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WSGR Entrepreneurs Report Fall 2008

WSGR Entrepreneurs Report Fall 2008

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01/08/2012

 
THE ENTREPRENEURS REPORT:Private Company Financing Trends
Fall 2008
Taking Advantage of the Downturn
By Greg Gottesman, Managing Director, Madrona Venture Group 
Unless you have been avoiding your in-boxin the past month or so, you probably got thewidely circulated email containing “theworld is coming to an end” slide deck from amajor venture capital firm. The essence ofthe presentation is that if you survive thecurrent economic meltdown, you win. Thatmeans cutting heads and getting to cash-flow break-even as soon as possible. Theadvice is well timed and important, butincomplete. The winners will not just survivethis recession—they’ll need to take fulladvantage of it, strategically and tactically.On the strategic front, companies shouldrevisit the basic questions they answeredwhen drafting their initial business plans,this time with the words “in this market” atthe beginning:• In this market, who are ourcustomers?• In this market, what is our valueproposition?• In this market, what is our businessmodel/how do we make money?• In this market, who are ourcompetitors?• In this market, what is ourcompetitive advantage?• In this market, how do wedifferentiate our product?• In this market, what are our coreassets?The answers to all of the above (and manymore) questions may have shifted in the lastthree months. If your customers were smallstart-ups, you may need to adjust your focusto a customer base that has money to spend.
continued on page 5 . . .
Feature Articles 
Taking Advantage of the Downturn
By Greg Gottesman,Madrona Venture Group 
........................Page 1
A Price on Carbon: Managing Risks andOpportunities
By Aleka Seville, First Climate 
..............Page 1
From the WSGR Database:Financing Trends
................................Page 2
Control: The Critical Issue in NegotiatingFinancing Terms
..................................Page 9
Navigating Down-Round and DilutiveFinancings
..........................................Page 11
The Do’s and Don’ts ofCompensation for Early-StageCompany Employees
........................Page 13
In This Issue
continued on page 7. . .
A Price on Carbon: Managing Risks and Opportunities
By Aleka Seville, Manager, First Climate LLC 
The results of the recent U.S. electionacknowledged the need for federal leadershipon many issues. This includes climate change,as an overwhelming majority of Americansvoted for a candidate who pledged not only totake decisive action to curb the country’sgreenhouse-gas (GHG) emissions, but also tosupport clean technology, ensure energysecurity, and create millions of new jobs.President-elect Barack Obama has promised toimplement federal legislation that ultimatelywould reduce GHG emissions generated in theUnited States to 1990 levels by 2020, and 80percent below that by the year 2050. Theseare incredibly ambitious goals that will not beachieved withouttranslating thecost of a changingclimate into aprice on carbonemissions.Early-stagecompanies areparticularly wellpositioned tosuccessfully respond to the challenges posedby future climate legislation, as they have theopportunity to build ratherthan refine processes tofunction in a low-carboneconomy. While runninglean is a benefit for mostbusinesses, it is nothingless than an imperative forthe early-stageentrepreneur. Emission-reduction measures,combined with a strategic
President-elect Obama’sincredibly ambitious goalswill not be achieved without translating the cost of achanging climate into aprice on carbon emissions.
 
For this report, we continue to evaluaterelevant trends in activity and valuation levelsfor the U.S. venture capital industry. Duringthis period of extreme volatility in the publictrading markets and continuing instability inall sectors of the economy, activity levels inthe U.S. venture capital industry through thethird quarter of the year have been relativelystable in comparison with prior periods.This is not to say that the venture capitalindustry has been immune from the financialstorms. Reports are appearing in the financialpress of institutional investors quietlyengaging in the secondary sale of theirexisting portfolio investments at highlydiscounted prices, or even defaulting on theircapital commitments to venture firms. Inaddition, with the virtually complete shutdownof the public equity markets as a source ofcapital over the first three quarters of 2008, itcurrently appears that any reasonableprospect of an IPO as an exit for most VC-backed companies has been eliminated for theforeseeable term. And the time horizon for thestart-up company from first funding to exitcontinues to grow, with the average exit nowat 8.3 years, as reported by Dow JonesVentureSource—a trend that potentiallyimpacts the return on investment for investorsevaluating venture capital as an asset class.However, the indications within our databaseof financing transactions for the third quarterof 2008, as well as for the first nine months ofthis year, support the conclusion that venturecapital activity continues at substantial levelsand, for the most part, compares favorablywith the same periods in 2007.For the third quarter and the first nine monthsof 2008, there were a total of 121 and 399financing transactions, respectively, comparedto 128 and 388 in 2007. The quarter-to-quartercomparison, reflecting a modest decline of 5%between the two years, may be an indicator ofincreasing stress in the sector that has yet tobe fully realized. In looking at each of thecompleted quarters for 2008, we reported insequence 144 transactions, 134 transactions,and 121 transactions, confirming a gradualdownward trend in financing transactionsin general.In terms of dollar amounts, the aggregatelevel for all financing transactions in the thirdquarter of 2008 was $1.115 billion, down only2% from the comparable figure of $1.143billion in 2007. The nine-month figures foraggregate dollars raised comparing 2008 with2007 actually showed an increase in 2008:$3.553 billion for the current nine months,compared with $3.255 billion for 2007.However, it should be noted that there werefour sizable financings—each $100 million ormore—in the first nine months of 2008 thathad a significant impact on the totals. Thesefour transactions are unusual for theirmagnitude in terms of dollars raised by privateventure-backed companies; most financingtransactions are for substantially smalleramounts, even for Series C and later rounds(i.e., mezzanine rounds). It is too soon to knowwhether the closure of the IPO market forventure-backed companies, the extendedperiod of time required to achieve an exit, andthe prevailing uncertainty in the economywere influential factors behind the decisionsof these companies and their investors toraise such large amounts of capital in a singleround of financing.If these unusual transactions are eliminatedfrom the data for aggregate dollar amountsraised for all financings, the third-quarter andnine-month 2008 totals fall to $793 millionand $2.931 billion, respectively—reflectingdeclines of 31% and 10% from 2007. Inevaluating the data with unusually largefinancings excluded, this pattern of declinemay portend a period of contraction in venturecapital investments in general.
2
THE ENTREPRENEURS REPORT:Private Company Financing Trends
Fall 2008
From the WSGR Database: Financing Trends
1281129303519121831172726020406080100120140
      N    u    m      b    e    r    o      f      F      i    n    a    n    c      i    n    g    s
Round
Total Number Angel Series A Series B Series C & Later BridgesQ3 2007Q3 2008
Comparison of the Number of Financings,Q3 2007 vs. Q3 2008
For purposes of the statistics and charts in this report, our database includes allventure financing transactions in which Wilson Sonsini Goodrich & Rosatirepresented either the company or one or more of the investors (although we donot include venture debt or venture leasing transactions, or facilities involvingventure debt firms). In some cases, for data involving averages, we use a truncated average, discarding the two or three highest and lowest figures toexclude the effect of transactions that are, in our judgment, unusual.
 
