Alex Lykken October 15, 2014
As part of our 4Q U.S. Venture Industry Report, we got in touch with Babak Yaghmaie and Matt Bartus, two partners at Cooley. Mr. Yaghmaie heads the firm’s New York Business & Finance Group and Mr. Bartus is a partner in the Cooley Business department, with offices in Palo Alto and San Francisco. To download a free copy of the 4Q U.S. Venture Industry Report, or browse the rest of our reports library, click here.
VC valuations, particularly at the late stages, are sensitive to movements in the stock market. Are you concerned how high valuations have gotten at the late stages, and what might happen to those companies if the markets turn sour?
While venture capital, as an asset class, is driven by an entirely different thesis and set of fundamentals than those that drive investment in publicly-listed securities, there is no doubt that both the level of dollars deployed and the sensitivity to price and valuations is inextricably tied to investor outlook in the public markets.
Over the last two years, we have enjoyed significantly higher levels of capital market activity in reaction to a meaningful increase in investor appetite for new issues and fast-growing, venture backed technology and life sciences companies, as well as a generally buoyant demand for equities. This is in large part due to the ongoing low interest environment in which it is increasingly difficult to attain yield without significant exposure to equity capital markets.
Late stage investment opportunities entail a shorter window to liquidity, which in today’s market means a near to medium term IPO event. As a result, public market valuations inevitably play a very important role in creating valuation markers for late stage ventures. This means that late stage investments in companies that are on a trajectory to an IPO – which coincidentally will always also increase the likelihood of a competing M&A exit opportunity – will garner higher valuations that more closely correlate to public market multiples in the peer group.
It stands to reason that if we experience a sustained and meaningful downturn in the public markets, high-priced, late stage investments will require a longer window to liquidity. This means, for companies that are likely to need additional capital prior to a liquidity event, raising future rounds at current pricing levels may prove to be very challenging. Having said that, there is some solace in the fact that high-priced late stage venture investments typically fall into one of three broad categories.
The first is paradigm-changing companies that in some ways transcend market fluctuations. These are companies that will attract investors at lofty levels because the venture investors, and some times cross over buyers, will be making an investment with a longer term outlook that allows for market conditions to normalize and for the investor to achieve it’s expected rates of return. Moreover, with many of these companies, a hefty premium is viewed as the price of entry.
The second category of companies is those for whom a future capital raise is optional – in other words, they can raise minimally dilutive capital at rich valuations but don’t necessarily need additional capital to achieve an exit or arrive at an IPO. These companies will also be able to withstand a public markets trough, although they will have to tighten their belts and manage growth and their bottom line more carefully.
The last category of companies are those that are not capital efficient and fundamentally need to raise more capital before an exit event if an exit event or IPO is extended beyond the near to medium term. These are the companies that will bear the brunt of public market downturn and will face very difficult decisions around potential down-rounds if they fail to raise more capital today than they currently expect to need in order to achieve an exit in the near to medium term under current market conditions.
Can you give us a sense of the optimism that VCs and startups have about exit opportunities? Some of these round amounts and valuations are a little startling, but investors and companies must be confident those numbers will hold up come exit time.
We think there is great optimism among VCs and startups. It’s true that valuations have been trending upwards. We have stronger teams and companies, lots of capital flowing into the industry to fund those teams and a very vibrant capital markets and M&A environment. All of these factors are great for the industry.
To some extent, top tier VCs will always want to be in the best companies with the best entrepreneurs, and sometimes the price of this is a higher valuation. However, we also see that historically things that seem overvalued today might seem very undervalued tomorrow. People were calling Facebook overvalued when its shares traded on the private market at $35B, but its market cap today is approaching $200B.
On the exit side, we have very strong capital markets activity described below, but also a vibrant M&A market. 2014 has been an excellent year for M&A and the outlook for the remainder of the year and 2015 looks strong. We all hear about the big exits such as Oculus, WhatsApp, Twitch and others, but there are many solid hits to be had in the middle market range as well. The large strategic buyers have significant cash coffers, elevated stock prices and are engaged in battle with each other, leading to great exit opportunities for teams at all levels.
In addition to the risk involved, high valuations are also leading to higher burn rates right now, according to industry players. Do you see the same thing? If so, how concerned are you about the trend?
There is no question that access to cheap capital – or frankly, sometimes access to capital even if not necessarily cheap – inevitably leads to a greater use of cash resources to accelerate growth and significantly higher burn rates than a business would manage to under different circumstances. Boards tend to be less frugal when the company’s balance sheet is very strong, capital is constantly knocking on the door of the company and market share growth can be fueled by a larger spend. Of course for some companies the acceleration of spend that is fueled by the availability of capital in the current market window may not necessarily correlate to the growth of the business and the desire market penetration, and may not create the inflection points that will drive greater enterprise value, and therefore, continued access to future capital. Those are the companies that will rue not managing their cash resources more carefully. But our experience tells us that most Boards, and most venture investors that have a large voice on many of the Boards with which we work, are cognizant of the shifting tides of sentiment in the market. They have been through the vicious cycles of capital constraint and remain mindful of the importance of managing the throttle between an increased spend to accelerate growth and managing cash resources in a manner that will enable achievement of significant, value-driving milestones without necessarily being at the whim of the market for future capital needs. Of course not all Boards and companies get this delicate balancing act right, but the good news is many do.
How do you see 2015 shaping up? Do you see continued optimism in the industry?
We are very optimistic about 2015 for a number of reasons. First, the level of company creation continues at strong level. Sometimes these companies are being formed by repeat players who are “getting the band back together” for another shot, and they have a good chance of success. But often times the companies are formed by strong teams of highly qualified, first-time entrepreneurs who are choosing entrepreneurship over the other great opportunities they may have in their lives. This bodes well for the future of our industry.
On the capital side, we see lots of capital being pooled for investment. Year to date in 2014, Cooley alone has helped 136 groups close funds and we see that pace continuing for the rest of the year. That capital will be deployed in 2015 and beyond, and will continue to flow so long as strong companies are being formed with realistic exit opportunities.
On the capital markets side, we think there is an excellent opportunity for robust activity in the IPO market. It’s always the case that capital markets activity is strongly influenced by factors outside the control of issuers, and we continue to see macro risks to the global economy including instability in world affairs.
Just to drill down a bit on capital markets activity, we had an exceptionally busy first three quarters of 2014 with technology and life sciences companies. On the technology side, there are indications that the fourth quarter might be a little slower relative to the first three quarters, though numbers are still strong historically. We are optimistic that life sciences will remain strong through the fourth quarter.
Assuming the IPO markets remain open, which is impossible to accurately predict, there are a number of companies, perhaps an unprecedented number of them, that are showing tremendous revenue growth and have very strong businesses that are gearing up for a public offering in 2015 or beyond. So the strength of the companies in our industry has never been better and this points to robust capital markets activity in 2015 and beyond.
Featured image courtesy of Wikimedia user Mark Coggins.