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Current Trends in Venture Capital

Client Advisory

March 2005
It appears that the venture capital market has made a comeback since the bursting of the dot-com bubble, and many start-up companies which survived the past decade may have a bright financing future ahead of them. Today, venture capitalists are searching for value, and innovative companies are competing in a fierce marketplace for venture investment. What should we expect from the venture capital market in 2005? This article provides an overview of the current state of venture capital marketplace, including a description of (i) investment activity in the venture capital market; (ii) the nature of deal terms in recent venture capital financings; and (iii) terms and conditions included in private equity fund documents.

Investment Activity Increases in 2004

Venture investments were higher in 2004 than in 2003, reversing a three-year downward trend in venture investing according to the MoneyTree™ Survey by Price WaterhouseCoopers, Thomson Venture Economics and the National Venture Capital Association (“NVCA”). The annual investment level fell every year since 2001, reaching a six-year low in 2003 of $18.9 billion. In 2004, however, investments rose to $20.9 billion according to the MoneyTree Survey.

The MoneyTree Survey attributes much of the increase of investment activity in 2004 to late stage investments. Later stage funding increased almost 50% over 2003, representing the largest amount of late stage funding in three years. In general, late stage financing is done in anticipation of a sale or initial public offering, suggesting a continued strengthening of the exit opportunities in 2005. In a press release issued December 14, 2004 by the NVCA, Sandra Ribeiro, Research Director of Thomson Venture Economics, predicted that the combination of a growing economy, accelerating earnings growth and rising equity pricing will lead to a promising exit environment.

While expansion stage investing fell slightly in 2004, early stage investing increased to $3.9 billion in 2004 from $3.4 billion in 2003. According to the survey, early stage investing represented a slightly greater percentage of all venture capital activity in 2004, suggesting that venture capitalists are investing for the long term according to commentators from the MoneyTree Survey.

With respect to the hot industries and sectors, the Life Sciences and Software Industries, as usual, drew the most dollars. The Life Sciences sector, which includes both the Biotechnology and Medical Devices industries, accounted for 27% of all venture capital dollars, and the Software Industry represented 24% of all venture capital dollars according to the MoneyTree Survey. Other promising areas of investment include energy, clean technology and financial services.

The MoneyTree Survey also reports that first time financings increased in 2004 with these companies receiving $4.4 billion in 2004 up from $3.6 billion in 2003. According to the survey, Software companies received the most first-time funding, followed by the Life Sciences sector. The increase in first time financings suggests that venture capitalists are funding new companies while supporting their existing portfolios.

Venture capital fund-raising activity exhibited a similar upward trend. As reported in the January, 2005 issue of The Private Equity Analyst, venture capital funds raised $14.9 billion in 2004, up a healthy 50 percent from 2003’s $9.9 billion.

Deal Terms Reflect Issuer-Favored Environment

The terms in venture capital deals are improving for issuers according to an analysis of the publicly reported venture capital financings during the third quarter of 2004 by David Dutil and Jonathan M. Aberman published in VC Experts (12/15/2004). The analysis was based on a review of the publicly reported venture capital financings which occurred in the Mid-Atlantic, New York metro, New England, Southwest and Southern California regions during the third quarter of 2004. The following summarizes some of the trends in recent deal terms, which were identified in the analysis.

The analysis noted that three-quarters of the transactions reviewed were “up rounds” or “flat rounds.” In general, up rounds mean that investors agree to an increased valuation from the previous round, and flat rounds mean that investors agree to a valuation at the same price as the previous round.

In addition, full ratchets and multiple liquidation preferences decreased, and there were relatively few recapitalizations according the analysis. In general, full ratchet provisions protect investors by providing that an investor’s convertible securities and options may be exercised at the lowest price at which securities were issued since the issuance of the investor’s convertible securities or options. Full ratchet provisions generally favor investors, by preventing dilution of an investor’s shares. A liquidation preference generally refers to an investor’s right to receive a specific value for its stock upon the sale or liquidation of a company. “One x” paybacks have become the norm again, so investors are seeking to recoup their investment rather than getting the multiple liquidation preference that was common two or three years ago. The decrease of these provisions means that companies are generally receiving more favorable terms.

