VC's Drive Up Tech-Valuations

Tech-Valuations Jump Published: April 10, 2013 in Knowledge@Wharton         

Venerable retailer J.C. Penney opened its doors more than a century ago and boasts annual revenues of nearly $13 billion from its 1,100 stores. Yet a three-year-old website with an untested business model and little discernible revenue is closing in on the department store chain's $3 billion market cap: 

Pinterest.

The online scrapbooking site recently raised $200 million in venture capital funds to bring its implied valuation to $2.5 billion, according to a February 20 story in The Wall Street Journal. Founded by three young entrepreneurs in March 2010, the tech start-up has 48 million users as of December 2012, up from nine million in the prior year, the article noted.

While Pinterest is wildly popular, its business model remains unproven. Users, including businesses, sign up for free accounts. The company is just gearing up to accept paid advertising and recently unveiled a free analytics tool for users with business-related accounts to track what has been pinned from their sites.

Pinterest may be thinking hard about ways to make money, but it remains unclear whether the firm's financial strategies can bring in enough revenue to cover costs and generate a healthy profit, which will be especially important once the company goes public. No matter. Pinterest has garnered the interest of such Silicon Valley blue-chip venture capital firms as Andreessen Horowitz (as in Netscape co-founder Marc Andreessen). For now, Pinterest has money to burn.

The company is one of at least 25 start-ups that command market caps of one billion dollars or more, according to a February 4 story in The New York Times. The billion-dollar start-ups club includes such familiar names as productivity application Evernote, travel rental site Airbnb, online questionnaire software SurveyMonkey and streaming music service Spotify. But such high valuations are bringing back concerns that the market is entering another tech bubble like the dot-com frenzy in the late 1990s that led to scores of Internet companies going belly up and investors losing vast fortunes.

Wharton finance professor Jeremy Siegel, who warned that Internet and other tech stocks were overvalued in 1999 shortly before the dot-com bubble burst, says the sector is not in the same kind of peril today. "It's a world of difference," he notes. Back then, tech companies -- including well-capitalized S&P 500 firms like AOL, Sun Microsystems and EMC -- were trading at sky-high valuations, Siegel says, adding that shell companies without good business ideas also were given similar pricetags simply because they were a "dot-com."

In an April 1999 editorial for the Journal, Siegel warned that tech's high valuations could not be sustained. Back then, Siegel pointed out that AOL was selling at more than 700 times its earnings for the past 12 months, an "unprecedented valuation for a firm with this market value," and one which put it among the country's 10 most highly valued firms. Yet, the Internet service provider came in only 311^th in profits and 415^th in sales against other companies. (AOL has since spun off from Time Warner and currently is valued at $2.8 billion.)

Such inflated valuations are not the norm in the tech sector today. "Big tech companies are [trading at] less than 20 times earnings," he points out, citing as examples the valuations of market leaders Google and Apple. "It's not overvalued."

At $450 a share, Apple is currently trading at about 10 times fiscal 2013 projected earnings per share of $44.19. Google is trading at $815, or 18 times fiscal 2013 projected earnings per share of $45.55. Microsoft is trading at 10 times 2013 earnings and Yahoo is at 21 times this year's profit. These price-to-earnings ratios are hardly inflated vis-a-vis the market: As of March 22, the S&P 500 was trading at 14 times forward earnings, the Nasdaq 100 was at 15 times and the Dow hovered at 13 times. The market is "nowhere near as speculative" today because investors remember the painful lessons of the dot-com crash, Siegel notes. "People have been burned. They're more cautious. Their memories are in place."

But there are several reasons why Pinterest and a select group of start-ups are getting valuations that any brick-and-mortar company would envy.

New Cycle of Growth

Social media is turning out to be a lasting tech trend, thanks largely to the success of Facebook, Twitter and LinkedIn. The exponential growth of users at Pinterest and other billion-dollar start-ups are signals that these companies could be the next tech leaders, and venture capitalists want to get in early to cash out at the time of an IPO or shortly thereafter.

On a macroeconomic level, it also helps that investor sentiment is rising as the U.S. economy recovers, according to Wharton management professor Saikat Chaudhuri. As a new cycle of growth emerges, investors are feeling more bullish. "They're optimistic now about the future and placing bets," he says.

But unlike the last tech bubble, "we're seeing investors being more critical," Chaudhuri adds. So while they are looking to invest, "they have also shown a bit more restraint." He notes that investors today are quick to ask the start-up where it is parking its money and how the business plans to "monetize" -- jargon for a business model that will lead to revenue and profits.

Venture capitalists have also become pickier, especially following a consolidation in the VC industry. The number of VC companies is down by about half from 1,000 companies five years ago, says Doug Collom, vice dean of Wharton's San Francisco campus.

