The State of Money, Part III: How to Navigate a Changed Private Equity Market

March 24, 2011

11:00 am

This is the third part of our three part series that looks at the private equity market and what it means for your startup.  In part I, we looked at the private equity market prior to and during 2009.  In part II, we analyzed the expected behavior of private equity markets in 2011.

2009 v. 2011

The More Things Change, The More They Remain The Same. There are certain significant differences between 2009 and 2011 that are undeniable: 1) There has been a return of leverage; 2) More deals were done in 2010 than 2009; and 3) By the last quarter of 2010, the amount invested in private equity deals was more than double that of 2009. However, it’s important to note that in the scope of recent history, the differences are relatively moderate: A) the return of leverage is gradual; B) the number of deals done in 2010 was the lowest since 2003; and C) the amount invested by the last quarter of 2010 only rivaled that of 2004 and was less than 25% of 2007 investments.

Equity Capital Markets—As It Was, As It Became, and As It Should Be

As It Was Pre-2009 As It Became 2009 As It Should Be 2011 ®
+ Widespread leverage   leading to record deal flow and invested capital in 2007, followed by contraction of investment volume in 2008. Freezing credit markets led to historically low investments, and lack of exits resulted in a glut of PE-owned companies. + Thawing markets leading to increasing leverage and greater exit opportunities are creating an uptick in deal and investments.
+ Gramm-Leach-Bliley Act allows for a minimal barrier between banks and alternative investments. Tumultuous markets have put regulators in an uproar and in search of a way to bring stability to the economy. Dodd-Frank Act has been passed and will create tighter regulations and increase costs and hurdles for private equity firms raising capital.
* Percentage of investment dollars in deals under $50 million is lower in 2008 than in 2007. * Percentage of investment dollars in deals under $50 million is lower in 2009 than in 2008. * Percentage of investment dollars in deals under $50 million is lower in 2010 than in 2009.

What has all of this meant for entrepreneurs?

2009—Panic at the Disco. By 2009, the lack of liquidity had created a “Dash to Cash” for issuers trying to reach the increasingly dry equity capital market. The ultra-low demand for equity resulted in issuers offering deep discounts in an attempt to grab any liquidity left. Patience, resourcefulness, and creativity are key when raising capital and maintaining positive cash flow in tough economic times.

Strategies for 2011—A More Zen Approach. Companies are required to be more strategic and thoughtful in raising capital. Entrepreneurs have had to resist the dash to cash approach of 2009 and embrace a more patient, resourceful, and creative approach to achieve success. In other words, it’s wise for entrepreneurs to consider the following:

Patience. Raising capital is an even more time-intensive endeavor when the capital markets are weak. Most investors (including angels and funds) will take longer to make decisions because they have less access to money, and investments take longer to yield a return.  This increases the investor’s interest in due diligence and determining the credit- and trustworthiness of the founders. Because of this, founders need to be prepared to work longer to raise equity. Of course, a time suck can hurt a fledgling enterprise so dividing labor such that someone is tending the company and someone is raising money is more important than before.

Resourcefulness: A start-up in a tight ECM must be able to last a long time on existing resources, and those that can be scraped together without outside money. Avoiding desperation is key here, and entrepreneurs must be able to resist selling equity to an investor that might foul up future rounds of financing. For example, an angel who takes 50% equity will probably make the company unattractive to VC investors later on.

  • Bootstrapping. About a quarter of American companies were started with less than $500. Being able to take the FDR approach—“do what you can with what you have” takes on new significance when equity and credit markets are tight.
  • Borrowing. Credit markets are still tight, which means borrowing is more expensive, and credit is harder to obtain. Taking loans from family and friends to fund strategic growth is a viable—but usually somewhat limited—way to continue operations during a weak market.
  • Convertible bonds. A bond issue increases capital and is an option for a company that can make periodic bond payments over a period of time and return the principle at a specified point in the future. However, finding buyers for bonds is not easy in tight markets, and a very young company will likely be subject to restrictive covenants that protect the holders’ interest. A convertible bond makes the issue more attractive, as it provides potential for the holder to take advantage of equity upside in the future.

Creativity. Founders that are open to alternative sources of finding and raising capital, or having an income—which is important from day one—might consider:

  • Private Placement. Private placements, which are sales of securities to a group of investors, are a way to access capital comparatively quickly and inexpensively. Still, finding investors is difficult when the economy is depressed.
  • Matchmaking. Some companies, such as CEECHIPS are in the business of matching entrepreneurs with potential investors. Also, stapled financing—where a seller’s financial advisor provides financing to a purchaser—increased in popularity during 2009.
  • Customers. Revenue from a loyal and growing customer base is more important when it is your only source of capital. Investing revenue into the business, rather than paying salaries to founders and staff may be uncomfortable in the short term. This discomfort can be mitigated by providing incentives to founders and staff with deferred payments or other compensation later on.
  • Consortiums. Key customers and suppliers may be willing to provide capital to the company in exchange for a certain beneficial right in the future. Vendor placings, where shares are traded for non-cash consideration, is another option.
  • Licensing. Technology companies can license their intellectual property to a third party. The license holder uses the IP without owning it. Licensing IP has the effect of reducing the cost of operations, and provides a source of income.
  • Consulting. Entrepreneurs may provide their skills unrelated to the enterprise to bring in revenue. The obvious downside of this is that the founder has an opportunity cost for every working hour spent developing a company outside the enterprise.

Entrepreneurial Trends and Strategies—As They Were, As They Are

As They Became 2009 As They Should Be 2011 ®
– Rush to the market to grab any liquidity possible. + Realize that raising capital is going to be more time-intensive endeavor.
– Offer deep discounts. + Use creativity and resourcefulness to realize value.
– Panic! +  Be patient and fully evaluate all options.

Blaire Jones and Aaron Horn are the founders of the Georgetown Venture Law Society, an association of professionals and students at the Georgetown University Law Center dedicated to cultivating a greater understanding of the legal and financial issues facing emerging companies.

Image by flickr member SpecialKRB.

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Blaire Jones is a law fellow at National Public Radio, where she focuses on technology and intellectual property matters, and a new graduate of Georgetown Law. At Georgetown, Blaire discovered a special passion for helping startups leverage intellectual property and manage risk. You can follow Blaire on Twitter @VenEnthusiast.

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