Global Vc Report 2009

From survival to growth Global venture capital insights and trends report 2009

Foreword

Nearly all aspects of the global economy are feeling the impacts of the economic downturn. The Venture Capital (VC) industry, for one, faces a number of difficult challenges: falling demand for portfolio company products and services; a dearth of exit opportunities through Initial Public Offerings (IPOs) and acquisitions; and the need for tough decisions about the prospects of some portfolio companies. But while the challenges are significant, a number of factors suggest that the industry will soon move from the challenges of survival to opportunities for growth. First, the venture industry is applying many of the lessons learned in the aftermath of the technology bubble of 2000. VC firms have reacted quickly to assess their portfolios in light of the downturn and to set aside reserve capital to support companies with the potential to succeed in the long term. Portfolio companies’ strategies are being adjusted to the new economic realities with cost management, an intense focus on the customer value proposition and overall operational excellence. Most important, venture-backed companies are identifying and pursuing the opportunities inherent in a downturn — “Never waste a good crisis” has become the new industry catchphrase. These opportunities include the ability to access cheaper resources, attract the best talent more easily and overtake or acquire struggling competitors. Forging innovation partnerships with large corporations that increasingly view innovation as a primary source of competitive advantage is another opportunity to be seized. Honing a business model and innovation strategy that work in a downturn can pay impressive dividends on the upswing. Indeed, many of today’s market-leading companies were founded or received their first round of venture financing in recessionary periods — Hewlett-Packard, Apple and Cisco, Starbucks, Intuit, Skype and Shanda, to name just a few. While it is hard to predict which venture-backed companies will emerge as market leaders this time, it is safe to say that some will develop and bring to market great new innovations and become the billion-dollar enterprises of tomorrow. As you will read in our interviews with leading VC investors around the globe, the work of funding great new companies continues despite the difficult economy. Investors point to cleantech, cloud computing, Software as a Service (SaaS), genomics and consumer applications as a few of the areas in which they expect to see disruptive innovation. Given the importance of innovation to the world economy, VC funding should not be taken for granted, especially in some of the most trying economic conditions since the Great Depression. That is why we make a number of policy recommendations for the support of the VC ecosystem: incentives for innovation and entrepreneurship in government stimulus packages; cross-border cooperation to improve the flow of talented individuals; and a multinational task force to develop a plan to increase the number of IPOs by venture-backed companies. From survival to growth, our seventh annual report on venture capital, examines the state of VC today and provides insights into such topics as strategies for seizing opportunities in the current downturn, managing working capital and concerns for technology companies. Throughout the report, leading company executives and VC investors from around the globe share their own perspectives on the impacts of the downturn and strategies for success. We are grateful for their contributions. We hope that you will find this report a source of valuable insight and look forward to working together with you on the global challenges and opportunities that lie ahead.

Table of contents

• From crisis to opportunity by Gil Forer, Ernst & Young, and Dr. Martin Haemmig, CeTIM.........................................................2

• Fireside chat on venture capital and growth companies Interview with Scott Carter, Sequoia Capital, and Paul Deninger, Jefferies ...................................10

• Lessons learned from building a company in turbulent times Interview with Matthew Szulik, Red Hat .....................................................................................14

• Innovation finds finance despite market turbulence by John de Yonge, Ernst & Young..............................................................................................18

• Perspective from Europe Interview with Bruce Golden, Accel Partners ..............................................................................20

• Current topics for technology companies Ernst & Young Global Technology Center ...................................................................................23

• Perspective from China Interview with Bo Shao and David Zhang, Matrix Partners ..........................................................26

• Perspective from the United States Interview with Deepak Kamra, Canaan Partners .........................................................................28

• How to manage cash by Steve Payne and Al Sardo, Ernst & Young ..............................................................................30

• Perspective from Israel Interview with Chemi Peres, Pitango Venture Capital..................................................................32

• Perspective from the United States Interview with Noubar Afeyan, Flagship Ventures .......................................................................34

• Perspective on corporate innovation and collaboration Interview with Steve Meller, Procter & Gamble ...........................................................................36

• Perspective of a corporate investor Interview with Nino Marakovic, SAP Ventures ............................................................................38

• Perspective on biotech Interview with Alex Barkas, Prospect Venture Partners...............................................................40

• Perspective on US cleantech policy Interview with Timothy Urban, Washington Council, Ernst & Young .............................................42

• Perspective from the United States Interview with Jeffrey Glass, Bain Capital Ventures ....................................................................46

• Contacts Ernst & Young Global Venture Capital Advisory Group ................................................................49

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From survival to growth Winning through excellence and innovation in a downturn

Gil Forer, Global Director, Cleantech, IPO and Venture Capital Initiatives, Ernst & Young

Dr. Martin Haemmig, Senior Advisor on Venture Capital, Stanford University (APARC-SPRIE), and Adjunct Professor, Globalization of Venture Capital, CeTIM

Key points The VC industry has reacted quickly to the downturn, moving to reassess portfolios and refocus portfolio company strategies. Operational excellence in a downturn means not only cutting costs and increasing revenues but also seizing opportunities to gain market share. Innovation partnerships between emerging-growth companies and large corporations become even more important in a downturn. VC industry financing for innovation should not be taken for granted — global policy initiatives to ensure the health of the VC ecosystem are needed.

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When assessing the current state of the Venture Capital (VC) ecosystem, an important distinction needs to be made between the current financial crisis and the aftermath of the burst internet bubble of 2000 — the last severe downturn faced by the VC industry with which it is tempting to draw parallels to today’s situation. In 2000, the venture industry was part and parcel of the bubble and the subsequent downturn. Fueled by “overexuberant” stock markets that placed unsustainable valuations on dot-com and technology companies, VC grew globally from a US$30 billion industry to a US$125 billion industry, only to retreat to a US$25 billion industry as public markets collapsed — all in the space of just three years. This collapse was followed by a real industrial downturn in telecommunications, software, computers and electronics, hitting even quality companies with real business models and real products. Even so, the downturn was largely confined to the technology sector while other parts of the economy continued to perform relatively well. The current downturn is much more complex and driven by fundamental issues that are not related to VC or the technology industry. A variety of overlapping circumstances combined to create today’s global financial crisis. Among them were the collapse of bubble-like real estate markets, poor lending practices, a lack of adequate risk management in the use of derivative financial instruments, and debt being overleveraged by both businesses and consumers. Thus, the venture industry is adapting to a financial crisis caused by external factors.

