We venture capitalists are an optimistic bunch. George Bush wouldn’t say the word. Henry Paulson wouldn’t say it. But now that the Honorable Ben Bernanke has uttered the unspeakable R-word as it pertains to the possible current state of the economy, it may be time for VCs and institutional investors to figure out where to invest in this market.
Some of us have been there before. It was March 10, 2000, when the Nasdaq peaked at 5,132 before beginning a long slide. For the first 18 months or more of that correction, the venture market certainly slowed down, but the assumption was that it would turn around quickly. The few smart ones—the soothsayers, those who saw it all coming—took their money off the tech table and moved instead into Nevada real estate. What better way to play the Nasdaq downturn than to invest in something tangible like real property? But we digress.
This economic cycle, we know what is coming and how to cope. Clearly public market investors have gotten smarter about technology. Gone are the thousands of companies dependent on E*Trade IPO investors to fund them to profitability. Gone also, for the most part, are billion-dollar build-outs dependent on late stage equity or mezzanine financings.
Where to invest
The current market offers an interesting dilemma. On the one side, exit opportunities will clearly degrade, and investors will be rewarded for sticking with good companies through the down cycle. Managing cash and expenses will be key to survival through a delayed or constrained exit environment.
The other question we should be asking is: What type of venture deals can make money in the current environment?
Unfortunately for venture investors, you can’t short the venture market. (Undoubtedly, if there were a way to do it, someone would make a lot of money.) However, the venture environment of 2008 offers several buy-low strategies for investors keen on capturing value. These include distressed debt, special situations and secondaries. Another creative way to go long in the 2008 venture market is through corporate IP spinouts.
A creative way to go long in the 2008 venture market is through corporate IP spinouts.”
Bart Schachter and George Hoyem
Corporate IP spinouts are pre-revenue or early-revenue projects that are spun out of high-tech corporations into new venture-backed startups. Technology projects with significant prior R&D often get spun out from corporations whose strategic mandates have shifted. For example, Mark Hurd of
Down markets provide a unique opportunity for private equity investors to leverage the perceived distress of prior investors. These prior investors could be late stage investors, debt holders, or corporations. As the accompanying chart shows, distressed players have traditionally outperformed private equity, especially during the last downturn.
Why doesn’t the aggregate venture market offer a similar buying opportunity? And why aren’t pre-money valuations dropping dramatically on Series A deals? Simple: If traditional entrepreneurs had to drop the “price” of their deals to reflect the current environment, their pre-money valuation would be zero. This isn’t a reflection on the merit of their ideas. It’s simply a reflection on the difficulty of discounting an asset with no prior cash investment. No second-buyer or distressed strategy can be applied here.
Pennies from Heaven
Corporate IP Spinouts actually offer early stage venture investors a means to buy low. A corporation that has invested $30 million in R&D in a technology project and has chosen not to move forward will look to sell the asset for a steep discount. Given the scarcity of acquirers for pre-revenue or early revenue projects, a venture investor can frequently negotiate attractive terms that value the company’s prior R&D at pennies on the dollar.
Our firm recently invested in a spinout in which more than $60 million in prior R&D was invested in a project, and the technology and IP were valued at less than 3 cents on the dollar. These deals—akin to secondary investments, where holdings are valued at a fraction of the current NAV—allow venture investors to capture significant value as part of the spinout and build capital-efficient companies that require less equity investment going forward.
Contrast this with traditional early stage startups, where valuations remain relatively stable in good times and bad. Let’s take another example of a bootstrapped garage startup that is seeking to raise Series A financing. Simple startup economics dictate that the founders and management team must retain sufficient equity (we consider 33% to be the absolute minimum threshold, though 50% team ownership is more prudent). Anything less than 33%, and employees lose their financial incentive. If the startup is raising a $4 million Series A round, the valuation therefore cannot drop below $2 million, regardless of the economic environment. This valuation floor doesn’t exist for corporate IP spinouts.
Our firm recently invested in a spinout in which more than $60 million in prior R&D was invested in a project, and the technology and IP were valued at less than 3 cents on the dollar.”
Bart Schachter and George Hoyem
We have good reason to believe that corporate IP spinouts will accelerate in the current economic cycle. Technology spinouts in the last cycle resulted from the excesses of the bubble era, and we expect this trend to recur in the imminent downturn. More importantly, corporate R&D investment has actually increased steadily for the last few years, spurred by competitive pressure, higher profits and steadily growing sales.
This pattern is not at all abnormal. During the 1991-1992 downturn, the corporate mantra was to raise R&D spending because that would be the most logical ROI in the souring climate. Certainly sales, advertising and discretionary spending would be of little use in an economic climate with constrained consumer spending. Then, as now, the smartest move a company could make was to invest in innovation.
A growing number of limited partners are starting to think about corporate IP spinout opportunities in defining their asset allocations. In many institutional portfolios, funds focused on these opportunities belong as part of their distressed or special situation allocations, given the unique deal circumstances and projected out-performance in a slow economy. Clearly investing in one of HP’s spinout innovations is tangibly different from investing in three guys in a Palo Alto garage.
For now, institutional investors and VCs alike need to ask themselves: What deals can I do today to best take advantage of the economic environment?
One thing is clear: You should invest appropriately, but never use the R-word. You can even write a two-page column about it and never utter the word!
Bart Schachter and George Hoyem are managing directors with Blueprint Ventures, an investment firm that focuses on capital efficient technology startups and Corporate IP Spinouts. They may be reached at firstname.lastname@example.org and email@example.com