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Article from SFGate.

It’s suddenly a lot harder for venture capitalists and startups to raise funds, as investors fed up with low returns turn their backs on the sector.

Most industry observers agree that lots of young firms will simply not be able to raise their next round of funding, commencing a period of belt tightening, consolidation and closures. At a minimum, it seems to mark the beginning of a more level-headed investment climate in Silicon Valley, after years of insatiable lust for all things mobile and social.

But if the drop-off is too sudden and steep, this new austerity could spill over into an economy highly dependent on the tech sector. Indeed, as The Chronicle reported last week, the industry has an enormous impact, with each tech job creating 4.3 indirect jobs in the community, according to a Bay Area Council Economic Institute report.

The investors and venture capitalists I spoke to insisted that we’re not on the verge of anything like the dot-com meltdown, characterizing the shift as a minor and healthy correction, or a “rationalization.” One suggested it was little more than the usual process of separating good and bad ideas in the marketplace.

But the numbers suggest something new is afoot. In the third quarter, the amount that U.S. companies raised in venture capital dropped 32 percent from the prior year, according to Dow Jones VentureSource. Venture capital funds themselves raised 17 percent fewer dollars from the second to third quarter, even as the number of funds grew, according to a joint report from Thomson Reuters and the National Venture Capital Association.

Economic uncertainty

Some partially blame the economic uncertainty surrounding the outcome of the election and the “fiscal cliff.” But the main problem seems to be that many of the “limited partners” that fund venture capital are pulling back after years of frustration.

Ever since a brief period in the late 1990s when venture capital burned bright, the industry has been delivering consistently weak returns on the whole.

In fact, despite requiring greater risks and larger capital outlays, venture capital has been underperforming the stock market over the past decade, according to a report this year by the Ewing Marion Kauffman Foundation.

Joe Dear, chief investment officer for CalPERS, told Reuters this summer that venture capital “has been the most disappointing asset class over the past 10 years as far as returns.” The huge pension fund for California’s public employees didn’t return repeated calls from The Chronicle.

Investment horizons have steadily spread out, from five to 10 to sometimes 15 years, as exit opportunities like acquisitions and initial public offerings fail to materialize. This has sometimes forced investors to put in more money to protect their initial funds.

‘Pretty grumpy’

“The industry definitely, for the last decade, has been a tough place to be,” said Ray Rothrock of Palo Alto venture capital firm Venrock. “We’re all pretty grumpy right now.”

Some of this is due to macroeconomic conditions outside the control of venture capitalists, notably the housing and banking crises. But at least some of it has to do with poor picks and herd mentality, funding companies with few real prospects and driving up the entry price for legitimately promising companies beyond what they could pay off.

“The market overfunded the number of companies in the system,” said Hans Swildens, founder of Industry Ventures in San Francisco. “There’s a glut.”

Even the grand promise of Web 2.0 companies that lured so much recent money hasn’t generated the hoped-for returns. The ones that managed to go public were often disappointments, including Facebook, Zynga and Groupon, in some cases leaving late-stage investors underwater on their holdings.

That was a final straw for some.

Last week, Forbes dug up figures from CB Insights that highlighted a wide and growing gap between the number of companies that raised initial funding and companies securing the follow-on investments, known as a Series A, generally necessary to keep going. This year, there have been 1,747 seed or angel rounds but only 688 Series A deals, underscoring the coming crunch.

Bad businesses

Based on as scientific a survey as the PR pitches in my inbox, there’s a tremendous number of silly, redundant and poorly executed companies out there that don’t warrant additional funding. The real problem isn’t that many of these companies won’t raise more money; it’s that they raised money in the first place.

For the venture capital industry to get back on track, it needs to embrace a renewed sense of discipline – on company picks, deal terms and total spending.

But hope springs eternal in Silicon Valley.

Rothrock stresses that the industry’s trend-line averages mask very strong results and ongoing investment at top firms, as well as growing venture capital activity among corporations like Google. Companies are just being more selective and looking beyond consumer Internet opportunities.

“We’re steady as she goes in terms of funding enterprise,” he said.

Secondary opportunity

Swildens oversees a secondary fund that buys shares from limited partners and venture firms looking to liquidate part of their holdings. He sees this period as a ripe opportunity for bold investors to get into promising companies at suddenly reasonable rates.

