June 2, 2009

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Cashed Out

Start-ups Face a Funding Dry Spell

June 2, 2009

Business investing in Utah is, if not in dire straights, certainly stalled. Entrepreneurs needing funding or businesses needing cash injections must be patient until liquidity is available. Funding sources from banks, venture capitalists, private equity groups and angel investors are quickly diminishing. According to Alan Hall, entrepreneur and investor, there isn’t going to be a lot of available money in 2009. “Companies will need to manage better their cost structures, find new streams of revenue and cut costs where possible,” he says. “What makes a business run is increasing sales and profit margins which then pay overhead costs. In a good economy, companies have profits left over to reinvest into themselves. But because of the cautious behavior among businesses and consumers, these extra profits aren’t there. Unless this behavior changes, we could end up in a greater mess then we’re already in.” Utah’s economy, although not immune from economic woes, still ranks among the nation’s best. According to a recent report from the American Legislative Exchange Council, Utah ranked first in the economic outlook for 2009. What then does the state’s investment landscape look like? Angels with Clipped Wings Angel investors are organizing themselves into groups or networks to pool their investment capital and buffer against the economic storm. For instance, the UtahAngles group has invested $16 million in 39 companies since 1998, including Omniture and MyFamily.com. The current economy has taken a toll on angel investors nationwide. “The most drastic change to the angel community has been the loss of liquidity,” says Hall. A majority of wealth is tied to the stock market, which is hitting all-time lows. Since wealthy shareholders do not want to sell shares in the current market, cash for investments is less available. Even real estate, a traditional safe haven, is not being leveraged or sold. “Because cash has dried up, there is very little participation from the angel community right now,” says Hall. Other financial experts say this timid behavior is understandable. “The reality is most angel investors have lost money and many are sitting on the sidelines, observing. There is certainly a state of fear right now,” says Brock Blake, CEO of FundingUniverse, a company that connects entrepreneurs with angels, venture capitalists and other lenders. “Because of this loss, there isn’t a lot of money flowing right now. This has forced many smaller investors out of the game, knocking everyone down the ladder a rung.” The horizon, however, may not be so dim. A recent FundingUniverse survey reveals some optimism: Of the 93 Utah angel investors surveyed, about half said that they are still actively investing in some form or another; about 2 percent stated that they are syndicating deals, but not leading any new ones; about 23 percent said that they are not making any investments outside of their current portfolio; and almost 23 percent said they are no longer investing. A strong theme is the lack of new deals and a focus on existing portfolio investments. “These new results are encouraging for investors,” says Blake. “Because entrepreneurism traditionally increases during a recession, those active angels looking for deals will have plenty of potential investments to choose from.” For entrepreneurs, however, this means more competition for dwindling funds. “Ideas alone won’t get funded anymore,” explains Blake. “Entrepreneurs and small businesses will need to have better business models, investor presentations and even demonstrate early sales.” Adventure Capital The National Venture Capital Association (NVCA) recently reported that 2008 was the first decline in total venture investments since 2003, down 8 percent over 2007. According to the Wall Street Journal, venture-backed companies currently account for more than 10.4 million jobs and $2.3 trillion in U.S. revenue. Cydni Tetro, chief marketing officer and co-founder of venture-backed NextPage, recently predicted that within the next 12 to 24 months the economy will be left with half of the venture capital funds there are today, little money to fund new deals, limited exits (M&A or IPO), very few start-ups getting funded and minimal new job creation. Because of this potential decline, venture capitalists are also driving for harder terms. An emerging trend, for example, is the rarely discussed practice of ‘pay-to-play’—when new investors can’t be found, companies often turn to existing investors for additional rounds of funding. If some of the current investors are cautious or hesitate to invest more money, the venture capitalists who intend to invest further create new terms that force the other investors to participate. If they refuse, they may lose their existing equity or receive other penalties, such as having their preferred stock converted to common stock. So far, 2009 does show some promise of recovery. According to Techrockies.com, Rocky Mountain area firms raised around $368 million in this year’s first quarter. The investment level was up significantly from last year’s fourth quarter, when only $197.5 million was invested in the region, but was down from last year’s first quarter when there was $492.65 million invested in the area. The quarter was dominated by Colorado, which saw $341.6 million of that $368 million in investments; Utah saw $24.85 million and Arizona $1.5 million. The