Group and has done extensive work in valuations, M&A, venture capital, and corporate finance with significant international experience in small firms as well as global corporations. Gunther earned a Masters Degree in Electrical Engineering and Business Administration from Darmstadt University of Technology in Germany, and was a Visiting Scholar at UC Berkeley. He is a holder of the Chartered Financial Analyst designation, and a member of the National Association of Certified Valuation Analysts. Gunther is Chairman of the Software/IT Industry Group of the German American Business Association (GABA).

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http://banner.thebrennergroup.com/2009/07/07/light-at-the-end-of-the-tunnel/

Indeed, commercial bankruptcies in the US have increased by 78% in the first quarter 2009 from the same period a year earlier, and almost tripled from 2007. [read more bankruptcy data]

However, first signs emerge that filings may have peaked in March, with April’s numbers slightly lower.

That still leaves a growing throng of bankruptcy-related M&A to work its way through the economic system. This population of distressed companies not only includes asset sales after a bankruptcy has been filed, but also distressed sales during crisis and liquidation. And while big name Fortune 500 companies like Chrysler and Circuit City are on the chopping bloc, there are many more smaller technology companies seeking to monetize their assets as well.

A good time to buy

This is a good time to buy up those distressed assets most of which are sold at impressively low valuations. It is astonishing how cheaply equipment can be bought out of bankruptcy. Who wants to buy new if you can get it almost new for pennies on the dollar? This is also true for intangible assets. Standard software as well as specialized software licenses that are transferable can be bought at a significant discount.

This could also be a good time to consolidate industries, join forces, increase economies of scale, and emerge stronger from the current crisis. This would be the time to keep a watch on your industry to pick up patents and other intellectual property from your competitor. So many technologies that started out as stand-alone companies in a stronger economy make more sense now as a piece of a larger entity. “Features” and “add-ons” do not make for sustainable companies.

Cash is king; as always. But most VCs prefer to see their stalled portfolio companies survive as part of something bigger than take the hit of a full write-off immediately. So stock and other paper consideration becomes more palatable in a recession than in better times.

Gunther Hofmann is a Vice President of The Brenner Group and has done extensive work in valuations, M&A, venture capital, and corporate finance with significant international experience in small firms as well as global corporations. Gunther earned a Masters Degree in Electrical Engineering and Business Administration from Darmstadt University of Technology in Germany, and was a Visiting Scholar at UC Berkeley. He is a holder of the Chartered Financial Analyst designation, and a member of the National Association of Certified Valuation Analysts. Gunther is Chairman of the Software/IT Industry Group of the German American Business Association (GABA).

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http://banner.thebrennergroup.com/2009/06/08/buyers’-market-for-assets-and-IP/

Technology companies are different in a number of ways.

1. They have little debt but a lot of equity in layers of preferred shares.

2. They are usually at an early stage: little if no revenue; the product development may not be completed.

3. The management is often incomplete.

4. There are few hard assets: most of the value of these companies is tied up in the workforce and intangibles.

5. They have a very limited cash runway (this is of course true for most distressed companies. However, VC-backed companies are generally financed to the next milestone, not to cash-flow break-even).

The key elements that affect a company’s turnaround options are technology, market, and management.

1. Technology: if it doesn’t work, the solution may be to redesign in order to reduce functionality to a commercially viable application.

2. Market: if the target market’s devloping too slowly, perhaps focusing on a narrower market segment will lead to faster revenue.

3. Management: if existing management is responsible for getting the company into the hole or the company is taking a new direction, the current management may not be the best choice to take the company forward.

External factors, such as the current economic downturn, can play a considerable, amplifying role.

So how do these high tech differences make turnaround management different ?

- There is less opportunity to raise cash through selling off hard assets.

- Sale of non-core assets usually entails liquidation of intellectual property, which may have a very limited market.

- Workforce reductions need to be carefully planned as the company’s value often lies within the workforce.

- Strategic refocusing may be more feasible than in established companies, as technologies can be applied in different applications, and the company is not yet locked into one specific market.

- The limited use of debt can lead to a faster decision, as VCs have been through this before.

- External advisors can play a crucial role as management is usually not trained in the dynamics and complexities of turnarounds and restructures.

Sadly enough, many technology companies fail to realize the severity of the situation early enough; many make insufficient changes too late when the only possible option is the liquidation of the company.

The full article can be found at http://www.thebrennergroup.com/assets/pdf/strategic-options-distressed-tech-companies.pdf

Gunther Hofmann is a Vice President of The Brenner Group and has done extensive work in valuations, M&A, venture capital, and corporate finance with significant international experience in small firms as well as global corporations. Gunther earned a Masters Degree in Electrical Engineering and Business Administration from Darmstadt University of Technology in Germany, and was a Visiting Scholar at UC Berkeley. He is a holder of the Chartered Financial Analyst designation, and a member of the National Association of Certified Valuation Analysts. Gunther is Chairman of the Software/IT Industry Group of the German American Business Association (GABA).

Original post permalink: http://banner.thebrennergroup.com/2009/04/17/turnaround-distressed-tech-companies/

Both have advantages and disadvantages. Let’s look at some of these:

Structure of Auction Deals
Auctions can be structured in multiple ways: open (like on ebay: bidders know the price and/or identity of other bidders) or closed (the participants receive little information about identity or prices). They can be limited by rounds of bidding, by time (again – like ebay) or can run its course until every other bidder drops out (your typical Sotheby’s auction). Which structure is chosen depends on the circumstances.

Auction Advantages
Auctions provide speed of execution and come to a definite outcome without dragging on. The seller may or may not like the outcome, but an outcome there is. Auctions are often used where the transacted asset can be well defined, the proposed deal is straight-forward, and the only significant open variable is the price.

Negotiated Deals
More complex transactions are usually negotiated on a one-on-one basis. The complexities may include questions on payment terms, earn-out provisions, representations or warranties by the seller, or – in the case of joint ventures – issues concerning control and additional buy-sell agreements. These transactions should still include a competitive environment with multiple suitors, but the process is far from the more formal character of an auction. Last but not least, individually negotiated transactions place a higher burden on senior management, the board, and investors.

Trends for Selling a Company  or Assets
We expect to see an increase in auction-type transactions in the current market environment: the speed of execution, reduced management burden, and straight-forward process lend themselves to restructuring plans where companies are capitalizing assets or investors are selling companies and are looking for a quick exit.

Gunther Hofmann is a Vice President of The Brenner Group and has done extensive work in valuations, M&A, venture capital, and corporate finance with significant international experience in small firms as well as global corporations. Gunther earned a Masters Degree in Electrical Engineering and Business Administration from Darmstadt University of Technology in Germany, and was a Visiting Scholar at UC Berkeley. He is a holder of the Chartered Financial Analyst designation, and a member of the National Association of Certified Valuation Analysts. Gunther is Chairman of the Software/IT Industry Group of the German American Business Association (GABA).

Original post permalink:
http://banner.thebrennergroup.com/2009/02/23/selling-company-via-auction/