“Ours is one of the few firms aggressively putting money into these funds,” he said.

Mark Heesen, president of National Venture Capital Association, is similarly optimistic. He says the industry could be primed for a strong comeback in 2013, as long as the broader economy strengthens.

Above all, what the industry needs are some wins – acquisitions or initial public offerings that put investors clearly in the black and start to restore some lost confidence.

“If we see these exit markets start to generate good returns, I think you’ll see limited partners look at this asset class again,” he said.

James Temple is a San Francisco Chronicle columnist. E-mail: jtemple@sfchronicle.com Twitter: @jtemple

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Article from GigaOm.

“I meet a lot of owners of midmarket IT services companies who almost immediately ask me, “What is my company worth?” Even those who don’t ask want to know often ask.

It’s a fair question, with a complicated answer. I can do a back of the envelope calculation and determine the enterprise value of a company today based on 12 months trailing revenue or perhaps a multiple of EBITDA (earnings before interest, taxes, depreciation and amortization). But the real value of a company is based less on its past performance than on its potential worth to a future owner. What the buyer can bring to the party and how well its management believes it can execute the acquisition and business strategy going forward is where a company’s true value resides and where the domain expertise or strategy comes into play.

Case in point: In 1996, IBM bought Tivoli Systems for $743 million, paying about 10 times trailing revenue. Many analysts concluded at the time of the sale that IBM grossly overpaid for the asset. Within a year, IBM was able to leverage Tivoli into almost a billion dollars in revenue. Just like beauty, value is in the eye of the beholder. Tivoli had more value to IBM than Tivoli had to itself at the time. So did IBM pay 10 times revenue or less than one times revenue for Tivoli?

Unfortunately, I don’t have a crystal ball. So I don’t know what potential buyers can do to leverage a company’s value. And a calculation on the back of an envelope almost always fails to satisfy.

Here is something else the owners I talk with really don’t want to hear: Chances are they have taken actions that over time have eroded — or even destroyed — the value of their company without even realizing it. In my last post for GigaOM, I wrote about “5 things that destroy a company’s value.” In this post and in future posts, I’m going to examine these value killers one at a time in greater detail.

Today, my topic is opportunistic acquisitions. And to be clear, my message is for owners of midmarket companies who are interested in making acquisitions designed to increase their own value. In doing so, they hope to become attractive acquisition candidates to buyers in the future.

Acquisitions fail 70 to 90 percent of the time

If you search for the phrase “acquisition failure rates,” you’ll be treated to study after study that peg failure rates at somewhere between 70 percent and 90 percent. Dig a little deeper, and you’ll find articles enumerating the many reasons most acquisitions don’t work.

Nearly all of these reasons can be boiled down to two:

  1. The acquisition was a bad match between what the seller had and what the buyer could do to create value. The bad match often occurs because the buyer was fooled, misled, or overlooked key points of the deal, or the buyer simply suffered from hubris.
  2.  The buyer did a poor job of integrating the acquisition and executing on the business strategy designed for its new asset.

In both situations, acquisitions fail because the buyer doesn’t really know what or why it’s buying — let alone what to do with the acquisition.

Think about when HP bought Compaq or when Time Warner bought AOL.

Of course there are companies that are successful with acquisitions. Cisco has acquired 150 companies since its first acquisition in 1993. In fact, acquisitions are a core competency of Cisco — few companies are better at it.

Cisco’s purchases are fueled by the desire to speed up the rate at which the company can offer new technologies in a market that is hyper-competitive and evolving rapidly.

Not all of Cisco’s acquisitions are hits. Remember the Flip video camera that Cisco shut down in 2011? But many were successful, especially in the early days. At the peak of its acquisition activity in 2001, Cisco’s purchases were widely credited with laying the foundation for about half of its business at the time.

The secret to Cisco’s fruitful acquisitions is its ability to successfully onboard companies. Cisco employs a full-time staff solely focused on integrating new companies into the fold — instead of haphazardly assembling part-time transition teams whose members are all busy with their regular jobs.