VCs historically make an annual average return of 15% to 20%, but recently that figure has fallen to 6% because finding good bets has been difficult, Collom adds. Start-up investors are not being compensated enough for the level of risk they are shouldering, and there are better places to put their money.

Not only is the number of VC funds shrinking, but so is the fund size, notes Wharton management professor Raffi Amit. "The industry is in a major transition and consolidation." Mitigating the decline somewhat is that 10 to 15 years ago, several million dollars typically was needed to get a company off the ground; today, $50,000 to $100,000 can suffice, he adds.

Still, the remaining VCs are placing their bets more conservatively, watching to see where others are investing. "There is the herd phenomenon. Some sectors are considered hot, and hence a disproportionate amount of capital flows into companies in these hot sectors," Amit says.

If VCs see that other firms with proven track records, such as Kleiner Perkins and Accel Partners, are backing a tech company, they are more likely to jump in as well because the start-up has been "validated," Collom notes. As more big name VCs invest in the same company, it creates a "feeding frenzy dynamic that drives the price up, pushing valuation up beyond rationality," he adds. Hence a $2.5 billion valuation for Pinterest becomes reality as VCs wonder, "Are they the next Google?"

Don't Throw Out DCF with the Bathwater

As one of the hottest social media companies to emerge since Facebook, Pinterest could well be worth a high valuation. But how did VCs arrive at $2.5 billion?

The traditional method of valuing companies is through the discounted cash flow model, or DCF, which projects a company's cash flows out by several years and discounts it to arrive at the present value. But applying the DCF model becomes a challenge when a start-up is not making any money.

"It's difficult to value companies that are very young, that don't have positive cash flows or even revenues," says Wharton finance professor Luke Taylor. Even so, the "discounted cash flow model is simply correct finance."

David Wessels, an adjunct finance professor at Wharton, concurs. In a book he co-authored titled, Valuation: Measuring and Managing the Value of Companies, Wessels suggests that the discounted cash flow model is the best way to value high-growth companies because the core principles of economics and finance apply even in uncharted territory. But instead of using a firm's historical performance in the model, Wessels says, one should start by examining the expected long-term developments of a company's market and work backwards. Given that long-term projections are uncertain, it is critical to develop different financial scenarios.

OpenTable vs. Groupon

Wessels, with co-authors Tim Koller and Marc Goedhart, analyzed the business of OpenTable, a provider of online restaurant reservations.

The company generates revenue by charging business customers $1 for every seated diner who uses the site to make reservations and 25 cents if the customer uses the restaurant's website. There is also a monthly subscription fee of $250 for restaurants to use OpenTable's proprietary computer system that manages reservations and table seating, keeps track of guests and provides e-mail marketing. In addition, there is a one-time installation fee of $800.

From 2004 to 2008, OpenTable's revenue grew from $10 million to $56 million, a compounded annual growth rate of 53%. Subscription fees comprised 54% of its 2008 revenue while reservation fees took up 42% and the rest came from installation fees.

In 2008, OpenTable reported that 34 million diners used its service at 10,335 restaurants. That comes to about 30% of the 30,000 reservation-taking restaurants in the U.S. The authors projected that by 2018, OpenTable will command 60% of the U.S. market and also profit from a continued expansion overseas. They based the 60% prediction on OpenTable's market share in San Francisco in 2008.

If the number of restaurants increased by 2% a year, or twice the rate of population growth in the U.S., there would be 36,500 U.S. restaurants taking reservations by 2018. A 60% share for OpenTable means it would have 21,900 restaurants as clients. As for the firm's foreign operations, the authors assumed the growth would match that of the U.S., delayed by six years. By their calculation, OpenTable could record global revenue of $306.8 million by 2018.

To stress-test their projection, the authors first compared OpenTable's growth path with the first five years of expansion of Internet companies founded in the 1990s that now make more than $10 million in revenue. "Benchmark against other high-growth companies in the past to see if the projection is reasonable," Wessels says.

OpenTable's revenue grew from $10 million to $56 million from 2004 to 2008, which matched the performance of the median Internet company. The book, released in its fifth edition in 2010, forecast that by 2012, OpenTable would book revenue of $141.2 million, a bit higher than the median Internet company but within the bounds of distribution.

The authors also looked at OpenTable's target operating margin of 30% to 35% and compared the forecast to other consumer Internet companies such as Expedia, Priceline, Orbitz and Monster.com. OpenTable's margin range is higher, but the authors predicted that achieving it is feasible because the company is the leader in the online reservations market and has little competition.