From survival to growth

Funding trends and challenges While the financial crisis began to be felt in 2008, overall VC financing declined only gradually over the course of the year. This is partly because the VC business has a long latency: while the economy may be slowing, there is still a lot of money in the system from the limited partners that have committed capital to funds for 7 to 10 years, regardless of the economy. Another reason is that cleantech investing remained strong throughout the year, supporting the overall investment figures. But by the first quarter of 2009, the impact of the downturn on VC investing became clear, with a substantial drop-off in financing globally. We can expect significantly few new VC investments around the globe in the near term as firms allocate more capital to reserves for existing portfolio companies (see Figures 1 and 2). However, the longer the global downturn lasts, the more likely it is that VC firms with relatively young funds will place bets on new investments. This is because the economy is likely to have recovered in the five to seven years it typically takes to build a company to the point of being ready for an exit. History has proven that many world-class companies have been funded in periods of downturn. Challenge: potential exit backlog Any company financed during this downturn will find thousands of other venture-backed companies ahead of it in the pipeline to exit. The years between 2002 and 2008 saw a wave of new financings by VCs around the world that seems disproportionate to the capacity of the capital markets to provide an

exit through Initial Public Offerings (IPOs) or Mergers and Acquisitions (M&As). In the United States, VC firms provided 6,013 companies with an initial round of financing. In Europe, the figure is 3,077 newly financed companies; in Israel, 325 companies. At the rates that venture-backed companies have conducted IPOs and M&As in the post-bubble period, it is questionable whether these companies financed post-bubble will achieve the rates of exit seen earlier. The large population of private venturebacked companies could not only hurt the weaker VC firms and their limited partners but could also damage the returns of stronger VC firms. This could happen through two mechanisms: first, overpricing of hot deals by venture firms drives the returns down, and second, the overfunding of “me too” companies creates an overcrowded segment, making it harder for the good companies to get heard. Challenge: dependence on government for early-stage financing Europe would have very few start-ups without government financing. There, almost all start-ups are funded in one way or another by government-sponsored programs. Many of them go on without further, VC funding and take a path of slower organic growth while a smaller number get venture funding in the next stage. China has spent an enormous amount of money on Research and Development (R&D) at universities and research labs and has learned the lesson that appointed government officials should not run VC firms. The Israeli venture community was

instrumental in advising the Chinese to set up guidance funds, similar to Israel’s Yozma program in the early 1990s, in which the government invests as a limited partner in local and foreign VC firms along with other institutional investors. The recently established Russian Venture Company (RVC) is doing the same to attract international brand-name VC firms to Russia. It remains to be seen whether the money will be used for early-stage companies in these two emerging nations. The United States, on the other hand, has a network of “angel” groups or individuals. As in every downturn, angel investors are also being hit, and their investment volume has come down accordingly.

Figure 1. Global VC investment by geography 1Q’08–1Q’09 Total investment (US$b) $11.8

$11.8

$0.14 $0.14 $0.46

$0.14 $0.25 $0.23

$1.02

$1.43

$2.22

$1.61

$0.25 $0.22

$0.26

$1.00 $9.0 $0.17 $0.29 $0.25

$1.94

$0.75

$1.64

$0.10 $0.12 $0.46 $1.21

$8.17

$7.78

$7.77 $5.95 $3.90

US

2Q'08

Europe

3Q'08

China

Israel

4Q'08

Canada

1Q'09

India

Source: Dow Jones VentureSource

Figure 2. Global VC investment in cleantech by geography 1Q’08–1Q’09 Total investment (US$m) $2,437 $45

$15 $140

$415 $1,693 $13

$15 $73 $1,348

$197

$21

$23

$1,130

$88

$25

$17

$222

$114 $1,823

$231

$604 $1,395 $994

A successful VC model must incorporate IPOs of portfolio companies to drive appropriate risk-adjusted returns. In the mid 1990s,

$5.9 $0.08

1Q'08

Venture-backed exits: in search of a way out Since 2004, M&A transactions have become a solid exit route for American, European and Israeli companies, while IPOs are the main path to liquidity in China and India. In 2008, both M&A and IPO transaction activity fell off a cliff in the major investment regions although IPOs are remaining relatively strong in China. It appears that the recent opening of the second board in China will lead to increasing domestic IPO activity. It is still too early to tell, however, whether the local Chinese stock exchanges can gain and maintain the trust of investors, making Shanghai and Shenzhen viable exit platforms for venture-backed companies from China and elsewhere.

$11.4

$14 $67

$5

$232

$742

$287 1Q'08

US

2Q'08

Europe

China

3Q'08

Israel

4Q'08

1Q'09

Canada

Source: Dow Jones VentureSource

Global venture capital insights and trends report 2009

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Global venture firm operating models Joint fund: a collaboration between a US fund and a China-based fund in which the China team is responsible for the day-today operations and investments and the US-based team provides expertise and experience Strategic limited partners: based on the approach that the local fund serves as a deal feeder and provides some local support to the fund overseas Independent local fund with global brand fund: a stand-alone local fund with homegrown partners and investment team that share a logo, investment practices, methodologies, philosophy and close cooperation with other funds under a global brand Team expansion to the emerging market: fund makes direct hires in the emerging market, from a junior team member to a full team on the ground Corporate partnership model: leveraging multinational technology firms as limited partners and in return, providing them access to the market or new technology solutions; can be combined with other operating models, as it represents a strategic platform and reference for the VC fund GP-LP joint operation model: limited partners leverage their brand name with top local venture capital or growth capital firm in an emerging market, providing fundraising and back-office support for compensation but gaining deep insights into the local market structure and investee companies

