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February 2008 Presentations

Panel Discussion: The Venture Capital Environment

February 19, 2008

The GCVA February 19 luncheon was a panel discussion on the Venture Capital Environment, moderated by Christopher Baucom of Fort Washington Capital Partners Group. Panelists were John Aplin of CID Capital; John McIlwraith of Blue Chip Venture Company; Carter McNabb of River Cities Capital Funds; and Bob Saunders of Chrysalis Ventures.

Christopher opened the discussion with a brief review of recent activity. He was happy to say that venture capital was in the news less lately, as “Things have calmed down since the late 90s.” Indeed, that is good for the industry, since the “news” of that time was, of course, of turmoil and challenges.

Prior to the bubble bursting, returns were “off the charts,” and compared to then, they have been unimpressive since the early 2000s. The question Christopher thus asked is, “Does venture capital still make sense?”

The answer is a solid “yes.” While its market share was extremely high a decade ago, VC is returning to a market share pre-bubble, which is a reasonable, stable level. Commitments to VC funds have been increasing steadily over the past few years, and Christopher reports that both Midwest and national investors are all experiencing nice exits in the past year to two years. “The industry has learned how to move forward from the challenges faced in the late 90s,” he said.

This is supported by recent one-year returns and other indicators that venture capital may be turning around. “Returns on VC are much better,” Christopher said. “They are not as good as buyouts, but they are certainly positive.” More importantly, the trend is increasing and has recovered from the significant losses seen in 2001-02.

M&A activity has also picked up, with returns improving. More importantly, said Christopher, “We’re seeing improvements in multiples where capital has been raised.” Although this is a national trend and the Midwest has been somewhat flat, the national trend bodes well for the region and the industry.

Venture-backed IPOs have also picked up and are rebounding nicely from the early 2000s. However, of the close to 100 deals in 2007, only 4 were from the Midwest.

Although the Midwest continues to represent a small percentage of VC investment, our share has been increasing over the past 3 years. Christopher feels this is due to various initiatives targeted at bringing VC back into the region: “We are providing more support and opportunity for VC investment, and it’s beginning to show,” as levels climb gradually back toward 1999/2000 share.

Following the bubble, VC has seen evolution of its leading sectors. Christopher says, “VC has migrated from just technology to more health care and industrial/energy investments.” This trend is definitely seen in the Midwest. We show a significantly higher interest in healthcare, industrial and Internet opportunities than nationally.

QUESTION 1: RECENT EXITS
At this point, Christopher turned the discussion over to the panelists. He began with Bob Saunders, asking what has worked in exits, how long before exiting, and what Chrysalis has learned from their deals.

Bob explained that Chrysalis invests in the Southeast and Midwest, mostly in healthcare services, media and communications, and technology-enabled business services. They had 4 exits in 2007, all from technology-enabled service businesses. “The single-best exit we ever had was this year,” Bob said. “We made more than 35 times cash on cash from our original investment. It was very nice for us,” he said, as the audience laughed.

One of the lessons they learned is that “it doesn’t always ripen early.” Bob said a change of CEO over the life of the investment made for a big change in focus. “The company primarily serves the government sector,” he explained. “The government can be very attractive if you’re selling certain things – such as software as a service. We didn’t know that’s what we were doing at first, but it became a very valuable business with reliable revenue.”

The other 3 exits were from education & training companies. One was a specialty corporate training company that brought 5.5 times cash on cash. “This company focused on Sarbanes-Oxley,” Bob said. “They tried to find a way to make money out of it, and they were very successful. We were in the deal 3 years or so.” When they sold the business, they were in for a surprise here, too – “We thought it was a training business, but it sold as software as a service, which increased the multiple.”

Their third exit was from a charter school that was sold to DeVry University. “In this deal,” Bob laughed, “we learned how to be flexible.” They learned that, while the original idea was an online support for school administrators, school districts couldn’t make decisions in a reasonable timeframe. “We starting going direct to consumers instead, and ended up with a nice 2-3 times cash on cash multiple.”

The fourth exit was also corporate training and the end result is too early to tell: “We’re still holding stock,” Bob said.

Carter McNabb was next, and summarized 2007 as “a good year, with 5 exits totally $50 million, which is up from $23 million in 2006.” River Cities had 4 M&As and 1 IPO. They had one software as a service business, an online data storage and recovery company. “They’re basically Iron Mountain shifted online,” Carter explained. “We invested when their revenues were $1 million. There were many bumps & bruises as they evolved, but then they discovered a law office niche.” The company moved from Alabama to California, grew to $33 million in revenue, and sold at a 5+ multiple. “Seagate Technologies bought them for $185 million and we made over 7 times our money.” What would River Cities do differently regarding this company? Carter said, “Nothing – except find more like it.”

For their IPO, it was a different situation. River Cities was co-invested in a company that owned a proprietary Russian process. The company grew quickly from $4 million to $50 million and, following cyclical demand and quality control issues, a new CEO turned things around and they earned 3 times their money in a $75 million IPO. “In this case, we should have identified the problems with the first CEO much earlier,” Carter said.

John McIlwraith was next. Blue Chip had 5 exits in 2007 with a gross value of $750 million. “One of these was $295 million; the other 4 were pretty equal,” he explained. This larger deal brought down the overall average of 4 times revenue: “If you strip the $295 and debt out, the rest of the companies returned 9 times revenue,” he said.

Blue Chip averaged 5 years to exit, with a high of 8 and a low of 2. All five companies were sold to strategic buyers. They are in the midst of selling 5 more companies with an average multiple of 4; three of these are profitable businesses. The average for these is 6 years to exit, ranging from 3 to 10. Three are strategic buyers, two are private equity: “The people willing to pay up are generally strategic buyers,” said John.

