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"Don't shoot until you see the whites of their eyes." These statements remind us that patience and careful conservation of resources for use at a strategic time is particularly important in the current technology investment market. Prices for local technology companies are down, down, down . . . . . . Both good and bad companies are out seeking capital at bargain rates. If you can identify the winners from the losers and have money to invest, returns on investment may be greater than at any other time. Why are even good companies selling stock cheaply now? Of course, one reason is the overall economic
climate, which is depressing both expectations and prices. The other
primary reason for fire sales is the inability of many current investors
to increase their investments in these companies. Why? In some cases, the current investors just ran out of cash after investing in early rounds. In other cases, the investors have contractual or other restrictions on the amount of cash they can invest in any single company. For example, many venture capital firms told their investors that they would hold a diversified pool of investments and that no single investment would constitute more than 10% of the fund's investment. There is no objective "market" value for companies seeking venture capital. Valuation is set through negotiations. One of the primary tools companies have when negotiating valuation with new investors is to convince them that it can sell to the company's existing investors if the new investors do not agree to a reasonable price. If, however, a company's existing investors are unable to invest more money, it loses one of its most important negotiating tools and negotiating valuation is like being on a raft in white water without a paddle; the company will crash into whatever rocks the current pushes it. This is a problem for many companies now, because of recent changes in the size of early stage venture investments and expectations about when an exit would occur. Until several years ago, a venture investor might invest $500,000 to $1 Million in the first investment round. A second round investment in the $2 Million to $5 Million range might follow a year later. Several years ago, however, $3 Million to $5 Million first round investments became common with even larger second and third rounds. During the height of the internet bubble many companies were sold or did IPOs within a year or two after formation. This caused venture investors to invest too much in early rounds in anticipation that there would not be a later opportunity to invest in these companies. The venture investment business changed temporarily from a patient long-term investment process to a frenzied effort to get in and out quickly. Now that quick exits are not possible, many investors find they lack the cash reserves required to protect their initial investments over the long haul. This has created artificially low market prices from which other investors can benefit. Investors who have large cash reserves to invest are now actively seeking to identify companies whose original investors are tapped out. Sometimes the new money has no prior connection with the company. In other cases, new money comes from some of the existing investors. In either case, the new money is invested at such a low price that all prior investment is substantially diluted. Investors who owned 75% of the company may be reduced to 10% ownership if they cannot invest more money in the new investment round. Obviously, this can cause turmoil among existing investors and investor Board members. Investor Board members who can invest new money may favor growing the company, which requires raising more capital, whereas investor Board members who cannot invest may favor firing employees and otherwise reducing expenses to decrease the need for more capital. The management teams of companies, who may also be Board members, are split between historic ties to the company's original investors and the need to slash valuations to attract new capital. Theoretically, a low valuation will dilute the ownership of both the management and all nonparticipating investors, but in many cases the new investors agree to protect management from all or part of the dilution. New investors often issue more stock options to incentivize management to continue to build value in the company. The interests of management then shift to the new investors and away from the old investors. Does this sound somewhat like the girl who goes to the prom with one date and leaves with another? Old investors usually have legal tools to protect themselves in the investment documents they negotiated when they invested. In most cases, the company needs the consent of at least a majority of old investors to sell securities to new investors. This buys the current investors a seat at the negotiating table in valuation discussions. Legal veto rights, however, usually are not an adequate substitute for economic muscle. Having veto power over new investments often merely means the old investors are limited to choosing between several bad scenarios; suffering substantial dilution, selling the company for a very low price or closing down the company. A high stakes game of "chicken" may ensue between management, new investors and old investors. Companies either get money or they die and investors usually decide a small piece of something is better than a large piece of nothing. It's the law of the jungle. If you have money to invest, you are a lion. If not, you are prey. See you in the jungle.
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