The analysis also noted that there were many deals that were single liquidation preference with no cumulative dividends and no participation rights. Cumulative dividends are generally dividends paid on preferred stock, which accumulate in each payment period if not declared or paid in the current payment period. Participation generally refers to a preferred stock holder’s right to share in the proceeds available to the holders of common stock, in addition to having all of rights available to holders of preferred stock.

The analysis also noted that while institutional investors are making more capital available, the funds are becoming concentrated among fewer managers. Without a dramatic change in the number of prospective companies, the concentration of capital will probably cause increased pressure on deal size and valuation. The analysis also expects that the issuer-favored environment will continue, and companies that support larger rounds of investment will especially benefit. The analysis anticipates that deal terms will continue to loosen, especially in Series B and C rounds.

Terms and Conditions Included in Private Equity Fund Documents

A recent survey by VC Experts, Houlihan Lokey Howard & Zukin and Thomson Venture Economics describes the standard operating procedures and best practices in private equity fund documents. 127 firms and individuals responded to the survey, with general partners comprising the majority. Several attorneys, who represent both limited partners and general partners, also responded to the survey. Approximately equal numbers of venture capital and buyout funds responded to the survey. The following sets forth some the survey’s key conclusions relating to terms and conditions included in private equity fund agreements.

With respect to fundraising, the survey concluded that there is a significant variance in the total time it has taken to market and close a fund. According to the survey, almost two thirds of the funds were raised in 12 months, but more than one out of three funds (36%) took over 12 months to a final closing.

Another trend cited in the survey relates to defaulting limited partners. According to the survey, 37% of all private equity and venture funds have been confronted with a defaulting limited partner. Further, 54% of the respondents dealt with defaulting limited partners through sales of their interests in the secondary market, and it is noteworthy that 44% of these sales had more than a 50% discount. Ross Barrett in VC Experts (10/8/2004) speculates that as larger funds are confronted with defaulting limited partners, there could be flight toward better quality, institutional limited partners, making it difficult for other limited partners to get into a “trophy” fund. Barrett also questioned whether the trend of defaulting limited partners could indicate that strong limited partners are not following on to funds with poor performance records.

Contributions by the general partner were also analyzed in the survey. According the survey, general partner contribution was between 1% to 2% for a majority of responding funds, and 26% of the respondents received general partner contributions of over 3%.

With respect to management fees, annual fees are generally between 1.5% to 2.5% of the total committed capital. According to Barrett, many limited partners view budgeted fees as better than a flat management fee structure, but he notes that scaled fees can help reflect the general partner’s higher level of effort during the early years of the partnership. While the survey concluded that most funds have a scaled fee structure, a range of responses were received by the survey and management fee structure remains an area of negotiation.

Conclusion

The future for venture capital appears promising. John S. Taylor, vice president of research for the NVCA predicted in the NVCA’s December 14th press release that “[m]any venture capitalists and entrepreneurs will be vindicated in 2005 as their companies which were funded in 1999 survived the “nuclear winter” and are now ready to go public or be acquired.” Taylor stated these organizations will help drive higher cash distributions back to the limited partners and ultimately provide better returns for the industry.

Others also predicted a promising future for venture capital in 2005. In the December 14th NVCA press release, J. Sanford Miller and Allan Ferguson of 3i stated, “We see no evidence of back to bubble period behavior or attitudes in 2005. Rather, it is a back to the future attitude - really a return to pre-bubble normalcy. Venture funding will continue to rise in 2005 but VCs are still understandably cautious. The challenge will be to avoid investing too cautiously . . . . So, it’s steak, not sushi. Martinis, not Dom Perignon.”


Alan Bernstein is a Partner and Christina Gray  is an Associate at the New York law firm of Carter Ledyard & Milburn LLP. Carter Ledyard is a sponsor of the CDVCA 2005 Annual Conference and also provides pro bono legal services to CDVCA for portfolio investments in CDVCA’s fund. Mr. Bernstein will be speaking at the 2005 Annual Conference on “Structuring Deals and Negotiating Term Sheets.”



Carter Ledyard & Milburn LLP uses Client Advisories to inform clients and other interested parties of noteworthy issues, decisions and legislation which may affect them or their businesses. A Client Advisory does not constitute legal advice or an opinion. This document was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. © 2014 Carter Ledyard & Milburn LLP.
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