Finally, they considered three scenarios for OpenTable: exceeding, meeting or underperforming expectations by 2018. If the company outperforms, its eventual valuation was estimated at $1.14 billion. If it meets forecasts, then $719 million was the calculated value. It was $545 million if OpenTable lags predictions. OpenTable went public in May 2009.

As of March 22, OpenTable had a market cap of $1.4 billion. Last year, it booked revenues of $161.6 million with an operating margin of 23%.

OpenTable exceeded expectations, as Pinterest and other highly valued tech start-ups one day might, but it also could easily have fallen by the wayside, much like what happened to daily deals site Groupon.

Before its IPO in November 2011, Groupon was valued at more than $6 billion. On the stock's first day of trading, Groupon's valuation jumped to $16.6 billion. But later on, accounting problems surfaced, profits stumbled and revenue growth fell below Wall Street's expectations. Last month, the company fired CEO and founder Andrew Mason. Groupon is now valued at $3.8 billion, a loss of $13 billion in market cap in little more than a year.

Going public is a sobering event. After an IPO, the focus of investors shifts from a company's user growth and buzz to its financial performance, testing the start-up's business model. "The real acid test is when they get out into the public market," Collom notes.

Until then, VCs make an educated guess whether these hot start-ups are worth the money -- and the dice keep rolling. Most bets do not pay off. And even among those investments that make it to Pinterest's level of funding, "there's a lot of debate about whether companies can sustain these valuations," Collom says.

Terry Stidham is the President and founder of Target Search Group. He is a Business Development Leader with extensive knowledge of the M&A process, combined with an in-depth understanding of the constantly changing global capital markets environment.  He has served as the head of entrepreneurial organizations as well as Fortune 500 companies.  He specializes with mid-market companies in a diverse array of industry sectors from service and manufacturing to technical and professional firms.

 

Mr. Stidham speaks the language of both the seller and the buyer having vast experience on both sides of the transaction. He has been directly involved in the execution and successful closing of hundreds of investment banking and corporate finance transactions.  Mr. Stidham has been instrumental in aiding thousands of business owners prepare their businesses for eventual sale by teaching them how to maximize efficiencies in operations leading to significant increased cash flow.

Top 10 Private Equity Tax Breaks

10 Top Private Equity Tax Breaks by Terry Stidham

Victor Fleischer, University Of Colorado Law School Professor, Identified These Top 10 PE Tax Breaks

1. Carried Interest - In exchange for managing an investment fund, managers receive a percentage of the fund’s profits, known as carried interest. The amount of carried interest is typically 20 percent, and in any given year, individual fund managers earn anywhere from nothing to tens of millions of dollars. Under current law, if the fund’s profits are capital gains, the manager’s carried interest is also taxed at capital gains rates.
2. Management Fee Waivers - Fund managers receive a fixed management fee, often 2 percent of capital, for managing the fund. Management fees are normally taxed as ordinary income. To avoid this, the fees can be waived in exchange for an almost-risk-free priority allocation of profits taxed at capital gains rates.
3. The Limited Partner Loophole - As labor income, management fees would normally be subject to the Medicare tax, now 3.8% for high-income individuals. Under current law, even investment income is subject to the 3.8% tax. Through careful structuring, some fund managers take their income through a limited partnership in which they are technically “limited partners” in the management company, even though it is their labor, and not their capital, that generates the fee income. Allocations to limited partners, however, are neither subject to the Medicare tax as self-employment income nor as investment income under section 1411.
4. The S Corp Loophole - This is conceptually the same as the limited partner loophole: wages are paid through an S Corporation avoiding employment taxes.
5. Private Equity Publicly Traded Partnerships - Normally, publicly traded companies are taxed as corporations, which mean that shareholders pay both an entity-level tax and also a shareholder-level tax on dividends or capital gains. But when investment firms go public, they use the favorable tax treatment of carried interest (which is treated as investment income, not labor income) to fit into an exception to the publicly traded partnership rules for “qualifying income,” which includes investment income. This enables publicly traded private equity firms to avoid the corporate tax altogether.
6. Supercharged Public Offerings - Private equity firms that went public structured the initial public offerings to resemble a sale of the firm’s assets to the newly public company, creating for the public company a new, higher “cost basis” in the firm’s assets. The value of those assets attributable to the goodwill of the firm could then be amortized over 15 years, generating new tax deductions at a 35 percent rate. As part of the deals, the newly public companies entered into tax receivable agreements, in which the companies promise to pay 85 percent of the tax benefits back to the selling founders.  The founders pay tax on the sale at low capital gains rate and they get a check each year from the newly public companies.
7. Enterprise Value - If the carried interest legislation were passed, individual managers may cash out by selling their carried interests to a third party and recognizing capital gain. The proposed legislation closes that loophole, but still allows the managers to sell interests in the management company — most of the value of which is attributable to past and future carried interest income and management fees — at capital gains rates.
8. The Angel Investor Loophole - Section 1202 allows investors in “qualified small business stock,” mostly angel investors and venture capitalists, to exclude 100 percent of their capital gains, in most cases up to $10 million.
9. I.R.A. Stuffing - Fund managers sometimes takes risk in partnership interests or shares in underlying portfolio companies and contributes those interests to I.R.A.’s at low valuations. If the interests are inside the I.R.A., appreciation in the value of the investments goes untaxed until distributed.
10. Interest Deductions - Interest deductions from the debt to finance an acquisition in taking a company private shields the portfolio company from tax liability.