In terms of strategy and execution, Oracle is even better at acquisitions. The company has spent billions on about 90 companies since its acquisition of PeopleSoft closed in 2005. Oracle’s chief skills are identifying companies that fit well into its longterm business strategy at the front end of the process, and its ability to integrate and act on these strategies at the back end. In 2011, readers of The Deal Magazine recognized Oracle’s track record with an award for most admired corporate dealmaker in information technology for deals completed from 2008 to 2010.

Until late in 2011, Oracle’s acquisition drive was to create the broadest portfolio of traditional enterprise software applications in the industry. With the company’s $1.5 billion acquisition of SaaS CRM applications provider RightNow Technologies (announced in September 2011 and completed in January 2012), Oracle now hopes to work its magic in the SaaS market. Oracle paid more than seven times trailing revenue for RightNow. I bet that in the next year or two, Oracle will make that multiple look like a bargain — just like when IBM bought Tivoli.

Still, Cisco, Oracle and other exceptions to the rule underscore the difficulty of making acquisitions work. It’s even harder when an acquisition happens because a buyer is presented with an unexpected “opportunity” and management decides it’s just “too good to pass up.” These so-called “opportunistic” acquisitions often lead to disappointment or disaster.

The reasons for failure are obvious. Acquirers lured by such a passive approach often have no clearly defined goals, have not thought through the attributes of ideal acquisition candidates, have done little or no pre-acquisition planning, and suffer from a lack of choice.

It reminds me of people who go to Las Vegas for the weekend and end up married. Getting married in Nevada is quick, easy and relatively inexpensive. All you need is a marriage license — no blood tests and no waiting period. And there is a wedding chapel on every corner.

Of course, when you wake up the next morning, there may be hell to pay.

I know. I’ve been there. Not in Las Vegas on the morning after, but at an organization that for many years only bought companies that showed up on its doorstep. We had no strategy and no process for integrating acquisitions into the mothership. I’m convinced that if the owner of the neighborhood car wash had offered us a “good” deal, we’d have taken it.

So here’s my advice for owners of companies seeking to enhance their value through opportunistic acquisitions. Acquisitions can do a lot of good. They can add to your growth and earnings, speed your entry into new markets, allow you to acquire human capital or intellectual property more quickly, and lower your costs through economies of scale. All of these things have the potential to increase the value of your company to a prospective buyer.

But just like marriage, acquisitions should never be decided on a whim. And you should never buy a company just because it’s for sale. Frankly, companies that are not for sale offer juicier profits and are likely a better strategic fit. Better to take some of that money and go have fun with it in Las Vegas.

And if you go there, don’t get married.”

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Here is some interresting thoughts from MondayNote.

“Limited Partners, LP, institutions or individuals put money into the fund. We, the General Partners, GP, make and manage the investments and we split the profits with the LP as the sole compensation for our services.

Over time, the split has varied with the industry’s prosperity and the fund’s reputation, it went as high as 35% of the profits for the GP but, as this WSJ story belatedly explains, is now back to about 20%. In our vernacular, that number is called the Carried Interest or, for short, Carry.
A second number, the Management Fee, needs a bit more elaboration.
As the Carry did, it varied and went up to 2.5% of the fund’s capital; it is now pegged at a fairly standard 2% per year. The Management Fee provides the money needed to run the firm’s operations, pay the rent, associates’ salaries, travel expenses and the like. It also provides fodder for misunderstandings.

The Management Fee is a loan, not a stipend. For the GP to get its 20% of the fund’s profits, both the capital, the money invested by the LP and the Management Fee must be repaid first.
When funds become very large, say a billion dollars or more, the Management Fee gets correspondingly large and can encourage spending habits, thus generating criticism the GP is more interested in the fee than in making money for its investors.
But, you’ll object, the advance must be repaid before profit-sharing kicks in. Yes…, and what happens if the fund doesn’t make money? Are the LP losing money while the VC enjoys a good time, living off the Management Fee? The answer depends upon the way the fund agreement is written. If it contains a Clawback clause, the GP is obligated to return the “unearned” fee. As you can imagine, this leads to interesting exchanges during the fund’s formation and, much later, if it turns out it loses money.

To summarize: profit sharing (Carry) of 20%, a yearly advance of 2% of committed capital (Management Fee), to be repaid before profit sharing kicks in.

