Table of Contents
Corporate VCs in the Innovation Economy
VC Continues Five-Year Record Run Through 2018, But Q3 and Q4 Took a Holiday
The last edition of Venture Capital Coast to Coast was in July 2017. It’s been too long. Looking back as far as the June 2016 edition, most VC market trends have continued.
After VC’s strong performances in 2014 and 2015, and despite skepticism and a perhaps healthy “correction” and some pullback in 2016, VC fundraising and investment have remained strong by historical terms. Now, after such a prolonged and good run — and amidst public market volatility, “trade war” concerns, another anticipated closing of the IPO window and growing concerns about sustained economic growth — economists have some VC experts again pondering a VC downturn.
2018 will be a good year, but Q3 2018 and Q4 2018 revealed a slowdown from the previous quarters. In Q4 2018, fundraising (down 80 percent from Q3 2018), investment deals (deal count down 43 percent from Q3 2018) and exits (M&A down 86 percent from Q3 2018 and IPOS down 93 percent) seem to have “taken an early holiday break.” https://www.pehub.com/vc-journal/nvember-dashboard-activity-slows-as the year-wind… That said, the year-end slump will not likely change the fact that 2018 has been a record fundraising year.
Despite questions about the sustainability of VC’s great run, LPs have enjoyed record cash-on-cash returns and appear eager to reinvest in funds. One main theme continues to drive the statistics: Capital is being concentrated into fewer, larger VC deals. https//xconomy.com/national/2018/10/09u-s-venture-capital-deals-on-pace-to-exceed-10…Unicorns were responsible for about 25 percent of the total capital raised. https://techcrunch.com/2018/10/09/venture-capital investment-in-us-to-hit-10… The high VC-backed investment-to-exit ratio in 2016 inspired a brisk 2017 mergers and acquisitions market, especially in the technology sector. Venture Capital Coast to Coast’s 2016 and 2017 emphasis on the internet of things, healthcare IT and software has proven on target, as these sectors are among the stars of 2018. But, as contrasted with 2016, any uncertainty in VC’s next phase is driven as much by the overall economic outlook as by VC-specific concerns like a capital overhang or inflated valuations.VC WATCH
Can the Innovation Economy Weather the Next Downturn?
VC fundraising dropped by 27 percent in Q3 2018 and 80 percent in Q3 2018 from the previous quarter, but LPs’ appetite for VC appears persistent. The Financial, www.finchannel.com/business/76186-venture-capital-report. VC dollars invested increased (for the fifth straight quarter) in Q3 2018 but will have decreased in Q4 2018, but, cumulatively, 2018 will surpass 2017 in total dollars raised by U.S. companies. Further evidencing the trend of fewer, larger deals, investment deal volume declined in Q3 2018 to the lowest level since Q4 2012 and will likely decline again in Q4 2018. Late-stage unicorns such as WeWork, Uber and Peloton each raised $500 million+ rounds. PWC/CB Insights MoneyTree Report Q3 2018 (MoneyTree Report). Robot pizza maker Zume raised $375 million in Q4 2018. https://www.pehub.com/vc-jounral/november-dahsboard-activity-slows-as-the-year-wind… Seed-stage investments declined, but early-stage deals rebounded in Q3 2018. Expansion and late-stage investment continued their increase as a percentage of all deals. Corporate VC investments continued their persistent rise, reaching 29 percent of all deals in Q3 2018.
Similar to 2016, but driven more this time by macro-economic concerns, pundits are again advising caution for VC investors. The VC ecosystem has not yet embraced the growing skepticism, but even the “bulls” in the room agree that, despite large stockpiles of fund money, significant economic shifts could stall VC’s great run. As an investment class which is non-correlated with the stock market, many astute VCs plan to continue VC investments despite any economic slowdown, viewing market volatility as an opportunity. Perhaps this philosophy will trickle down to seed and early-stage investors and support VC investments during any period of public stock portfolio declines. But perhaps not.
The MoneyTree Report™ reveals that industry sector allocations did not change materially during 2017 and 2018, although healthcare saw a slight increase (particularly in digital health). Some large deals in the automobile and agricultural technology verticals grabbed headlines, further revealing the evolving impact of AI and the convergence of technology and software with all sectors. As in a past Venture Capital Coast to Coast, it cannot be emphasized enough the extent to which data analytics and all things AI have transformed the SAAS economy into the innovation economy.
