May 8, 2012 10:55 pm

Rising tech valuations put pressure on VC exits

This article is provided to FT.com readers by mergermarket—a news service focused on providing actionable, origination intelligence to M&A professionals. www.mergermarket.com
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There is a stiff price to pay when technology companies take on venture capital money.

Twitter is one example. Thus far, the five-year-old Northern California company has raised more than USD 1bn and is now valued at USD 8bn, according to previous media reports. Yet, the company is still in its “experimental stage,” Venrock partner David Pakman told mergermarket.

Many entrepreneurs think they are the “belle of the ball” when they raise a lot of money, said Parkman, “but there is a cost of taking more money than you need, even if it’s at a high price.” Raising a lot of money increases the risk to a successful exit, because the exit valuation has to be higher, said Keith Cooper, CEO of Connotate, an Internet data collection company.

The ‘Barbell Effect’: Valuations Rise

Twitter’s high valuation expectations may be a result of what is commonly known as the ‘barbell effect’ or series B crunch, Pakman said. Few investors focus on the USD 8m to USD 15m capital need, opting for early or late-stage investments. Seed funding hit a historical high in 1Q, accounting for almost one of every five VC investments, according to a report by CB Insights.

The increase in seed investments could be due to low yields in traditional and volatile stock markets, turning some individuals into angel investors in the US, said John Matthews, an industry consultant and founder of Comscient Group. The increase in funds has inflated valuations, he said.

At the same time, limited partnerships are becoming more selective with their VC investments, so there’s a massive concentration of capital in the more successful funds, said Firas Raouf, partner at OpenView, an early-stage VC firm. These funds need to write bigger checks to deploy capital and are offering higher valuations, in order not to dilute original investors too much. It also leads to “an aggressive drive to IPO”, he said.

Delayed floats

Following the Sarbanes-Oxley act of 2002, going public became more expensive in the US, Pakman said. Also, he said, the Global Settlement of 2003, which separated investment banking and analyst departments in 10 investment firms in the US, led to those firms underwriting fewer technology IPOs. The result is that companies are delaying going public so they can scale, while buyers delay acquisitions because the threat of a target going public is reduced.

“When I got into this [business], it was a USD 40m run rate and four quarters of profits that get you public,” said Mark Solon, managing partner at Highway 12 Ventures. “Now it’s USD 100m, while kicking off a whole bunch of EBITDA, and that is the low end. Seeing the mega IPOs doesn’t mean the IPO window is open -- it’s just not slammed shut.”

However, Solon argued that lengthened holding periods, from four years to about eight years, are just a return to the norm. Cooper argued that the increase is a natural part of the investment cycle. Cooper was CEO of FaxNet, which took four years to exit via a sale in 1999 and then he led Carbonite to a 2011 IPO. The latter exit took seven years, due to difficulties in the market, he said. During the 1997 to 2000 period, the Internet craze created a frenzy of technology investments and acquisitions, and “that brought the norm way down,” Solon said. “It takes a while to build a meaningful company.”

Instagram to spur larger exits?

The surprising USD 1bn Instagram acquisition by Facebook is the first in a wave of huge VC exits to come, particularly in mobile, said Eric Setton, co-founder of Tango, which provides mobile video calling. Hopefully, it will lead other companies to execute large buys, Pakman said.

Apple could return to acquisitions now that the late Steve Jobs, who had a high bar for acquisitions, no longer steers the ship, Pakman said. Yahoo might have to acquire to continue to grow and Twitter has to respond to Facebook’s aggressive approach to acquisitions. M&A in the enterprise sector has been high, with active companies such as IBM, Oracle, and Salesforce.com.

Still, skepticism remains. Instagram’s USD 1bn price tag for a non-profitable company suggests a “pretty frothy valuation for some companies that are just in development, particularly those that may be strategic to the likes of Facebook”, said Jeff Dearth, managing director at DeSilva & Phillips. “I think the appetite of the VCs has been fed by some of these big deals and they think, ‘Oh we can get 100x if the right group is interested, and we can charge a hell of a lot.’”

The response from companies for whom these opportunities are not strategic: “’No way I’m going to pay for that,’” Dearth said.

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