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30% of venture-backed exits in the US came through IPOs. During the period from 2004 to 2007, this figure was only 10%, despite increasing global IPO activity that culminated in a record year in 2007, both in the number of transactions and in the amount of capital raised. It is clear that this decline in venturebacked IPO activity in the US poses a significant challenge to the US VC ecosystem. The reasons for the decline are complex and include: changes in the regulatory environment; a higher bar for entry, which resulted in the lack of an equity market for small-cap emerging growth companies; changes in the investment banking industry; and reduction in analysts’ research coverage. While the structural barriers to venturebacked IPOs are real, part of the solution lies in investing in companies focused on the right end markets. VC investors should ask themselves whether their portfolio company target markets are large enough to enable a critical mass of companies to grow and, critically, achieve profitability — a key requirement for IPOs in many industries. New platforms enable such opportunities. For example, the start of the personal computer era and the creation of the internet led to “green fields” that could sustain hundreds of companies, many of which grew rapidly and became market leaders. Green fields are based on a technological breakthrough, the opening up of new user segments or emerging markets driven by huge domestic growth with an increase in the purchasing power of a growing middle-class population. It is clear that the creation of significant market opportunities cannot come from marginal improvement of efficiency or added features in a mature product market. Limited partner dilemma Investors in VC funds are currently faced with their own challenges because of their investment allocations to alternative investments generally, and the private equity asset class in particular, where buyouts often account for 80–90% of allocations. We may expect some serious valuation problems

From survival to growth

in limited partners’ investment portfolios that will result in the reduction of capital allocation to VC funds. Nevertheless, the top-performing venture funds with long track records are not likely to encounter challenges that will prevent them from raising their next fund. However, the trickle-down effect on the rest of the venture industry is inevitable as fundraising becomes more difficult. The firms that managed to close their most recent funds in the last 6–18 months will likely see the best opportunities in years to come since valuations have come way down and entrepreneurs are forced to build their ventures in a capital-efficient manner. Although the world’s economies are either in a recession or a significant slowdown, entrepreneurs continue to pursue their dreams. Real value creation through innovation will be one of the key drivers to restart growth around the globe. Swift reaction Very few VC firms moved quickly to correct their portfolios and strategies following the dot-com bust. For example, when the telecom companies and carriers cut their spending dramatically, many venture firms kept pouring money into the start-ups. This time, however, most VC firms reacted quickly and have worked with their portfolio companies not only to address the market changes through cost cutting but also to better understand the opportunities that have been created by the global economic crisis. But as VC investors work with their portfolios to adjust to the new market conditions, limited partners might pressure their invested venture firms to reconsider their experiments, such as expansions into emerging markets or branching into new sectors that have not yet proven their business models and do not have their new specialist teams fully in place. On the other hand, the innovation pipeline is robust, and we have witnessed both new technology-based and business-model innovation. Emerging growth companies will also have to accelerate execution of their

Figure 3. Surviving and thriving in turbulent times

Financial/capital: extend cash burn • Cash/working capital management • Develop 13-week rolling forecast — know cash position • Any “going concern” considerations anticipated and addressed • Cost reductions — improve accounts receivable and inventory age • Defer capital expenditures • Sell/leverage assets/Intellectual Property (IP)

Innovation/IP • Evaluate internal R&D programs • Maintain/accelerate • Partner/joint venture • Divest/defer/kill • Acquisitions • Companies • Technologies/IP • Talent • Investor strategy/preferences • Early vs. late • Tax planning for managing IP

Systemic risk

• • • • •

Financing alternatives Debt — new funding opportunities/address existing covenant issues Additional equity capital — when are valuation inflection points? M&A Confirm readiness for transaction/investment/IPO or divestiture

Reputation and brand C-suite

Ability to operate

Operations/supply chain • Supplier relationships • Counterparty risk assessment • Negotiate better pricing/terms (COGS and SG&A) • Supplier reliability/delivery times • Compensation strategy and staffing • Retain and protect best talent • Evaluate size of workforce — hiring freeze, reductions, outsource • Compensation freeze/rollback/deferral • Move compensation to more “pay for performance”

Cost reduction

• • • • • • • •

Market/customer • Confirm stability/quality of current customer relationships • Reevaluate service/product offer — where are customers really spending/what are critical key features and benefits of product • Do niche or emerging markets offer better growth potential? • Reassess sales strategy • Pricing and terms • Sales/marketing channels, partnerships and alliances • Monitor competitors — “buy or bury”: seize opportunities to take market share, M&A, hire best people and so forth

Cash vs. equity alternatives — consider tax and accounting impact Availability of government incentives to offset training and so forth Other cost control/expense reduction Product — bill of materials and Selling, General and Administrative expenses (SG&A) Lease/premises costs VC or other coordinated preferred vendor/group buying power and/ or shared service/resources models Communications Suppliers, employees, customers, stakeholders/board

Global venture capital insights and trends report 2009

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To build the next wave of billion-dollar market cap venturebacked companies, there must be a major new platform that will enable a large number of companies to introduce disruptive solutions, either in the form of new technology, new business models or, ideally, a combination of both. Ingredients for success in China Invest in sectors where you have expertise/experience. Conduct solid due diligence not only from a financial and commercial perspective but also from a people perspective. Invest at a controlled pace with a disciplined valuation methodology and the willingness to walk away. Focus on a stable team and have ”entirely local” decision authority. Senior partners and leaders of a VC fund should be able to perform realistic self-criticism, adjustment and continuous improvements for the firm to stay ahead and remain competitive. acquisition and partnership strategies to gain advantage in an increasingly competitive world that demands innovation in capital, partnership models and distribution channels. Managing start-ups in the downturn By now, most entrepreneurs have acted on their own experience and the advice of their boards to be more prudent with their cash, focus on sales and cut costs. In this downturn, however, entrepreneurs may also be well advised to invest more in product development and improvements to be ready when the market rebounds. From a product perspective, entrepreneurial teams should think about what constitute their core customers and about intelligent ways to segment and meet those customers’ needs.