Comparing VC industry sectors is increasingly difficult in the innovation economy, where different traditional investment verticals converge. Technology solutions, including software as a service (SAAS), now serve every sector, from healthcare (with digital health reaching the second-highest investment amount on record), to insurance and financial (highest quarterly investment on record), to old-line sectors such as food, real estate and energy. Each of these sectors is at a different stage of innovation, with auto tech maturing to later-stage deals and the more nascent real estate tech and insurance tech sectors garnering significantly more seed and early-stage capital. The same goes for industrial technologies (robots, drones, 3D printing, etc.) spawned by artificial intelligence, as highlighted below in “VC VERTICALS.”
McGuireWoods continues to see and work on seed, early-stage, Series A and later-stage VC investment deals. As with the national Q3 2018 numbers, our firm’s seed and early-stage deals constitute 50 percent or more of the total number of our VC investment transactions. www.firstrepublic.com/innovators/articles-insights,us-venture-cap-report-q32018 (Prequin and First Republic Bank). If economic headwinds become a drag on VC investment, perhaps more investors will look to diversify their bets to lower-priced, earlier-stage investments. Although VC investments generally increase during strong public markets, as a non-correlated investment and especially in light of the longer holding periods for VC stakes, perhaps an economic downturn will result in a higher allocation of VC dollars from high-priced unicorns to earlier-stage companies and rounds.
Corporate VCs in the Innovation Economy
Venture Capital Coast to Coast previously discussed the continued impact of corporate VCs on VC investing, but they are assuming an even more important role in the innovation economy, where technology is transforming old-line industries. Despite their total percentage of all VC investment remaining relatively constant (corporate VC increased to around 29 percent in Q3 2018), corporate VCs’ investment in industrial technologies has doubled since 2013. In 2017, 61 percent of VC funding for industrial technologies went to companies with a corporate VC on their cap table. See “VC VERTICALS” below. Through Q3 2018, corporate VC investment represented almost 47 percent of venture capital deal value in the U.S., an increase of 5 percent over 2017. Corporate Venture Sets a Record With More Than $12 BLN Deployed, Venture Capital Journal, page 31, Buyouts Insider, Simplify Compliance, LLC.
The Rest Continue to Rise, Albeit Slowly
While California, New York and Massachusetts continue to dominate the VC landscape, more companies in the “other” U.S. regions are getting funded due to less local or regional competition (fewer companies), albeit at lower valuations due to less investor competition. Investors increasingly may view companies outside Silicon Valley as candidates for lower valuations and higher returns. Of course, a VC migration from Silicon Valley to points between the coasts eventually may make high valuations a national reality.
The MoneyTree™ Report confirms the continued dominance of California, New York, Boston and the Midwest in VC deal count and dollars for Q3 2018. Given our national footprint and extent of our practices in the mid-Atlantic/DC, Midwest and Southeast regions of the U.S., we are always interested in the “other” and “between-the-coasts” markets. These are, importantly, defined by the location of our client companies rather than the investors. Including Illinois and Pennsylvania and some contiguous states, the Midwest is first among the “other” VC regions. Here, agricultural, energy and healthcare technologies flourish. When combined, the Southeast and D.C. regions are comparable in VC dollars raised. Of course, D.C. is a major center for all things IT and cybersecurity, while the Southeast boasts a surprisingly diverse population of industry sectors, also including energy and healthcare businesses.
Texas, a region unto itself, has almost 25 percent of the deal dollars and volume of these “other” multistate regions, with its economy benefiting from, but now diversifying well beyond, energy. Colorado (a second-tier VC hub, similarly not situated in a notable VC region) surpassed Texas in Q3 2018. Funding in the Southeast (from North Carolina to Tennessee, Georgia and Florida) was comparable to that in the Northwest (including Seattle) in Q3 2018. After California, New York and Massachusetts, the Q3 2018 state rankings in terms of reported deal numbers were, in order of ranking, Colorado, Washington, Texas, Illinois, Florida, Pennsylvania and Maryland.
The “rise of the rest” is not just about small deals, although active seed and early-stage investing continue outside the major VC hubs primarily from investors who live close to the companies. According to the Venture Capital Journal, 2018 brought a noticeable increase in $50 million+ VC rounds to the East Coast, the Midwest and states such as Florida, Texas, Minnesota, Ohio, Illinois and Colorado. If this trend continues, it may have the benefit of more later-stage financings in “other” regions, albeit with increased valuations. New Take on Rise of the Rest: Large Growth Rounds Spread Across U.S., Venture Capital Journal, page 32, Buyouts Insider, Simplify Compliance, LLC.
The Innovation Economy and the “New Industrial” Sector
Venture Capital Coast to Coast previously discussed artificial intelligence (AI) and the “industrial internet of things” (IIoT). The impact of startups on better, smarter and more energy-efficient manufacturing and transportation appears greater than in any other sector. As companies in more mature and specialized sectors become unicorns, entrepreneurs, inventors and early-stage investors are turning to machine learning and AI to develop solutions for the huge manufacturing, transportation and logistics market. Not surprisingly, corporate VCs have already become active investors in industrial technologies to gain a first-mover advantage in automation, robotics and logistics visibility solutions. Pitchbook, 2018 GE Ventures Report, New Industrial.