Tax Advice Disclaimer

The information on this blog should not be used in any actual transaction without the advice and guidance of a professional Tax Adviser who is familiar with all the relevant facts.

Although the information contained here is presented in good faith and believed to be correct, it is General in nature and is not intended as tax advice. Furthermore, the information contained herein may not be applicable to or suitable for the individuals' specific circumstances or needs and may require consideration of other matters.

Terry Stidham and Target Search Group, LLC assumes no obligation to inform any person of any changes in the tax law or other factors that could affect the information contained  herein.

IRS Circular 230 Disclosure

Pursuant to the requirements of the Internal Revenue Service Circular 230, we inform you that, to the extent any advice relating to a Federal tax issue is contained in this communication, including in any attachments, it was not written or intended to be used, and cannot be used, for the purpose of (a) avoiding any tax related penalties that may be imposed on you or any other person under the Internal Revenue Code, or (b) promoting, marketing or recommending to another person any transaction or matter addressed in this communication.

Terry Stidham is the President and founder of Target Search Group. He is a Business Development Leader with extensive knowledge of the M&A process, combined with an in-depth understanding of the constantly changing global capital markets environment.  He has served as the head of entrepreneurial organizations as well as Fortune 500 companies.  He specializes with mid-market companies in a diverse array of industry sectors from service and manufacturing to technical and professional firms.

 

Mr. Stidham speaks the language of both the seller and the buyer having vast experience on both sides of the transaction. He has been directly involved in the execution and successful closing of hundreds of investment banking and corporate finance transactions.  Mr. Stidham has been instrumental in aiding thousands of business owners prepare their businesses for eventual sale by teaching them how to maximize efficiencies in operations leading to significant increased cash flow.

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US Venture Capital Q1

US Venture Capital Market

 

VC Funds invested $6.9bn in US start-ups across 841 deals during the first 3 months of this year, up from $6.8bn in the fourth quarter of 2012, which saw 834 transactions, a study by industry database CB Insights has estimated.

According to the analysis, funding for internet companies soared by 12% on a sequential basis during the first quarter of 2013, to over $2.7bn.

Terry Stidham is the President and founder of Target Search Group. He is a Business Development Leader with extensive knowledge of the M&A process, combined with an in-depth understanding of the constantly changing global capital markets environment.  He has served as the head of entrepreneurial organizations as well as Fortune 500 companies.  He specializes with mid-market companies in a diverse array of industry sectors from service and manufacturing to technical and professional firms.

 

Q1 Funding

Private Equity Fundraising Outstrips Q1 Targets

by Terry Stidham

130 private equity funds raised $69.3 billion globally in the first quarter of 2013. This is similar to 2012 when on average $73.7 billion was raised in each quarter. However, the total represents a significant upside vs. fund targets of $59.9 billion. Although the LP's have improved confidence they continue to seek firms that can deliver.

PEI PRESS RELEASE

Private Equity Fundraising Outstrips Q1 Targets

• Private equity funds collected $69.3bn in Q1 – $9.4bn in excess of fund targets
• Buyout funds account for almost half all private equity closed funds
• High targets of funds in market indicate returning confidence

Private Equity International, the leading information provider for the global private equity, asset class (www.privateequityinternational.com), today publishes its quarterly report on global fundraising data.

Funds raised

The data, compiled by PEI’s Research and Analytics team, shows a total of $69.3bn raised globally, by 130 funds, across all private equity strategies in the first quarter of 2013. The figure is roughly in line with fundraising totals for 2012 – on average $73.7bn was raised in each quarter in the year – but represents a significant surplus on fund targets, with firms having aimed for an aggregate of $59.9bn.

“The totals being raised are still no way near peaks of the pre-crisis period but closed funds are evidence of consistent returning confidence,” said Dan Gunner, Director of Research and Analytics, PEI. “What’s most striking about these Q1 figures is the capital raised in excess of what fund managers were targeting. It reinforces the belief that for those managers with strong track records and a good story to tell, there’s ample opportunity.”