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Ernst & Young has developed an execution map for turbulent times to help emerging growth companies and their investors formulate an approach not just to cost cutting and revenue generation but also to better understanding how to seize opportunities, gain market share and beat the competition. The execution map is organized according to four opportunity areas: financial/capital; innovation/IP; market and customer; and operations/supply chain (see Figure 3). Growth capital funds Over the last 24 months, a number of early-stage VC firms have added a growth capital fund or raised a large fund with the mandate to invest both in early-stage and in growth capital companies. Some leading venture firms have been making growth equity investments for a decade or even longer. These seasoned players realized long ago that growth equity is a distinct product line, with a different skill set, different mindset and different operational DNA from early-stage investing, even if both types of investing are conducted under the same organizational brand name. There are two types of growth equity investment structures. One uses a separate team, separate fund and separate compensation scheme. The other uses a global fund but separate early-stage and growth equity teams with crossovers in various organizational dimensions. Since growth capital requires a different analysis and the business is entirely different, deal discussions will often be held in separate sessions even when the team is mixed. Since there are already many seasoned private

From survival to growth

equity players in this space, the new entrants from the VC side will have to bring new added value or clear differentiation. The next big bang What is the next mega breakthrough that will create a huge market and enable some new market leaders to become global market leaders? Will it be cleanech, cloud computing, Software as a Service (SaaS) or another upand-coming set of innovative and disruptive technologies? For many, if not all of us, the answer is not clear. But it is clear that to build the next wave of billion-dollar market cap venture-backed companies, there must be a major new platform that will enable a large number of companies to introduce disruptive solutions, either in the form of new technology, new business models or, ideally, a combination of both. Globalization and investment patterns Globalization for portfolio companies and VC investors has become mainstream. In the mid 1990s, Israel was one of the first places to experience the entrance of foreign VC funds. In the last five years, foreign VC funds, mainly from the US, have entered the fast-growing emerging markets of China and India. In Russia over the last few years, well-known corporate investors and VC funds — such as Intel Capital, Index Ventures, Benchmark Capital and Cisco Systems — have made important new investments. In 2007, Cisco announced that it would pursue investment opportunities not only in Russian emerging technology companies but also in local teams, as a limited partner. Last year, the Russian government established RVC to

provide capital to VC firms to create funds for investments in Russia, like the Israeli Yozma model that sparked the development of the Israeli venture industry in the early 1990s. RVC is targeting about 10 to 15 foreign funds from the United States, Europe and Israel. Bigger brand names, such as Draper Fisher Jurvetson, have already entered Russia under this regime. Vietnam, Brazil, South Africa and other emerging markets are seeing increasing VC investments as well, mainly from local investors, but early-stage investment is still largely absent. VC operating models During the last five years in China, the last two years in India and the last year in Russia, foreign VC funds have established various investment models. Since it has become clear that implementing just a frequentflyer model is not sustainable for the long term and that the risks will be greater than potential rewards, the foreign funds, mainly from Silicon Valley, have chosen the right models for themselves or a combination of models that allow them to maximize value and mitigate risk. All these models are based on various levels of collaboration between foreign and local funds, as well as foreign and local investment teams (see descriptions on page 4). As we expected, the same scenario is occurring in India these days, and the lessons learned from China are being implemented in India at a faster rate. Some of the top US-based VC firms entered China or India rather late. To make up for lost time, they either acquired an existing local VC firm or partnered with it first and invested

as a limited partner. The two high-profile examples of this strategy in 2008 were the Matrix-WI Harper deal in China and the AccelErasmic deal in India. Lessons from China As the VC ecosystem matured in China, it became clear that not all the models and relationships/partnerships between foreign and local teams would be successful. The VC ecosystem in China has now become more sophisticated, with more knowledgeable and experienced investment teams. Although it is too early to declare the winners in the Chinese VC market, we have already seen signs of failure in some funds, and it is evident that the next five to seven years will be critical in determining which funds will emerge as leaders. Over the last several years, many VC funds in China implemented an investment strategy of investing mainly in pre-IPO companies about 12 to 24 months before the IPO. With rising competition for deals, the growing maturity of the VC ecosystem and the changing landscape of global capital markets, these opportunities are disappearing rapidly — and along with them, some VC partnerships. Early-stage deals in China take between three and five years to mature. With valuations becoming increasingly rational, it is an ideal time to consider investments in companies at this stage. One of the current investor challenges in China is that a large number of deals are at a stalemate as the founders still hope to get higher valuations while the investors exercise valuation discipline. Another challenge is that many of the funds that were the most active

Global venture capital insights and trends report 2009

Market-leading companies started in economic downturns 1939 — William Hewlett and David Packard start Hewlett-Packard in a garage in Palo Alto, California 1975 — Bill Gates and Paul Allen found Microsoft during the recession of the mid–1970s 1976 — Steve Jobs and Steve Wozniak launch Apple Computer 1980 — Mitch Kapoor founds the Lotus Corporation 1983 — Len Bosack and Sandra Lerner start Cisco Systems in their living room investors over the last five years are now highly focused on portfolio management. Their portfolio management work is made even harder because many of the firms lack industry focus and invested in multiple industries without having a deep sector understanding or operating background. Partnerships with large corporations in innovation networks Under pressure from global competition and challenged by the fast rise of emerging markets, corporations understand that to maintain or increase their competitive advantage, they must reach beyond the boundaries of their own payrolls to find the best brains and the smartest ideas wherever they are in the world. Venture capitalists too have recognized the dramatic changes and are moving to where the talent is today: everywhere on the planet.

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It has thus become imperative that corporate innovation today embrace a more collaborative, flexible and open model with many innovation partners, including VC funds and their portfolio companies. Such a model has already been described as an “innovation network” by Larry Huston of the Wharton School of the University of Pennsylvania. The potential benefits of the innovation network model include an ability to combine internal and external sources of innovative ideas, increased efficiency in converting innovation into products and services and better risk management through partnerships and collaboration. Given their resource constraints, small companies naturally look for outside help to address challenges. Emerging growth companies are increasingly among the key drivers of innovation as they now file 35% of all patents. Large corporations need innovation; small companies need market access. Innovation networks provide a structure for them to work together successfully.

corporate venturing by emerging marketbased corporations is practically absent. Since many of these global growth companies have either grown through manufacturing or business process outsourcing, they can only maintain their long-term growth rates by adding innovation to their lists of priorities. This forces them to consider their strategic options, of which insourcing innovation from start-up companies through a venture network or corporate VC business unit is one of the key success factors on the path to long-term value creation.

