Do you get the feeling deal flow is picking up a bit? Well, you might be right. But does that make things better for entrepreneurs? Not necessarily. As Boston lawyer John Hession sums up: “The market is improving. That doesn’t necessarily mean that deal terms are improving or valuations are improving. It means the number of financings, maybe, are improving.”
Yesterday, I put out a six-question quiz about venture capital deal terms. The questions were culled from a survey of second-quarter deals by Hession’s firm, Cooley Godward Kronish. Michael Greeley, chairman of the NEVCA and a general partner with Flybridge Capital Partners. Thanks to John and Michael. Let’s see how you did.
1) What was the median pre-money valuation of a Series A round in Q2?
Correct answer: $4.4 million
Commentary: Cooley’s survey from Q1 had median Series A pre-money valuations at a scant $3.4 million—so this marks a hefty rise. But it’s still well below the median from last year, which ran at about $6.5 million.
2) What was the median pre-money valuation of a Series B round in Q2?
Correct answer: $17 million
Commentary: Another uptrend. The figure was $13.2 million last quarter, but still a fair bit from the $24 million in the first half of 2008.
3) What was the median pre-money valuation of a Series C round in Q2?
Correct answer: $33 million
Commentary: Whoopdedoo! It’s a trifecta of valuation gains! The Q2 figures are up from $26.7 million in Q1 and quite a bit better than the $24 million seen in the fourth quarter of 2008. But you don’t want to look farther back than that, trust me.
4) What percentage of financing rounds were flat or down from the previous round?
Correct answer: 56
Commentary: Not a whole lot new to say here. It’s better than the two-thirds seen in Q1, but you’d have to go back quite a ways in the database to find a worse number than that figure. As Hession says, “Deal terms are tough.”
5) What percentage of financing deals included Full Participating Preferred terms?
Correct answer: 60
Commentary: What is full (or fully) participating preferred? Here’s a good backgrounder from Brad Feld. The quick answer is it’s a way for investors to get more out of a deal. If an investor invests $10 million, say, for a 20 percent stake in Xconomy (first, she’d be getting a good deal) and the company is later sold for $100 million, she could normally expect $20 million back, right? Not with Full Participating Preferred. Instead, she gets her $10 million back first, and then 20 percent of the remaining $90 million, for a total payback of $28 million.
As Greeley explains, this is not good news for entrepreneurs. “It’s directly coming from the founders,” he says. “It kind of speaks to how dire the situation’s been—that investors were asking for, and getting that term.”
Cooley’s survey showed a smidge of an improvement on this measure (from the entrepreneur’s viewpoint) over the first quarter’s 61 percent. But it’s still a ways from the 54 percent average of last year.
6) What percent of non-Series A rounds had “carve-out” provisions for management?
Correct answer: 5 (based on partial data for Q2)
Commentary: I’ve got no comparison data for you, but Greeley says this is low. Carve outs for non-Series A rounds protect management teams, especially if the other deal terms make it hard for management to get much from a sale of the company. “It’s a way to incent management to stick around,” he says. “Sophisticated management will do the math and say, ‘I need this protection because these terms are so onerous or the environment is so bad.'” In the current environment, Greeley says he would have expected this number to be higher. The results, he says, show that entrepreneurs don’t “have much leverage.”
Hession takes a somewhat different view. “Management always has more power than investors think—if they do not want to sell, or want to get out and not hang for the long haul–they can profoundly influence the sale process,” he says. “Unless it is a pure asset/IP sale, where the buyer is picking up only the technology, buyers need management (especially the CEO, CTO and VP-Sales) to carry the transition.”