Funds with a focus on investment in North America proved the most popular, securing $23.3bn – a figure marginally higher than quarterly averages in the previous four years. Those looking to deploy capital globally raised $18.8bn. In 2012, such funds averaged quarterly fundraisings of $31.8bn.

The single largest fund close in the quarter was that of Cinven, with The Fith Cinven Fund collecting $6.5bn for pan-European investment. Both EnCap Investments, a US firm focused on investment in oil and gas, and Highbridge Principal Strategies, also US-based, raised $5bn.

Buyout funds proved most popular, accounting for $28.5bn of the total capital raised in the quarter. That figure is roughly in line with capital raised for the investment strategy in 2012 – $137bn was raised in the year, a quarterly average of $34.25bn.

Venture capital and growth equity funds also demonstrated a strong quarter, collecting $17.9bn. Such funds had targeted capital of $14.5bn.

Both distressed and secondary funds showed a marked decline relative to fundraising performance in 2012. The former raised just $1.2bn compared to a total of $15.3bn in the preceding 12 months. Secondary fund managers raised $2.1bn – in 2012 they collected $20.8bn.

Funds in the market

In addition to funds outstripping targets in Q1 2013, a review of those in the market also suggests a returning confidence among private equity managers. Seven funds are currently each aiming to raise at least $10bn with three firms, Apollo Global Management, TPG, and Warburg Pincus, targeting $12bn to invest globally.

Funds aiming to invest in Asia-Pacific are notable for their growing confidence. In 2012, $34.6bn was closed by general partners (GPs) with funds targeting the region. Currently, however, there are 417 – almost a third of all funds in the market – aiming to collect $195bn.

“Fundraising activity since 2009 has shown a gradual, steady improvement and the number of funds in the market is high”, said Dan Gunner. “The example of Asia-Pacific demonstrates neatly the disparity between what funds have raised in recent years and what they are aiming for now. There’s clearly an improved confidence globally but it’s never been more competitive... LP investors are increasingly choosing established managers with good track records so some of these funds on the road may not raise what they hope.”

 

Terry Stidham is the President and founder of Target Search Group. He is a Business Development Leader with extensive knowledge of the M&A process, combined with an in-depth understanding of the constantly changing global capital markets environment.  He has served as the head of entrepreneurial organizations as well as Fortune 500 companies.  He specializes with mid-market companies in a diverse array of industry sectors from service and manufacturing to technical and professional firms.
 

Mr. Stidham speaks the language of both the seller and the buyer having vast experience on both sides of the transaction. He has been directly involved in the execution and successful closing of hundreds of investment banking and corporate finance transactions.  Mr. Stidham has been instrumental in aiding thousands of business owners prepare their businesses for eventual sale by teaching them how to maximize efficiencies in operations leading to significant increased cash flow.

 

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Keeping the Culture

Maintaining Company Culture in an Acquisition Can Be Crucial to Its Success

by Terry Stidham

Many company founders don’t set out to establish a unique company culture, yet according to a Mercer Culture Integration Snapshot Survey; almost 75 percent of deal teams regard culture as a key component in creating deal value.

That’s because a company’s culture is often a major factor in defining its role in the marketplace. That culture is developed largely according to the personality, background and values of its leaders. Since most businesses start out with a small, closely knit team handpicked by their founders, certain attitudes, visions and values simply become “how we do things around here.”

The resulting company culture becomes a major contributing factor in the company’s failure or success.

During an acquisition it can be difficult to maintain a company’s culture - yet failure to do so can undermine the business’s ability to perform as expected.

The Sweet Taste of Success: A Case Study

Ben & Jerry’s Ice Cream is a household name today, but in 1978 it was just a dream thought up by two men who had first met in 7^th grade gym class. Neither knew quite what to do with his life, so they identified a shared passion—ice cream—and decided to start a company together.

Ben Cohen and Jerry Greenfield had strong social convictions, leading them to buy only from local farmers and to give 7.5% of their pretax profits to charities. They developed a company culture based largely on social responsibility and left-leaning social activism.

When the company sold to Unilever in 2001 its stock price had begun to fall.  Although its customers loved the unique brand, which was Fair Trade Certified and used environmentally friendly packaging with flavor names like “Imagine Whirled Peace,” its alternative management style lacked the fiscal and managerial discipline analysts and investors demanded.

So Unilever was faced with a challenge: how could it maintain the Ben & Jerry’s image, while mixing in some much needed discipline?