With greater globalization, innovation has become the new currency of competition. A robust innovation strategy includes both internal initiatives and mechanisms to access external innovation, including collaborations, partnerships, acquisitions, joint ventures, licensing and investments in emerging venture-backed companies. Corporate VC is a vital component of the innovation strategies of corporations around the globe. With the exception of more developed economies,

In the present world economic crisis, the need for partnerships between emerging growth companies and large multinational corporations has become even more critical for both sides. External innovation, availability of capital, access to markets and faster development and deployment of technologybased products are some of the key drivers. Further, the current challenges in certain sectors, such as cleantech, have created the need not only for partnerships but also for partnership innovation. Cleantech is a complex and growing sector that involves not only technology-based corporations and emerging growth companies but also corporations from all industries and governments. The economic crisis has created opportunities for partnership innovation between emerging growth companies, their investors, large corporations and governments. The capital formation challenges in cleantech have also led to innovation in capital formation and

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From survival to growth

new players along the financing value chain of cleantech. Market-leading companies are started in downturns While it is a natural tendency to retrench in economic downturns, it is worth remembering the origins of some of today’s largest marketleading companies in hard times past. Companies like HP, Microsoft, Apple Computer and Cisco were launched when economic conditions were less than ideal. In the article “Innovation finds finance despite market turbulence” on page 18, we discuss some of the market-leading companies that emerged from the most recent downturn periods, 1991–1993 and 2001–2003. A down economy can offer advantages to entrepreneurs — cheaper rent, more available talent, more flexible suppliers and weakened competitors. That said, a recession is not necessarily a better time to start a company; rather, the evidence suggests that it is as good a time as any. What matters most is the innovation and drive of the entrepreneurs. Call to action The VC industry today faces serious challenges around the globe, some common to mature and emerging markets and some unique to different levels of market development. Innovation, both in technology and business models, as well as the ecosystem of entrepreneurs and VC funds, are critical for future growth, job creation, closing the gap between rich and poor and

enabling the recovery from the current global economic crisis. Given the importance of innovation and the venture ecosystem to the global economy, an immediate action plan is needed to facilitate the continuing vibrancy of these economic drivers. We use this opportunity to ask the key stakeholders, including governments, to take the following actions based on the current state of the local market: • Make certain that current and future economic stimulus packages include: • A focus on fostering innovation • Incentives for capital formation that will be invested in innovation and entrepreneurial initiatives • Incentives for entrepreneurs • Incentives for corporations to invest in R&D centers • Incentives for technology adoption by businesses and consumers • Reduction of red tape • Cooperate globally on human capital flow to enrich VC ecosystems and innovation • Create a global task force to discuss what needs to be done with capital markets to facilitate future IPOs of emerging growth companies, including stock exchanges, policy-makers, accounting firms, investment bankers, VC/private equity firms and institutional investors

Outlook A substantial reduction in the number of VC firms is inevitable. It is the natural churn of the 1999 and 2000 vintage funds that lost a fair amount of money, and many managers of these vintages will quietly leave the scene. In addition, many limited partners not only got badly burned during the bubble years but have also become better informed and more professional in the intervening time. Further, their private equity and VC allocations are out of balance, due to the dramatic collapse of public markets and real estate, and their long-term asset ratio needs to be adjusted as a result. With the cheap debt market for private equity gone for some time to come, VC is clearly the best alternative asset for real value creation realizable over time. With new innovation platforms such as cloud computing, cleantech, personal medicine and security, new market leaders that go on to achieve billion-dollar exits are likely to appear. It is the new technologies, combined with global applications and the emergence of new untapped markets, that can lead to the creation and growth of new market leaders. We anticipate that the lessons learned from China and India will be applied in new emerging markets and that the global flow of capital and people will continue to increase. Both VC funds and corporations will follow opportunities around the globe. In addition, both China and India will continue to evolve from a VC perspective while the mature VC

Global venture capital insights and trends report 2009

We would like to thank the following leading venture capitalists for their insightful contributions to this article: David Skok, General Partner, Matrix Partners, Boston Dick Kramlich, Cofounder and General Partner, NEA, Beijing and Menlo Park Doug Leone, General Partner, Sequoia Capital, Menlo Park Dr. Helmut Schuhsler, Managing Partner, TVM, Munich Jean Bernard Schmidt, Managing Partner, Sofinnova Partners, Paris Steve Krausz, General Partner, USVP, Menlo Park

hotbeds will have to face, recognize and act quickly in a collaborative way to solve their local challenges. We will also see the acceleration of involvement by corporations in the innovation pipeline to source technologies and solutions or localize them in the regions where they will be deployed. With the lack of robust IPO markets in the immediate future, M&A transactions will remain the dominant exit route. No crisis should be wasted, and we are confident that entrepreneurs, investors and innovators will make the most of this one. •

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Fireside chat on venture capital and growth companies Interview with Scott Carter and Paul Deninger

Scott Carter Sequoia Capital

Paul Deninger Jefferies & Company

Scott Carter of Sequoia Capital and Paul Deninger of Jefferies & Company participated in a fireside chat at Ernst & Young’s Strategic Growth Forum and shared their perspectives on the impact of the economic downturn on VC and growth companies. Following are highlights of their discussion. A partner at Sequoia Capital, Carter focuses on software and services investments. Prior to joining Sequoia Capital in 2006, he was with Summit Partners where he was involved in private equity investments in the financial services and technology sectors. Earlier, he was with JPMorgan and its predecessor entities and served in various staff positions in the United States Senate. Deninger is a vice chairman at Jefferies. He was previously Chairman and Chief Executive Officer(CEO) of Broadview, the specialist technology investment banking firm acquired by Jefferies in 2003. With more than 20 years of experience working with companies in the technology and, more recently, the cleantech markets, Deninger has advised on more than 125 M&A transactions and numerous IPOs. Ernst & Young: Are we in a recession or a depression? What is your view and what advice would you give to CEOs of emerging growth companies? Paul Deninger: What the last two years prove is that there is a good and a bad side to globalization, and that we really are in a global economy — when the US consumer catches a cold, then China sneezes and vice versa.