Interestingly, they have two companies now in the IPO registration process. “They will bring $200 million or more, about 3 times revenue,” John said.

He said two deals were worth noting. The first, a media company, was an early-stage investment: “We invested $500,000 in this mobile advertising platform,” he said. “It’s a hot space and we hoped to build it over 5+ years, expecting a 10 times exit.” However, after just 2 years, “AOL came along and paid a premium, a multiple of 30 times.”

The other is a medical company that provides renal dialysis at home. Once again, a strategic buyer came along earlier in the process than Blue Chip had hoped. “We got a $190 million exit price and 4 times our money,” John said, “but we thought we had a shot at 10 times if we held it longer.”

John Aplin finished this discussion, explaining that CID invests in broader spectrum companies than many VCs. “We saw a different experience than the others,” he said. “We had 8 exits, 6 venture and 2 private equity. One didn’t have revenue when we sold it to a strategic buyer… we really liked that revenue multiple!”

The private equity deal was an investment in Muncie, IN, a “low-tech company in combustion engines and service.” EBITDA went from 7 to 23+, and the company was sold to Honeywell for 7 times their money.

On the VC side, John said they had “an unusual experience in the amount of corporate interest” in the deals. “We had earlier exits than anticipated, and we see these trends continuing.” Many of these deals were buyer-initiated, and CID has three offers on the table right now with strategic buyers.

QUESTION 2: UPSIDE FROM HERE
The second question posed by Christopher went first to Bob again. He said it was good to hear the panel was experiencing the same trends seen nationally, with better returns and successful deals. He asked them if, assuming last year was one of the best in the past 5 years, what is the upside from here in terms of portfolio and maturation?

Bob said that indeed last year was great, but this year he’s not so sure about the affect of the credit market on deals. “So far, there are no issues,” he felt, “and we have one deal that will be an astonishing result.”

Overall, he feels 2008 will be good, even though he does question if PE buyers will drop out of the market and if the strategic buyers will continue to be willing to pay up.

John M. said Blue Chip had 2 deals fail in 2007 because of the credit market: “Financing fell apart.” In 2008, he expects 3 strategic deals and 2 PE. “If you’re buying companies for their platform,” he felt, “then you don’t need the credit; but others where you need leverage for the sale, those probably will not get done.” On the bright side, however, he sees no sign of people backing off from deals.

QUESTION 3: EXPECTED RETURNS & RISK MANAGEMENT
Christopher’s next question was directed to John A., asking where returns are expected to be and how risk is managed in today’s market.

John A. said that over the past several years, there’s been a significant increase in emphasis on life sciences: “There is significantly less volatility I this area,” he felt. He added that if you have the basic core technology, you do all right in the transaction. “Even if the company does not have the ability to stand alone, you can frequently find a corporate buyer who wants to integrate the technology.”

Their investment orientation is to move further into the development cycle in order to mitigate risk: “You then have more credibility factors to build in and de-risk the deal.”

Bob weighed in on this issue as well, saying Chrysalis is focused on early stage but tries to have as low a risk possible by focusing on execution versus technology. “We invest early and leap as quickly as possible to lower our exposure.”

Carter said 90% of their exits are M&As today, which is very different than the past: “We target our investment to create exits in our sweet spot,” he said.

John M. says their portfolio is more balanced today than in the past. They are looking for profiles with 5 times multiples, and deals in the $100-125 million range. “We have 30 companies in our portfolio,” he said, “and about 15 of them will go for 2.5-6 times our money.”

QUESTION 4: QUALITY OF DEALS
The next question was, “In this new era, what is the quality of the deals you are seeing?” Bob started the discussion by saying the past 9months are the best deal flow he’s ever seen – “It’s extraordinarily good.” But the past month has been worrisome. “There are two deals where we’d like to be lead, but firms from the Silicon Valley have taken lead.”

John M. feels all areas are generating venture-backable companies, and that East and West Coast companies are being drawn here. “They see what we’re seeing,” he said. “Companies are starting to bubble up – this is a great place to invest and build companies.”

Carter feels their focus will be primarily IT and healthcare, but “we have to be more focused. Our expertise is in the vertical expertise and business model, which adds to value.”

He says there is a shift in healthcare focus from research to medical devices, basically because of the prevalence of chronic disease, demographics, advanced diagnostic capability, improved understanding of disease pathways, and people being willing to pay more for healthcare. He says the medical device & equipment market is up 40%, while biotechnology is growing at 5-10% and health services is actually down.

He also sees a fever over energy and industrial investments: “Renewal energy is one of the biggest opportunities today,” he felt.

Christopher agreed, saying the National Venture Capital Association fees strongly about energy as well. Bob added that there are many different tacks to take in energy – “There are all kinds of options, and each needs a lot of expertise.” He described one company where garbage is their niche. Their focus on radiation disposal is doing quite well for them.

QUESTION 5: WHAT ARE THE OPPORTUNITIES FOR ENTREPRENEURS?
John M. feels entrepreneurial investments are more hands on and messier, but definitely have the potential for much more success at an early stage. “There is not a lot of competition in the Midwest for entrepreneurial opportunities – the biggest competition is catching them when they’ve outgrown angel funding and are ready for venture.”

John A. adds that early stage opportunities are great for regionally focused firms where expertise and knowledge are the biggest success factor. “I’ve seen a lot more sophistication in the entrepreneurial marketplace,” he stated. “Entrepreneurs are a lot more educated than they were 10-15 years ago.” He feels Midwest firms need to get more into this space because “otherwise, East and West Coast firms will come in and snatch up these great opportunities we have.”