3 Tips for Maintaining Company Culture 

Tip 1: Create a plan to keep core cultural principles—and make it part of the deal. 
In Ben & Jerry’s case, The New York Times reported that Unilever agreed to something called the “social mission process.” Unilever agreed to commit 7.5% of profits to a foundation and agreed not to reduce jobs or alter the way the ice cream was made.

Tip 2: Realize some change is inevitable, but it can go both ways.
The company’s founders, both Ben and Jerry, continued with the company with board seats after the acquisition, and the deal included plans for Ben to work with Unilever on evaluating its involvement in activities like protecting the environment—integrating some of Ben & Jerry’s culture into the larger organization.

Meanwhile, Unilever brought in a new CEO, Yves Couette, to manage the brand and help institute some much needed discipline. Yet even that was done with care—Couette took the time to adapt his management style and organizational decisions to fit within the existing culture, allowing him to gain trust and build credibility with Ben & Jerry’s employees and, ultimately, allowing for the best of both to succeed.

Tip 3: Start integration early and communicate the plan effectively.
The Ben & Jerry’s deal happened in the public eye, so everyone was aware that change was coming. Blindsiding employees often leads to increased stress over how the change will impact them individually.

While some deals need to be kept under raps until some form of agreement is in place, the sooner both companies share their future trajectory and allow employees at every level to begin adapting, the better. Make sure to “sell” the deal internally as well as externally to all stakeholders.

While implementing these tips won’t guarantee a smooth M&A transition, they are a good first step to getting the companies in sync.

5 Key Characteristics for a Startup CEO

Scott Johnson, Managing Partner with New Atlantic Ventures recently posted the following blog in which he identifies key habits and characteristics of what it takes to be a great startup CEO.

"Being CEO of a startup is quite similar to being the parent of a newborn.  The neighbors see a clean cooing newborn with smiling proud parents.  But we all know what goes on inside the house.  Sleepless nights, stress, no time to attend to other relationships.  You are a slave to the new creature.  It is ultimately incredibly rewarding, but parenting is very hard work and not at all glamourous.  And just the way not everyone handles parenting well, not everyone is a good candidate to run a startup.  As a matter of fact, a great startup CEO is as rare as a 70 degree day in March in Boston.

I have compiled the qualities that great startup CEOs share – you know – the CEOs that actually get multiple B-round term sheets in down markets and get that marquis exit at an unusually high multiple.  These are the ones that consistently surprise their board on the upside, investors love to back, and that acquirers pay up to bring in-house.  If you are a founder looking for a CEO to really grow your company, here are the five personal attributes you should look for:

1) Attracts Great Talent.  This is the best indicator of success, as it really encompasses all of the other attributes.  If A+ talent flocks to work for someone, that person has got something special.  Be careful though.  An orangutan could be CEO of super fast growing startup and attract great talent.  So, make sure it is the CEO who can attract talent, not someone riding the wave at a hot company.

2) Networking God.  A good CEO shortens sales cycles with contacts, shortens hiring time with contacts, and shortens fundraising time with contacts.  A CEO who networks well can hence shorten time to exit and massively reduce dilution to founders.  Give 8% to a great CEO, prevent 20-30% or more in downstream dilution.

3) High Intelligence.  The CEO is usually not the highest IQ in the room.  But he needs to be in the conversation.  At high tech startups, a certain acumen is needed to keep the respect of the troops, and gain the respect of customers and investors.

4) Strategic Thinker.  The trick with startups is to channel all of the companies limited resources in the optimal direction.  And to quickly alter course as markets dictate so not a single moment is wasted by indecision.  This requires strategic thinking, not tactical execution.  Many line executives from larger companies struggle as CEOs of startups because they  have not had the opportunity to deviate from a strategy that was handed down to them from above.

5) Stamina, Energy and Productivity.  This gets back to my point at the top about parenting a newborn.  The CEO needs to be all-in, and one of those productive people that doesn’t waste a second of his or her day.  The CEO sets the culture at a company, and that should be one of reward for achievement, productivity, hard work, and accountability.

Every founder CEO should be very honest in his or her self assessment, and then when they see someone with the above profile, move quickly to hire them.  But do your diligence. Hiring the wrong CEO can be every bit as costly as hiring the right one can be helpful."

Generalist Funds Prevailing

Capital is Available for Funds that have Delivered Strong and Consistent Results

Mary Kathleen Flynn with Source Media recently wrote the following post on how firms like Huron Capital Partners are going against the common wisdom of the last few years that generalist funds were waning.

“Huron Capital Partners LLC is among a handful of private equity firms that have recently raised new generalist funds, going against the common wisdom of the last few years that generalist funds were waning. At $500 million, Huron Fund IV is the Detroit firm's biggest fund to date. Like Huron's previous funds, it will make control investments in lower middle-market companies.