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From survival to growth

It is clear that the financial crisis is driving the process of a massive deleveraging of the global capital markets, and the use of synthetic investment instruments exacerbated what was already an extremely highly leveraged situation. The thing that had kept the system going was asset quality. When the asset quality came into question, everything started to come apart. In its most simple form, that is what’s happened. The European-based global megabanks have double the leverage ratios of the US banks that are having problems, but their asset quality is better — they don’t have the domestic mortgage problem so badly. Our biggest problem may be a crisis of confidence. The depth of that crisis will dictate whether we’re merely in a recession or we are going to end up in a depression. When the history of the financial crisis in the US is written, I believe that the event that people will point to as the breaking point was when The Reserve Fund broke the buck. And it broke the buck when Lehman Brothers defaulted and US$4 billion worth of bonds the fund had that they thought to be cash suddenly wasn’t. Someone at Treasury either (a) didn’t know that or (b) didn’t think it mattered. Either way, it was unforgivable because it was the catalyst for what was effectively a run on the bank by highly sophisticated investment professionals. In my view, that was the tipping point. Since then, people have had no confidence in the rules by which the Treasury plays. I can’t tell you how it’s going to be solved, but solving this crisis of confidence is the key to whether we end up in a recession or a depression.

That said, I’m relatively optimistic it’s only a recession. A lot of the fundamentals in the global economy remain positive. The biggest issues are the cost of squeezing this leverage out of the system and the crisis of confidence. One reason for optimism is that those hedge funds that don’t go out of business will be sitting on 40% to 70% cash — there is no way those funds can stay in that position forever. And even if they go out of business and give the money back to somebody, the cash still has to go somewhere. A diversification strategy that is 50% cash in a mattress and 50% cash in a can in the backyard is not a long-term investment strategy. It’s logical in a three-, six- or ninemonth period like we are seeing now, but not long term. At some point, someone is going to wake up and see that Google is trading at 9 or 10 times forward EBITDA* and that’s a buy, or that MGM Mirage bonds are nearly investment grade — yielding 18% to maturity. That’s an equity return with senior debt. And at some point, people are going to start to buy into those securities. When they do, I think we’ll be on the way to healing. Scott Carter: We often feel that our growth companies serve as leading indicators for the direction of the economy. Why is that? Because a small consumer products business in China or a private technology company in the US will tend to have orders cut before a company like Cisco or before you see a decline in sales at Wal-Mart or Target. This is something we have been witnessing across our portfolio for awhile. Across India, China and the US, almost every one of our companies is experiencing a slowdown on some level. There seem to be a few common themes emerging. Companies that are burning through, or are low on, cash had better tighten their belts now. What inevitably happens in situations like this is that you take mini-steps along the way and then six months down the road, you realize you aren’t even close to where you need to be. It puts the company on a downward spiral that’s

very hard to correct. When a company is out of money, no one wants to invest — at least not under reasonable terms — and there aren’t a lot of other capital resources that are available to small businesses. So a big part of the message is to belt-tighten now and do it in a more extreme manner than you would for a “normal” slow economic period. There are companies in our portfolio that are actually doing quite well in this environment. They may not hit their forecast, but the competitive landscape has suddenly become more attractive than it had been in previous months. For those companies, the time is perfect to increase business in a new geography, to recruit people or develop in other ways. Realistically, it’s a minority of companies that are going to be able to execute a growth strategy in this kind of economic environment. But those that can, need to do it. They’re going to find themselves significantly ahead of the competition when the economic environment improves. Paul Deninger: If you can avoid interfacing with the capital markets between now and the end of 2009, then you should. The lowest-cost capital is the capital you already have. Said another way, your lowest-cost capital is the cost you haven’t cut. That’s the attitude I think you need to bring at the moment because there are so many things we do not know. Ernst & Young: What are the characteristics of those companies that do represent growth opportunities? Scott Carter: There are some markets where there’s a company or two that is clearly a cut above the others. For example, one of our portfolio companies — Green Dot — has the largest prepaid credit card network in the country. In the US, Green Dot’s distribution network is enormous. They have anyone you could possibly want if you were in the prepaid credit card business. There are a whole lot of other competitors who may have a handful of relationships, but they don’t possess nearly the scale or reputation in the

marketplace. This is a company that has the opportunity to really wreak havoc on some of its competitors. Ernst & Young: Cleantech has been massively capital intensive in some aspects — energy generation being one of them. Can you talk a little bit about those companies that were built in the expectation of some normalcy in the capital markets? Paul Deninger: I’m very nervous about cleantech because the capital intensity is so significant. Investors in environments like this get more risk averse. So we’ve suddenly got a huge pipeline of private placement prospects — companies that need to raise US$50 or US$100 million and don’t think they can do it on their own. But we’re being very selective about which ones we take on because this is not the kind of environment where significant technological risk is something that investors want to undertake. They still seem to be interested in taking on risks in scaling operations or expansion, but fundamental technological risk is a different matter. Having said that, a lot of customers of cleantech companies that have gone green have saved money — turning off a light switch automatically saves money. So the lowhanging fruit and most exciting opportunities in the near term are on the demand side rather than the generation side — managing the cost of energy and by happenstance, being green, rather than managing the carbon footprint directly. People don’t appreciate the incredible inefficiencies in existing energy infrastructure because until now, energy has been so cheap. So we think there’s going to be enormous interest and enthusiasm for energy efficiency, next generation lighting, etc. As a consuming society, we are used to energy being cheap. And cheap energy is the foundation of all economic development around the world. So we have to find carbon reduction solutions that are cheap. There are massive opportunities around

