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Ups, downs of valuations
Survey shows 60 percent of VC deals in third quarter involved lower valuations for companies
From the November 8, 2002 print edition
Stacey Higginbotham, Austin Business Journal Staff
When it comes to raising money in Austin, entrepreneurs are gaining a few concessions from investors and the number of deals appears to be increasing, according to a survey by law firm Wilson Sonsini Goodrich & Rosati PC.
The firm's survey of third-quarter venture capital deals in Austin shows 15 companies completed deals, and more than half those deals were for software and Internet applications startups. Sixty percent of these deals were "down rounds," or rounds where the company is valued lower than it was in previous funding rounds.
When a company raises money, it accepts a valuation assigned to it by the group of investors. A company might have raised a second round of funding in 2000 when the company was valued at $10 million, only to investors value it at $5 million two years later.
After a down round, an investor is left with a smaller, less valuable stake in a company.
Compared with down rounds making up 86 percent of the deals in the first quarter and 67 percent in the second quarter, the worst might be over for valuations, says Rob Suffoletta, a partner with Wilson Sonsini.
The Austin office of the Palo Alto, Calif.-based law firm conducts the survey for its high tech clients.
"Overall, we think there has been an improvement in the deal terms from a company's point of view," Suffoletta says. "Investors are becoming more comfortable with valuations, and the quality of companies is going up."
Suffoletta says reasons for the down rounds are basic - securities markets no longer are valuing companies as highly, and financial prospects for early stage companies are uncertain.
Most VC firms will institute price protections to ensure the value of their stake continues to grow. In many cases, they also will reprice the options of the executives to keep them on par with the preferred shareholders. But other common shareholders - people who hold stock but no longer work at the company - might not be so fortunate.
Wilson Sonsini's survey also examined a few other funding terms aside from valuations that affect entrepreneurs. Those terms are shifting more in line with a company's interests, the survey indicates.
Suffoletta says liquidation preferences - which determine how the money from an acquisition or merger is divided among shareholders - has moved from rewarding preferred shareholders to a more normal range.
For the first nine months of the year, the survey indicates 25 deals in Austin, or 66 percent, that rewarded preferred investors with a price equal to their preferred stock. However, the other 44 percent of deals rewarded preferred investors with a return that was more than the value of their stock. These higher preferences were negotiated as compensation for investors who were taking on more risk, but meant common shareholders would receive less money.
Valuation measures known as anti-dilution clauses, which protect preferred shareholders from dilution during a down round, remain common. All but three of the deals during the first nine months of this year, or 8 percent, contained some sort of anti-dilution protection for investors.
Mike Shultz, president and CEO of Infoglide Software Inc., recently raised a $4.2 million in funding at a lower valuation. Valuations and the shares of a company an entrepreneur gives up now are similar to levels before the tech boom, he says.
But he says companies caught between the boom and the bust are facing lower valuations - a rarity in the business.
"The bottom line is down rounds used to be done because a company had not met its plans, processes and commitments, and now down rounds occur because the valuation gauge has changed so dramatically from where it used to be," Shultz says. "It was just highly over-rated in 1999."
John Boyd, a director with Wayne, Pa.-based VC firm TL Ventures, says valuations have stabilized. In fact, even early stage companies are more mature in terms of having products and better management teams, he says.
