5 questions with John Warnock

Several years ago, Greg Warnock, an entrepreneur and a founding managing director of vSpring Capital, decided venture capitalists weren’t being adequately compensated for the risk of investing in pre-revenue deals. So he started a new firm.

Warnock joined with former MarketStar Corp. CEO Alan Hall to launch Mercato Partners in Salt Lake City to invest exclusively in revenue-producing startups with the goal of finding companies “grappling for their first foothold,” and bolstering their sales forces from 10 to 500. Two years and four investments later, the firm’s IRR is in the low triple digits, while its portfolio company sales grew 50% last year, he said.

PE Week contributor Erin Griffith asked Warnock a few questions about Mercato’s strategy and how it fits into today’s market.

Q: What’s your fund status?

We closed our first fund in November 2008 with $52.5 million. We’ve deployed less than half of it. Our typical investment is in $5 million to $7 million in equity. We might think about our next fund in 2010.

Q: How has the current environment affected deal flow for your type of investing?

A: We’re seeing a lot of interesting opportunities in part because debt financing for growth is less available than it was historically, so it pushes more opportunities to equity investors. If you are a fast-growing company, you’re desperately trying to hold onto equity. High flyers are being forced to look at equity to be opportunistic. We’re seeing more conversations that wouldn’t normally happen. We are going to do larger investments in a smaller number of companies. We’re not looking for a big portfolio.

Q: What kind of deals do you look for?

We like tech companies that have the possibility of developing a sales channel. Companies that sell to small businesses through the VAR channel. You often sacrifice some margin to the channel because the VARs need to make money too, but at that time in a company’s life cycle, it is really a value creating move.

Q: How does Mercato’s strategy compare to other venture firms?

We’re seeing other firms hunkering down and triaging their current holdings, trying to drive businesses to profitability because they’re concerned about long holding periods and lack of cash or available debt. We don’t use debt, so we’re driving our returns out of growth. Companies are generally close to profitability when we enter so we don’t have to compromise investment decisions.

Q: Given the longer hold times and talk of changing the venture capital model, are more firms moving toward a sales-driven model?

: Some venture firms would find it very difficult to shift strategy in this way. When I look at some firms that have historically made early stage investments, they have 20 to 30 companies that have scarce follow-on financings, and the value is down, and they’re not profitable. I’m not sure how you would shift it to a growth model. It’s a daunting task for a firm to move from traditional venture to growth equity. Not impossible, but there’s so much baggage in early stage that it’s difficult to be nimble. I will say that growth equity as a strategy has become more prevalent.