* EBITDA = Earnings Before Income Taxes, Depreciation and Amortization

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energy utilization and energy management that are, in this economic environment, the low-hanging fruit since they are less capital intensive. Scott Carter: There’s going to be a massive amount of money lost in cleantech over the next few years although Obama’s presidency will probably give it new life for awhile. But that doesn’t mean we’re not fans of cleantech and alternative energy. We’ve been actively investing for three years, but we have one golden rule, which is investing where low capital expenditures are required. That means a big part of the market is a lot less appealing to Sequoia Capital. We view innovation in cleantech as we do in other technology sectors. If you have great entrepreneurs who are incredibly frugal, who really focus on delivering a product that solves an immediate need, and you apply those principles to cleantech, then you’re going to make money. You may not make money every time, and it’s going to be challenging, but it’s a formula that fits well with our overall investing strategy. Other people are perfectly comfortable investing heavily in a biofuels facility in the Midwest. They may make money, but it has not been our approach in cleantech. Ernst & Young: What are your thoughts on the Obama administration’s impact on cleantech? Scott Carter: I think there will be meaningful changes in healthcare, environmental regulations, the relationship between companies and unions and tax policy. I don’t think there’s enough money in the system to make all of those things happen. But I do have some concerns about the impact on small and growth businesses. In the US, we are on the verge of embracing a number of policies that we abandoned long ago because we recognized how detrimental they were to business development. How do you prepare for the changes? I don’t think anyone knows the answer because they don’t know exactly what’s coming. I am very concerned, though,

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that we will become less competitive. Paul Deninger: On cleantech, I’m nervous about too much investment from government going down another corn ethanol-type hole. That was a disaster from day one. Anybody who knows anything about energy knows ethanol is a weak fuel. You can’t get as much power out of a gallon of ethanol as you can out of a gallon of diesel or a gallon of gasoline, never mind the cost. So I really worry about government’s deciding what is the “right solution.” But there are things that government could do that would be fantastic. For example, mandating that a significant percentage of the federal fleet be electric, hybrid or plug-in hybrid or mandating that the federal government only buy vehicles with a certain mile-per-gallon target. Here’s another example: the biggest property holders in the country are our governments — federal, state and local. Let’s do something there on the building-energy-efficiency front. One of the things that made the tech industry in the US the leader in the world over the past 20 years was that we had the largest homogeneous market for those products in the world. So the companies that were founded here got better and faster customer feedback. They got to scale faster and so on. We could do that in cleantech if the federal and state governments get out in front as consumers of these technologies in order to drive better products at lower costs. That’s the most important thing I think they could do. Ernst & Young: When do you think the IPO market will open up, and how can we best make it happen? Paul Deninger: Rather than telling you when, let me tell you the signals that will tell you that it’s going to open up. The first signal is a return to price stabilization — rational price stabilization — on certain investments. The T-bill went negative in yield in September ‘08 for the first time since 1940. I was at an event with the Boston Fed chief and somebody asked the question: “Are you worried that

From survival to growth

people aren’t going to buy US Treasuries because they’re worried about the US economy?” He laughed and said, “Our biggest problem is people all over the world only want to buy US Treasuries.” So when that changes — yield goes back to around 4% — that’ll be a good sign. When Google is trading at a reasonable multiple or when the Mirage debt that I talked about earlier is trading at a 10% or 12% yield to maturity rather than 18%, that’ll be a good sign. What is the IPO market? The IPO market is a primary-issuance equity market. In order for the primary-issuance market to be effective, first the secondary market has to be fixed. And right now, the secondary market — which includes the three types of instruments I’ve just talked about — is all messed up. So once those instruments start seeing price correction, that’s your first sign. The second thing that needs to happen is a couple of big IPOs. No one is going to choose a US$100 million revenue, US$400 million market cap technology company to be the first onto the market. So something big — such as a spin-out or a big foreign company — is going to need to hit the market. That’ll give people some confidence. The third sign is established issuers coming back into the marketplace to issue followon stock — specifically issuers other than financial institutions who are doing it now because they are desperate to reduce their leverage ratio from 25 to 1 down to 12 to 1. When those three things happen, you can then look to an IPO market as being a possibility. Scott Carter: The only thing I would add is I think it’s going to take a while for institutional capital to return to the table. The hedge funds, endowments and pension plans that fund them are all upside down. I think when they start to figure out exactly where they are in terms of redemptions and their overall portfolio, then there will be a lot more stability and interest in having new capital

“We're focusing aggressively on cleantech because we think that is one of the growth areas. But we need stability in the stock market. … The problem is not a lack of growth opportunities; the problem is stability.”

pumped into the system. Hopefully, that leads to an IPO market of sorts. It’s just very difficult to predict when that would happen. Paul Deninger: Part of the dislocation in the IPO market over the last several years has been the consolidation in the institutional investor and investment banking industries. And what’s happening now is even more consolidation. So what made it harder for small companies to go public is going to be worse, not better, because the bar for what makes a deal important to a Goldman Sachs or to a Fidelity is going to be set even higher. So there needs to be an emergence of a new set of banks to make a smaller-cap IPO market work. Ernst & Young: Do you anticipate confidence in the M&A market returning earlier than in the IPO market? Paul Deninger: The M&A market for growth and venture-backed companies is flat. In fact, it’s actually down, and it’s been going down for a couple of years. What’s made people feel good about the M&A market is that over the last four or five years, the number of larger deals has approximately quadrupled. But if you looked at the deals between, let’s say US$20 million and US$100 million for VC-backed companies, those deals are down in number and down substantially over the last three or four years. That is because we are in the eighth straight year of a decline in the number of public companies in all markets, never mind technology. The reason for that is the lack of IPOs.