GE Ventures describes itself as an active investor in the “new industrial” segment, both early-stage and growth-stage, with particular interest in the intersection of energy and manufacturing, mobility and “smart” environments. It also agrees with McGuireWoods’ frequent observation that, like technology and SAAS before it, “smart” manufacturing and AI are not a single sector at all, but serve every other sector of the economy. Cleantech was perhaps the precursor to industrial technologies as a discrete investment sector, but today VC dollars are moving away from pure cleantech plays to smart machines and mobile environments, although with some continued focus on energy savings as a byproduct of greater efficiencies and better vision into production and transportation. Another byproduct of industrial technologies is the need for cybersecurity to protect critical data and communications systems. Years ago, the convergence of the economy was attributed to all things SAAS. The industry had not seen anything until the innovation economy replaced the information economy. The new world of robots and data analytics will increase the connectivity within the economy and bring incredible efficiencies, along with new risks and challenges.
In contrast to the overall VC ecosystem, where in recent years, larger checks have been written to fewer companies, the number of deals completed in the industrial technologies sector continues to rise. And angel/seed and early-stage investments exceed late-stage investments. This, coupled with the fact that corporate VCs provide valuable support and an obvious exit alternative to early-stage companies, should make seed and early-stage VC investments promising for companies providing industrial technology solutions.
Founder Stock: What’s Myth, What’s Market?
Company founders often ask about receiving “founder stock” instead of basic common stock. Most company founders receive common stock, which is junior in preferences and certain other rights to the “preferred stock” often issued to VC investors. The common stock issued to founders upon the formation of a company typically has a relatively low value and therefore can be purchased at a low price or received in exchange for the founders’ contribution of the business plan and any intellectual property to the company. Thus, there should not be significant income tax consequences to the founders. If an employee later receives common stock in exchange for services, it may be taxable based upon a possibly higher value for the shares at that later time. Employees also can receive common stock options, which are not taxable on receipt but can trigger income taxation upon exercise if the fair market value of the stock exceeds the exercise price.
“Founder stock” is not actually a different legal class of stock, but rather, may refer to common stock with special vesting or conversion rights. While many companies do not impose vesting conditions on founder stock, they should consider doing so for several reasons. First, if there are multiple founders, a founder who leaves within a few years should expect to lose all or some unvested portion of his or her shares. This protects the other founders who remain with the company. Furthermore, investors often request that founders’ stock be subject to normal vesting conditions. These typically provide for vesting of a portion in one year (so-called “cliff” vesting, more common for later employees than founders) and monthly vesting thereafter through three or four years. Vesting is often accelerated (that is, the founder would be entitled to all of the shares) in the event of an early sale of the company or termination without “cause.”
Providing for vesting conditions at the outset may have the benefit of avoiding more onerous vesting restrictions being imposed by later investors. For example, while founder stock vesting is usually “single trigger,” in that all of the shares vest upon a company sale, some investors seek to negotiate for a “double trigger,” which accelerates vesting (on all or some portion of the founder’s shares) only if the company is sold and the founder is terminated without cause within some period of time after the sale. This technique is designed to provide founders with the incentive to remain with the company for some period following a sale if the buyer prefers that they continue with the company.
More recently, “founder stock” has come to refer to shares that may have special, or disproportionately high, voting or even liquidation rights similar to preferred stock. “Series F” stock refers to founder common stock with special voting rights. “Series FF” stock refers to common stock that is convertible into preferred stock prior to a Series A round or other financing. Upon a VC financing, the founders would sell the Series FF shares to investors so they have the opportunity to receive some cash prior to a company sale. Both types of “founder stock” are relatively uncommon and may not be viewed favorably by future investors in the company.
As discussed in prior editions of Venture Capital Coast to Coast, founders should consider two things regarding their common stock in the company. First, they should allocate the initial common stock among the founders based upon a fair and honest analysis of each founder’s expected contributions to and role in the company. Equal percentages is rarely the fairest approach and may lead to future discontent and disputes among the founders. Second, when VC capital is raised, founders should expect their shares to become subject to various investor agreements and rights. For example, if a founder wants to sell shares, he or she likely will be required to first offer the shares back to the company. In addition, investors may negotiate for “co-sale” rights that entitle them to sell a proportionate amount of their shares if and when the founders sell shares. These terms and agreements are common to all Series A and other VC rounds.