Let’s move to the heart of the matter: making investments. Here, let’s focus on a basic, oversimplified but usable formula:

We like to invest between $3M and $15M to end up with 20% of a company worth $250M when it “exits”.
“Exit” can mean going public through an IPO (Initial Public Offering). IPOs are rare these days, they’ll come back when the economy does. In the meantime, exits are achieved through M&A (Mergers and Acquisitions) deals, that is the company is sold to a larger one such as Cisco, Google and countless others who thus get access to valuable technology and/or people. In may respects, we, the VC, have become an engine of “externalized” R&D, of technical innovation for larger companies. We make and manage speculative investments in riskier technologies on the big companies’ behalf. This is a meaty topic all unto itself, maybe for a future Monday Note.

Going back to the numbers, they need three qualifications. First, they’re only valid for a mid-size fund, in the $200 to $400M range. Larger funds, billion of dollars, can’t make “small” $5M investments, they deal with bigger projects requiring larger amounts of capital such as infrastructure investments, semiconductors or biotech.
Second, the $3M to $15M bracket covers the total amount poured in over the life of the investment, that is 2, 3 or more rounds, over 3, 5 or more years.
(Add to this we never invest alone, for financial reasons, more capitak, and psychological, we don’t want to “fall in love”, a small (2 to 5) group of investors, called a syndicate, provides more viewpoints, more objectivity.)

Lastly, the $3M, $5M, 20%, $250M set of numbers is a neat simplification, reality gets much more complicated, from outright failures, to so-so, middling results, to the occasional “out-of-the-park” success. It’s not called venture capital (capital risque in French) for nothing.
If we invest “only” $3M and get 20% of $250M, that is $50M, this is more than 15 times our investment. If we risk the “full” $15M, we get about 3 times our money. Either way, it looks good, even if you keep in mind a few hard failures.
But you need to introduce time: how many years did the adventure take? 3 times your money over 7 years yields “only” 17% in compound interest, but 44% if the exits happens after 3 years. (Readers interested in geekier Excel simulations of cash-flows can go back to the May 17th, 2009 and May 24th, 2009 Monday Notes.)

The permutations, the possibilities for success and failure are, pardon the bromide, endless; they make our profession so fulfilling as it engages so many dimensions of human endeavor, from technology to psychology, from the fleeting desires of customers to the hard realities of time-expiring cash.”

Read the full article here.

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Here come an article written by Mark Scott at BusinessWeek.

“Last week, I was in Geneva attending a cleantech summit that brought together Europe’s top venture capitalists and entrepreneurs looking for investment. One theme kept emerging: VCs are moving their money away from energy generation projects, such as wind-farm and solar-parks. The reason? Funding those types of businesses is just too expensive for investors already struggling from the global downturn.

That message was reinforced on June 23 when consultants New Energy Finance released preliminary results about cleantech investment. Not surprising, they also found VCs were steering clear of energy generation projects. In the first half of 2009, venture capital and private equity firms forked out $3 billion globally for clean energy companies — a 56% drop compared to the same period last year.”

To read the full story, click here.

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Here is a good excerpt for Mercury News.

“One of the world’s pre-eminent venture capitalists, Michael Moritz of Sequoia Capital, has picked winners like Flextronics, Cisco Systems, Yahoo, PayPal and Google by focusing on small teams or individuals that on first glance might appear to be unfundable. In a rare interview, Moritz spoke with the Mercury News about one of his latest long-shots, a call-center company founded in India, how he picks companies to back, and the silver lining in the financial meltdown. Following is an edited transcript.

Q How has the financial crisis reshaped the economy and affected the way you pick winners?

A I think tougher circumstances just serve to shine a brighter light on everything. The manner in which we pursue the business hasn’t changed.

Q Has it affected the way you view your portfolio companies?

A I think the managements of companies all across America understand that the sooner they don’t have to rely on the kindness of strangers to support their operations, the better off they are going to be. Again, I don’t think that is a startling new insight. It’s just when money is harder to get and credit is tight and investors are less giddy, I think companies and managements become much more disciplined. It means the people who start companies in times like these are people who are genuinely interested in starting companies. You have to be very determined to venture out into atmospheric circumstances like the ones that we’ve been through in the past nine months. Which means that the pretenders and posers and people who are really much more interested, if they are honest about it, in becoming rich than starting a company — those sorts of people will stay on the sidelines and wait for the weather to improve.”

