Six Capital Market Changes to Watch in 2010

12/3/09

Where are we? And where are we going? Those are the questions we need to address and, if possible, answer as 2009 recedes and 2010 approaches—hopefully, bringing better markets and a better economy with it.

As you know, we’ve been trying to assess and analyze the ebb and flow of things for more than a year.

Back in Q4 2008, for example, we issued our first report in a series designed to help companies make sense of the uncertain economy. Earlier this year, we followed up with a group of interviews that helped show how promising technology companies were coping with financial anxiety. Now, in this installment, we’re going to talk about changes in the markets—both permanent and temporary—and what they mean going forward.

The key take-away is that raising equity dollars is—and will remain—difficult.

The second hard truth is that the venture capital model is broken. The past recession shined a bright light on that, and it’s clear that pension funds will not allocate a greater percentage of their diminished dollars to a non-performing asset class. As a result, the VC population will definitely shrink; expect these lowered numbers to be permanent.

The third reality is that capital efficiency is critical. The emerging facts are stark here: exit values will be lower; relatively few companies will make it public; and investors and strategic buyers will expect strong growth to earn lofty multiples. In the end, making the math work with existing and future VC funds will be tough because lower value exits will translate into fewer dollars paid into startup companies. This will also be a permanent change—although, as always, there will be certain deals that smack of insanity.

The fourth certainty is that those VCs left standing will be disciplined. They’ll stay in markets in which they have demonstrated expertise. And they’ll attach premiums to revenue quality, subscription models, high growth, and consistency while applying discounts to the pure license model with more modest growth. The days of 10x TTM (trailing twelve months) revenue multiples for software-as-a-service companies are gone.

The fifth fact that has resonated is that business is emotional; investors and CEOs won’t forget these brutal years anytime soon. And, as the environment continues to improve, companies that struggled through the past two years will look for ways to diminish their risk going forward. That means recaps, strategic partnerships, equity infusions, grants, and NRE (non-recurring expenses). My prediction is that this, too, will be a permanent change for the generation of business people who have endured the financial meltdown and its aftermath.

The sixth outcome is that the M&A market will rebound. A number of factors point to a robust year in M&A for 2010: companies have been hoarding cash and will use it for inorganic growth; valuations are still quite reasonable; quality companies now have the threat of an IPO, which drives buyers; and private equity and access to debt capital will eventually come back. We all know that the M&A markets are cyclical, and the down cycles are typically 2-3 years, while the up cycles typically are more like 5-6 years. So the time for a turnaround may be approaching.

In the meantime, at least the worst appears to be over; at least we’ve learned something from the recession; and at least some form and semblance of sobriety has returned to the world of equity formation. We should be thankful for that.

Kevin Cable is co-founder and Executive Vice President of Seattle-based Cascadia Capital, a national investment banking firm. He specializes in the software and services industry. Follow @

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