The fundraising climate today is "tough overall," reports partner Gretchen Perkins. "But capital is available for funds that have delivered strong and consistent results."

Although the firm raised funds quickly - fundraising began in October, and the fund closed in December - the process was more challenging than it had been for the previous fund, which was raised during the exuberant market of 2007.

"Limited partners are much pickier today," explains Perkins. "They conduct a far greater level of due diligence, and it requires more resources internally to respond to all of that."

Huron went into the process well prepared, Perkins says. "We found that great LPs were prepared to move, with lots of detailed, comprehensive backup."

The firm added some new investors, as well as retaining past investors.

The new fund will invest in companies with the same criteria as previous funds, without a focus on particular industries. "While we do invest in a range of industries and sectors, we do focus very specifically on solid companies where we believe we can improve operations to create value," explains Perkins about the firm's investment thesis.

"We will continue to invest $10 million to $50 million of equity in lower middle-market companies in the new fund. Additionally, we can invest up to $100 million and, therefore, close deals with no outside financing."

The last three businesses that Huron has invested in from its third fund are "representative of the types of businesses in which we will continue to invest from our new fund," she says. These include Six Month Smiles, a provider of cosmetic orthodontics; Ronnoco Coffee, a coffee roaster and distributor; and Bloomer Plastics, a producer of engineered plastic films.

When asked how the dealmaking environment is shaping up in 2013, Perkins responds, ‘I would say stable. We are closing on three companies now, which is on pace with 2012."’

Terry Stidham is the founder and principal of Target Search Group. He is a B2B Business Development Leader with extensive knowledge of the M&A process, combined with an in-depth understanding of the constantly changing global capital markets environment.  He has served as the head of entrepreneurial organizations as well as Fortune 500 companies.  He specializes with mid-market companies in a diverse array of industry sectors from service and manufacturing to technical and professional firms.

Mr. Stidham speaks the language of both the seller and the buyer having vast experience on both sides of the transaction. He has been directly involved in the execution and successful closing of hundreds of investment banking and corporate finance transactions.  Mr. Stidham has been instrumental in aiding thousands of business owners prepare their businesses for eventual sale by teaching them how to maximize efficiencies in operations leading to significant increased cash flow.

PE Assets in Unsold Companies at Record Levels

PE Sets on Record Collection of Unsold Portfolio Co's in the Asset Class. Investors Take Notice.

Arleen Jacobius recently wrote the following post elaborating on several of my recent posts that looks at  the overhang of unsold companies and LP's sentiment. 

The glut is enormous: an estimated 6,500 unsold portfolio companies as of year end, representing 69% of private equity firms' total assets under management as of Sept. 30. That is the highest number of unsold portfolio companies ever recorded by PitchBook Data Inc.  It is estimated to double that of 2006.

Institutional investors are beginning to ask managers about these portfolio companies and the likelihood of achieving exits — before committing capital to new funds. Whether these holdings are sold for sizable profits could affect private equity returns in years to come.

For example, both the $41 billion Los Angeles County Employees' Retirement Association, Pasadena, and the $38 billion Teachers' Retirement System of the State of Illinois, Springfield, tracked Silver Lake Partners' portfolio company exits before making commitments to its latest fund, Silver Lake Partners IV. Each eventually committed $150 million.

Investment Concerns

LACERA's staff named exits of unsold portfolio companies as one of its two “investment concerns” related to investing in Silver Lake's fourth fund, according to a staff memo for the Feb. 13 board of investments meeting. The staff noted Silver Lake has about $7.6 billion invested in 24 still active companies. Some 70% of the capital invested in Silver Lake's second fund, which closed in 2004, and 75% of the capital invested in Silver Lake's third fund, which closed in 2007 is still active.

And it's not just Silver Lake. LACERA staff noted in the memo that a “lingering impact of the financial crisis is the large quantity of unsold portfolio companies building up in large buyout funds.”

Andrew R. Cristinzio, McLean, Va.-based partner in PricewaterhouseCoopers LLP's deals practice, estimated the overhang in assets is double 2006 levels.

“If you look at private-equity-backed portfolio companies back at pre-crisis levels, current private-equity-backed portfolio company overhang at the end of 2012 was somewhere around 6,500, which is estimated to be double that of the pre-2006 period,” said Mr. Cristinzio, citing PitchBook data.

Indeed, of the more than $3.27 trillion in total worldwide private equity assets under management as of Sept. 30, $2.27 trillion is “unrealized portfolio value” or unsold portfolio companies, according to data prepared for Pensions & Investments by Preqin, a London-based alternative investment research firm.