signs of hope continue. According to the latest quarterly Silicon Valley Venture Capitalist Confidence Index, confidence measured 3.03 on a five-point scale in the first quarter, up from the previous quarter’s five-year low of 2.77. The nation is slowly starting to see a degree of stability in the financial markets, and because company valuations have dropped so low, investors and venture firms can get great deals. In addition, the downturned economy has created a surplus of talented people who are willing to work for smaller companies or start-ups. Private Equity “The economic turmoil has impacted the private equity industry in two principal ways,” explains Fraser Bullock, a managing director and co-founder of Sorenson Capital. “First, the liquidity from the banking industry has become extremely scarce. Most banks have ceased lending to new credits, making it far more difficult to complete a transaction. Private equity firms need to become far more creative in this environment. We were able to complete two new investments in December by employing specialized transaction structures, so deals can be completed.” Bullock also says that demand for products and services have declined precipitously. “Such companies with significant leverage as a percentage of their capital structure are struggling against debt covenants and are working with the banks in work-out situations.” Two of Sorenson Capital’s local portfolio companies continue to shrug off the economy—Provo Craft and Omniture. The former finished 2008 with a 50 percent increase in top line sales and 104 percent bottom line growth. The latter achieved record revenues in its fourth quarter, $83 million, compared to $43.1 million reported for the fourth quarter of 2007, and $77.8 million reported for the third quarter of 2008. “This economic period has created a difficult exit environment for venture backed businesses,” says Greg Warnock, a managing director at Mercato Partners. “But despite the decline in M&A activity and scarcity of venture backed IPOs, we remain optimistic that now is an opportune time to be investing and cultivating growth stage companies.” Many private equity investors are constrained by the unavailability of debt and early stage investors are increasingly reluctant to deploy additional capital into unproven business models. But while not entirely immune, growth equity stage investing still remains promising. “Companies with comfortable cash positions, strong growth rates and average trailing revenues in the tens of millions will continue to be resilient despite negative macroeconomic conditions,” adds Warnock. Investment Innovations Franchise Foundry is a Springville-based strategic investment and growth firm focused on transitioning proven businesses into franchises. The company is receiving a lot of attention because of its unique business model. Traditionally, raising a fund under $50 million, or even $100 million, is difficult because of the management fees for the limited and general partners of the fund. But the company recently closed its first fund of just under $5 million because, says Ryan Money, VP of business development for Franchise Foundry, its business model doesn’t include management fees, but drives its revenue from the companies it takes to franchise. Despite the size of Franchise Foundry’s fund, the company is still able to complete as many deals as a traditional venture capital firm. “This is the most unique business model I’ve ever seen,” says Money. “We’ve been successful in providing numerous promising businesses the necessary systems and processes they need, and then growing them into thriving franchises.” The Franchise Foundry model is particularly relevant in today’s economy. A recent study by FRANdata predicts that borrowing by franchises will fall 27 percent in 2009 when compared to 2008. The company’s portfolio includes some of the fastest growing franchise concepts in North America, including Spoon Me, Five Star Painting, Fairway Divorce Solutions and other rapidly growing companies. Mercato Partners, a Salt Lake City-based growth equity firm, brings to its portfolio companies experience with launching technology products. Mercato combines growth equity investing with sales and marketing execution. This is enabled through strategic partnerships with companies such as MarketStar Corporation. The firm’s strategy has uniquely prepared its portfolio companies for early exits when the liquidity window re-opens. Traditionally, private equity firms, banks and other financial institutions show expertise in their pursuit of deal flow and acquisitions but often lack the bandwidth to accomplish the loan workouts and dispositioning of assets. Eagle Point Servicing, a Sandy-based financial services company, was specifically created to fill that void and now plays a vital role in the acquisition, repositioning and dispositioning of assets within private equity portfolios. Light on the Horizon Although dark economic rumblings can clearly be heard across the state, it should be remembered that venture capital and growth equity emerged during the recession of the 1970s. Great companies like Microsoft and Apple also emerged during recessions. Troubled economies often give birth to innovation, new industries and undiscovered investment opportunities. “Utah has very strong business roots,” says Alan Hall. “The state will eventually see its way through this crisis and investment will become plentiful once again.”
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