Healthcare IT from the Investor’s Chair 10/3/12

Whither Venture Financing? Or, Where Have All the Cowboys Gone?

I was delighted when Mr. H mentioned he’d gotten some feedback from readers that they would enjoy more columns from the Investor’s Chair. I really enjoy writing them, and even more, I enjoy the responses they generate.

Readers might recall my post two years ago that discussed several ways to capitalize a new venture. I’d like to use today’s post to discuss some of the root challenges in one of those options: venture financing.

While raising capital isn’t what I do at ST Advisors (though we do occasionally advise on aspects of it), from time to time I speak with entrepreneurs who need investors for their business. They tell me that raising venture dollars, especially for companies in earlier stages of development, has become increasingly difficult over the past few years. I attribute this to three major factors:

Funds have gotten larger … There are two main reasons for this fund size growth. Pensions and endowments have grown, so they have been looking to deploy larger amounts of capital. And, VCs are typically paid using a formula known as “2 and 20.” What that means is that 2 percent of the amount of the fund is used for a management fee, i.e., office space, support, travel, reporting, salaries (of both partners and associates), etc. The “20” refers to the carried interest, meaning the venture team gets 20 percent of the fund’s profits.

As a matter of historical curiosity, I recently learned (but have not been able to substantiate) that this virtually sacrosanct ratio was selected by one of the first venture funds and replicated the percentage of a clipper ship’s profits the captain and crew received. Of course, they were risking their lives…

At any rate, the 20 percent carried interest gets divided among the general partners and other fund employees as each fund sees fit. Simple math suggests 2/20 on a $500 million or $1 billion fund is much more appealing than 2/20 on a $100 million fund.

Whichever reason, it’s as much work for a venture fund to write a large check as a smaller one, and both the $2 million and the $10 million investment require similar time and effort for due diligence, negotiation, governance, management, and oversight. It’s only logical that investors are seeking to write bigger checks, as those will have a bigger impact on their funds’ (and their own) financial performance.

… but returns have been lacking … Further challenging the traditional venture investor is the fact that venture funds as an overall asset class, or type of investment (as opposed to real estate, public stocks and bonds, private equity) have underperformed the other asset classes over the past decade. A good overview of returns relative to public markets can be found in this excellent article. Some say that only $0.25 of every invested dollar has been returned. Even if you’re the best VC in the pack, raising money for a new fund in light of this performance has to be a challenge.

I’d postulate two primary reasons other than the most recent recession. First is the law of supply and demand. When venture was hot, too many funds were started and, in 1999, raising a fund was just too easy. With too many dollars chasing too few quality companies, too many bad (or even marginal) companies got funded at valuations that were simply unrealistic as investors were seeking to put money to work in a timely fashion. The chickens ultimately came home to roost, and so there’s been a shake up.

Second, cashing out has become orders of magnitude more difficult, even for investments in high quality companies. When I started my career as a research analyst in the mid-90s, $35 million IPOs were common. Today, as public equity funds (pensions and mutual funds) have gotten larger, a deal under $200 million is challenging to accomplish. Just as above, it’s harder to move the needle on a larger fund. It takes as much work to oversee a small position in a microcap company where you can only invest 0.01 percent of your holdings, as a more liquid stock where you can make a 5 or even 10 percent bet in your fund.

Not only is the stock market demanding larger IPOs, it’s also harder even for companies whose valuations can support an IPO to be public as a result of the Sarbanes–Oxley Act of 2002. Hastily passed as part of the backlash associated with Enron (overdue, but too long after the horses had left the barn, IMO), it contained needed laws and regulations for public companies. But it also undeniably increased the costs, risks, and difficulties of being public as well. An unintended consequence was that it further slowed the IPO market, especially for smaller, typically venture-backed companies.

Virtually by definition, fewer liquidity options will impact returns. Previously, smaller companies could contemplate an IPO for liquidity. Now M&A is often more attainable, and the buyers realize that. The more recently passed JOBS Act of 2012 may make IPOs easier, but I doubt it will prove to be a good thing for the investing public. See noted investor Dogbert for a common view of retail IPO investors (or simply check Facebook’s aftermarket performance).

…and so, there are fewer venture funds. The typical investors in venture funds — entities like pensions and endowments — typically follow a guideline on their asset allocation. They invest set percentages of their portfolio into different types of investments such as public equities (US and foreign), real estate, private equity, venture, etc. With the US stock market’s lackluster performance of late, the denominator has dropped. The total amount they’d seek to invest in venture, even if it performed well, has decreased. Given the poor asset class performance (and a certain degree of herd mentality), these investors have been piling into private equity rather than venture, further exacerbating the trend.

Furthermore, as readers of this blog know all too well, healthcare is complex and difficult to work in. Rooks’ First Rule of Healthcare Investing therefore states, “If you want buyers who make rapid and rational decisions, you shouldn’t target physicians or hospitals.” This means healthcare-focused venture has been hit particularly hard. The broader technology funds which seem to prefer to roll the dice on the next Instagram or gaming app are managing to raise billion-dollar funds despite the challenges of asset allocation, while some of the best venture-stage healthcare investors I know are struggling to raise their next fund, even though they have backed companies that are household names to the readers of this blog (and include current and former HIStalk sponsors.)

So, we have fewer venture investors out there, and they both need and want to want to write larger checks. What are they seeking? That’s likely another post, but in my mind, the top criteria tend to be:

• Scale. Investors seek to maximize returns while minimizing risks. For many, that means they want to back a business that has already shown a lower adoption risk. In other words, does the business have a sales track record, and will the product or service sell? The proxy for this seems to be at least $5 million in revenues. One-time revenues such as licenses are often acceptable, but recurring (i.e., subscription) is obviously preferable. Investors love SaaS for a reason.
• Barriers. What is proprietary about the offering? Can it be easily replicated by competitors with time and capital?
• Market. What is the size of the addressable market? I find most of these statistics are pulled from thin air, but at least some attempt to quantify should be made, and please avoid what my entrepreneurship professor called The China Syndrome: “There’s a billion people in China, if they each buy one …” When a sector approaches 20 percent of the US GDP, this is an easy road to go down, but without an earnest attempt at quantifying the market for the specific product, it will lead to, “Interesting story, love the idea, call me back when …”
• Team. “Bet the jockey, not the horse” is a truism that proves out repeatedly. Investors would typically prefer to back a failed entrepreneur than someone who’s never been one. Track record is why I believe Humedica has raised over $60 million and Castlight raised $100 million in one recent round alone. Whether they will prove to be good investments can’t be known, but the fact that Michael Weintraub and Giovanni Collella both ran successful businesses with good exits (Pharmetrics and Relay Health, respectively) is as good a predictor as one can find.

Filling the so-called “venture gap,” groups such as super angels have arisen, typically offering not only checkbooks, but also expertise and relationships similar to what VCs can provide. Exploring this topic will be a post for another day.

In the mean time, please keep those questions and notes coming. While I’m rarely shy about sharing an opinion or sounding off, my biggest challenge is what readers would find interesting. I’ve spent most of my career as an analyst or banker, so what I take for granted (albeit sometimes painfully gained knowledge), might be unfamiliar to readers whose daily lives are more focused on patient care or with a vendor. If there’s a relevant topic you’d like to read about, please let me know!

I’ll be attending Health 2.0 here in my new hometown in a few weeks, which I’m sure will provide the grist for another post. If you’d like to connect there, let me know.

Ben Rooks spent a decade as an equity analyst and six long years as an investment banker. In 2009 he formed ST Advisors to work with companies on issues that don’t solely involve transactions. He loves e-mail.