Read the full interview by Elise Ackerman at at SiliconValley.com here.

Others covering this story: Reddit, Trading markets, MATR.

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Facebook avoid the IPO and steam ahead with expansion plans. It is not your average valuation we are talking about – $10B is quite a accomplishment. Please find earlier Facebook articles here; Facebook turned down funding at $8B, Few IPO candidates, Rapid growth and several more here.

Here is a story from Read Write Web.

“After we saw some rumors about this over the weekend, Facebook today confirmed that it will receive a $200 million investment from Digital Sky Technologies (DST), one of the leading Internet investment groups in Eastern Europe. This investment puts Facebook’s valuation at $10 billion. DST also plans to offer to purchase at least $100 million in Facebook common stock from existing shareholders.

According to Facebook‘s CEO, Mark Zuckerberg, roughly 70% of the company’s users are now outside of the U.S., so cooperating with an international investment firm seemed to make sense in order to bring a global perspective to Facebook’s operations. DST will not get a seat on Facebook’s board, however.”

It continues…

“Digital Sky Technologies is a major player in Eastern Europe, and with Mail.ru, Forticom, and vKontakte among its assets, the company claims to account for over 70 percent of all all page views on the Russian-speaking Internet. Interestingly, DST (mostly through its investment in Forticom) also owns interests in a number of social networks like one.lt and Odnoklassniki.ru.

This deal also fits in well with other rumors about Facebook trying to raise capital to allow its employees to cash out some of their options. Just two weeks ago, our colleagues at VentureBeat reported that Facebook’s current investors “found it a stretch to supply the full amount of capital” that would be needed to provide Facebook with enough money to allow it to buy out roughly 15 million common shares at around $10 each.”

Zuckerberg commented this deal on the pressconference by saying…

“The company does not have any immediate plans for the cash it will receive from DST. Zuckerberg was also asked about a possible IPO, but according to Facebook’s CEO, an IPO is not on the “immediate horizon.”

Being asked about Microsoft’s investment in Facebook at a $15 billion valuation, Zuckerberg mostly sidestepped the issue, but stressed that this investment was part of a larger partnership at the top of the bubble and that he thinks that $10 billion valuation is “fair” and that he “feels good” about it.

Given the nature of the call, there was not a lot of focus on specific features, but Zuckerberg did confirm that Facebook is testing out a video chat feature. Our friends at All Facebook spotted references to this in Facebook’s code two weeks ago.”

Read the full article here.

Other sources for this topic include: TrolleyBlog, The Next Web, PEHub, Northloop,

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Building on the trend of Apple, Nokia and others – Sun makes the move into a independent Appstore deployment. As Apple has shown that it is a viable business model, it only makes sense – end-users like to shop around, and are willing to pay for smaller apps. As Google Android starting to make its way into mobile phones, and Nokia “opened” up Symbian – the end-user community developer trend will create a business eco-system worth spending some research on. The project is codenamed Vector but will likely be called “Java Store” after its official launch.

Here is some quotes from Jonathan Schwartz by way of Washington Post.

“Candidate applications will be submitted via a simple web site, evaluated by Sun for safety and content, then presented under free or fee terms to the broad Java audience via our update mechanism. Over time, developers will bid for position on our storefront, and the relationships won’t be exclusive (as they have been for search). As with other app stores, Sun will charge for distribution – but unlike other app stores, whose audiences are tiny, measured in the millions or tens of millions, ours will have what we estimate to be approximately a billion users. That’s clearly a lot of traffic, and will position the Java App Store as having just about the world’s largest audience.”

“The store will be for all Java devices. Initially, the PC desktop will get the most attention from developers and customers, but there’s plenty of Java-enabled phones and developers will be pleased to have another distribution channel, especially one with the power of Sun behind it.”

Read the full article here. Read Jonathan Schwartz blog entry here.

Other bloggers covering this topic include: OStatic, Mobile Marketing Watch, Mobile Blogs, IndicThreads.

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