The worst offender in terms of vintage year is 2007 funds, which as a group have the highest unrealized value of portfolio companies — $527 billion — compared with total assets under management of $617 billion, the Preqin data show.

When Preqin compared the proportion of private equity companies invested in each year since 2006 that are still being held by fund managers, 70% of companies invested in throughout 2006 are still being held, said Nicholas Jelfs, Preqin senior analyst and press officer.

The overhang in unsold private equity portfolio companies has never been higher in the history of the asset class, asserted Michael G. Fisch, president and CEO of American Securities LLC, a private equity firm in New York.

“The overhang that is not sufficiently talked about is not the overhang of capital, but the overhang of older portfolio companies and older funds that have not been sold and need to be sold,” Mr. Fisch said.

What ends up happening to this glut of unsold portfolio companies could have a big impact on the private equity industry.

Some firms can't sell some of their portfolio companies because they are worth less than their original investment, Mr. Fisch said.

“What will happen to them? Who will buy them? When will they get sold? What will happen to the returns of the industry when they do get sold?” Mr. Fisch asked.

Every situation will be different, he said. If a manager's relationship with the firm's limited partners is good, investors will give the general partners more time to sell their portfolio companies.

Where the general partner-limited partner relationship is not good, the entire private equity fund might be sold to another general partner, or investors might bring in a new general partner because they have lost faith in the original one, Mr. Fisch said.

New Commitments
Holding onto portfolio companies also can affect investors' ability to make new commitments, said Sanjay R. Mansukhani, senior manager research consultant in the New York office of Towers Watson Investment Services Inc. That's because exiting companies is a prime source of distributions back to limited partners. “When net asset value is not coming back in distributions, investors find themselves overallocated” to private equity, Mr. Mansukhani said.

Given the lessons of the financial crisis, when overexposure to alternative investments made the entire portfolio less liquid, investors are loath to increase their target allocation in order to commit capital to additional private equity funds, he explained.

Portfolio company refinancing, called recapitalizations, has led to some distributions to limited partners, but most distributions in Towers Watson's portfolio are from portfolio company exits, Mr. Mansukhani said.

This makes it tougher for general partners to raise money, even when their portfolio valuations are rising from the effect of the uptick in the equity markets in the U.S. and the value general partners have added to the portfolio companies, Mr. Mansukhani said.

"Even core investors are giving less money, even for great-performing funds,” he said.

Distributions also are a sign that a private equity firm is a solid performer, noted David Fann, president and CEO of TorreyCove Capital Partners LLC, a San Diego private equity consulting firm.

“Most private equity investors would like to see at least a portion of the prior fund's investments achieve realizations before committing to a new fund,” Mr. Fann said. “Realized investments validate performance and success.”

Damage to Returns
Another aspect of this historic overhang of portfolio companies is the damage it is expected to do to overall private equity returns.

“It's just on the math of the internal rate of returns,” Mr. Mansukhani said.

A longer portfolio company holding period will affect internal rate of return because IRR is time based.

“General partners may gain a little multiple by holding out for a better price, but what it is going to do is dilute the internal rate of return,” he said. “You have to balance those two things.”

It also becomes an issue of capacity, whether a manager with a collection of portfolio companies in older funds and a new fund has enough executives to manage the entire portfolio, Mr. Mansukhani said.

“It's about bandwidth,” Mr. Fann said. “Understanding the capacity of general partners to make new investments is critical. Investors want their GPs to work solely on their behalf. Investors don't want to commit to funds whose general partners are consumed working on the previous fund's investments.”

However, some industry executives are betting the portfolio company overhang might diminish if the economy, at least in the U.S., continues to improve and debt for deals remains available.

“Clearly, there's a general acknowledgement that there's been an increase in the average hold time from investments made in the 2007-2008 time frame,” said PricewaterhouseCoopers' Mr. Cristinzio. “But if the economy continues on the current trend and financing continues being available as it is, we will see an increase in exits.”

Terry Stidham is the founder and principal of Target Search Group. He is a B2B Business Development Leader with extensive knowledge of the M&A process, combined with an in-depth understanding of the constantly changing global capital markets environment.  He has served as the head of entrepreneurial organizations as well as Fortune 500 companies.  He specializes with mid-market companies in a diverse array of industry sectors from service and manufacturing to technical and professional firms.

Mr. Stidham speaks the language of both the seller and the buyer having vast experience on both sides of the transaction. He has been directly involved in the execution and successful closing of hundreds of investment banking and corporate finance transactions.  Mr. Stidham has been instrumental in aiding thousands of business owners prepare their businesses for eventual sale by teaching them how to maximize efficiencies in operations leading to significant increased cash flow.