3
THE ENTREPRENEURS REPORT:Private Company Financing Trends
Fall 2008
As illustrated by the chart on the right, thereare other trends and observations that may berelevant to entrepreneurs and managersevaluating the current climate in venturefinancing transactions.Although the number of angel financings inthe third quarter of 2008 fell compared withthe same quarter of last year, it is a hopefulsign that the number of Series A financingtransactions—which, in almost all cases,involve institutional venture firms—haveremained at very stable levels, both on aquarter-to-quarter and a nine-month-to-nine-month comparison. Since Series A financingsfrequently represent the first infusion ofinstitutional investment capital in a start-upcompany, this stability is one of the keyindicators of the continuing rate of innovationin the sector, and clearly a positive sign in theface of the ongoing economic turmoilimpacting world markets. The aggregateamounts raised for Series A financings alsoremained relatively flat in comparing the thirdquarter of 2008 with 2007—$133 million and$139 million, respectively. It is also interestingto note that the average dollar amount raisedin a Series A financing transaction (i.e., thefirst financing involving the investment ofinstitutional venture capital) continues to be inthe neighborhood of $4-6 million, whetherlooking at the third-quarter or the nine-monthdata for 2008 and 2007.The number and dollar amounts invested inSeries B financings have declined noticeablyin the current periods. Series B financingstypically represent the second round ofinstitutional financing, frequently in support ofcompanies making the transition from productdevelopment to first product sales. The currenttrend in this stage of financing transactionsmay indicate that venture investors aremoving cautiously in supporting their portfoliocompanies and taking every opportunity toconserve cash in existing funds, thus ensuringthe adequacy of future capital for their moresuccessful portfolio companies. The number ofSeries B financings declined from 30 to 17—adecline of 43%—in the quarter-to-quartercomparison between 2008 and 2007, with anequally marked decline in the aggregateamount of dollars raised, from $363 million to$217 million. The declines for the nine-monthdata for Series B financings are more muted.Similar observations can be made for Series Cand later financings for the current periods.This phase of financing transactions—whichincludes mezzanine-stage financings—isintended to support companies thatsuccessfully have introduced products tomarket and are looking for growth capital toramp revenues and market share. The numberof Series C and later financing transactions forthe third quarter of 2008 declined to 27, withan aggregate of $527 million invested, downfrom 35 financings, with an aggregateinvestment of $573 million in the same quarterof 2007. If two financing transactions withunusually large investment amounts—each inexcess of $100 million—are removed fromthis category for the third quarter of 2008, theaggregate amount invested for this perioddrops from $573 million in the third quarter of2007 to $324 million in 2008, a decline of 43%.Finally, the data relating to the number ofbridge transactions for the three- and nine-month periods in 2008 compared with 2007 isrevealing. Bridge financing transactions forraw start-up companies may be nothing morethan a preferred choice of financing structure;this form of financing temporarily obviates theneed to establish a company valuation as thebasis for the investment. For a later-stagecompany, however, a bridge financing isusually a form of debt financing funded byexisting investors when a new lead investorcannot readily be brought in to establishvaluation and other investment terms.As shown on the chart on the next page, forthe third quarter of 2008, the number of bridgetransactions increased from 19 to 26; for thenine-month period, the number increased from64 to 96. The dollar amounts for each bridgefinancing transaction averaged for all periodsbetween $1.5 million and $2.0 million, butwith a wide deviation from transaction totransaction. We believe that the increase inthe number of bridge transactions, coupledwith the data that reflects a decline in thenumber of Series B and Series C and laterequity financings, may be indicative for later-stage companies of the increasing difficulty infinding new investors willing to invest in theselater rounds. It also may signal increasingcompetition among companies for newinvestors at a time when venture funds arebecoming more conservative in theirinvestments. In some cases, the decision toproceed with a bridge financing may resultfrom a determination to forego another roundof equity financing (and the resulting
$1,143$28$139$363$573$28$1,115$18$133$217$527$169$0$200$400$600$800$1,000$1,200$1,400
Round
      (      $     M      )
Q3 2007Q3 2008Total AmountRaisedAngel Series A Series B Series C & Later Bridges
Aggregate Amounts Raised by Series,Q3 2007 vs. Q3 2008

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