In today’s M&A market, the best companies will get good value, but everybody else will have trouble. Because there are fewer buyers, you can maybe sell the best company in its space and you can maybe sell the second-best company in the space, but while 10 years ago, you could sell six companies in a space, that is no longer the case. The M&A market is really difficult right now. In regard to cleantech, there really isn’t much of an M&A marketplace in cleantech right now because very few companies have the kind of revenue that makes them attractive or have proven themselves to be the solution that big oil or whoever else wants to buy into. We have a few things going on, but they are in energy efficiency and smart grid. Ernst & Young: A few economists predict growth, noting that there is cash sitting on the sidelines, the cost of energy is going down and that the subprime problem areas cannot, by themselves, kill the US economy. Given that backdrop, where do you think the growth will be?

markets in recent months have been an equal opportunity destroyer — literally. No category of investment has been positive. Paul Deninger: We’re focusing aggressively on cleantech because we think that is one of the growth areas. But we need stability in the stock market. I don’t care whether the stock market stabilizes at 10,000, 9,000, 8,000 or 7,000; I just want it to stabilize. The problem is not a lack of growth opportunities; the problem is stability — even at a level that is low, any stability is better than the current volatility. People need to be able to make decisions knowing that they won’t appear stupid tomorrow — the sovereign wealth funds, for example, invested US$75 billion in investment banks in Q2’08 and not a nickel in Q3’08. Not a nickel. Why? Because in Q3, those Q2 investments looked stupid. No one wants to look stupid. When the bullets stop flying, people will come out of the bunkers. There are no points for courage in facing a machine gun. I think that’s where we are right now. •

Scott Carter: I agree with you. But let me revert back to what I said in answer to the very first question, which is confidence. Specific geographical areas of real estate can’t bring down the US economy. But the worry is that there’s always going to be another problem around the corner, and then another one behind that and another one behind that — that’s what causes people to turn inward and not focus on growth. Growth requires a mind-set that is a search for opportunity and a belief in a better future than today. The

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Lessons learned from building a company in turbulent times Interview with Matthew Szulik

Matthew Szulik Chairman Red Hat

Matthew Szulik joined Red Hat in 1998 as President and CEO and was immediately faced with the challenge of turning Linux technology into a profitable business when no one believed a company could make money on free software. Stock in the company soared to more than US$300 per share at the height of the dot-com boom, only to fall back to less than US$3 per share after the crash.

technology. That was without precedent and naturally raised eyebrows. Next we had to show that we could create and sustain an economic model that would lend itself to becoming a proven and sustainable publicly traded company. Then we had to work out how to compete with a monopoly — people forget that there was a very large competitor out in Seattle that did not want us to succeed or survive.

Szulik found a new direction for the company by talking to customers who were tired of paying for software licenses and maintenance and then waiting for upgrades, only to receive imperfect software. Szulik bet the company on a strategy to compete in the enterprise computing market by offering businesses an alternative to other operating systems.

In many ways, it’s no different from what I think successful companies that emerge from the terrible economic crunch we’re facing now will need to do. That means working 24/7 on the very basics — making sure that they have an absolutely crystal-clear understanding of their markets and who their customers are. They will need to have a very clear relationship with, and understanding of, the forecasting of demand and the management of their cash and burn rate. They must also be ruthless in the operational execution of their company. That ultimately will allow them to build sustainable customer relationships and to manage the cash consumption of their overall businesses.

Red Hat is now the only profitable public open-source software company and has revolutionized the software market. Red Hat has become one of the world’s most recognized technology brands, with 3,000 people in 60 offices worldwide and annual sales of US$523 million in 2007. In November 2008, Szulik was recognized as the Ernst and Young Entrepreneur Of The Year® for the USA. Ernst & Young: Red Hat is a venture-backed company that went public at the height of the dot-com boom. How did you deal with the subsequent decline in the stock market and the economic downturn? Matthew Szulik: At that time, we had three important issues to present to the public. First we had to prove you could build a business around the free distribution of your

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From survival to growth

Red Hat was a magazine business in 1998. That’s very hard for people to get their heads around today because now it’s the world’s leading supplier of open-source software to companies. Organizations like the New York Stock Exchange, Swiss Telecom and DreamWorks are now highly dependent on our technology and their relationship with Red Hat — people never dreamed that was possible back in 1998.

“Throughout that process, the management and investors continued to believe in the vision, despite the enormous risk, that some day we could become a great enterprise supplier.” The vital thing for entrepreneurs is being very careful in the selection of their venture partners. We were incredibly fortunate to have two outstanding investors and directors in Bill Kaiser of Greylock Partners and Kevin Harvey of Benchmark Capital. They brought incredible knowledge of how to build companies, in contrast to how to make a short-term buck and flip the company. We were never obsessed with valuations, which is something I see in a lot of earlystage companies. There was a willingness to potentially compromise short-term valuation, to select board-level partners that could help the management team and build a great and sustainable organization. Ernst & Young: You made a strategy shift that paid off hugely. What were the success factors in executing this shift? Matthew Szulik: The critical success factors were great partnerships between the board members and the senior management of the company. We never felt that board members were being onerous or difficult to the management or that there had to be a liquidity event so they could get their money back. We had the support of our board and investors every step of the way, and they had confidence in our abilities to eventually find a solution. I think we were very fortunate to have partners and management that were willing to sacrifice and take a big gamble on Red Hat. Think about it. We were stepping into an enterprise computing market that had been dominated by the likes of Oracle, IBM, Hewlett-Packard and Microsoft and sitting down with the Chief Information

Officer(CIO) saying that our technology is developed by millions of developers that don’t work for our company and it’s free — “Just trust me; it will work!” Throughout that process, the management and investors continued to believe in the vision, despite the enormous risk, that some day we could become a great enterprise supplier. That was vitally important. When I speak to CEOs and entrepreneurs, there often isn’t the level of collaboration that we had. You need that to sustain companies over the long term and produce great enterprises. Some of the big names in the tech sector have become very aggressive in buying up great young companies at a fraction of their value. I find that very unfortunate for the entrepreneurs because there are probably great opportunities for them if they can sustain themselves longer term. But for whatever reason, they’re liquidating now and selling out at pennies on the dollar. I think we were very fortunate. Ernst & Young: Based on your experience, what is the role of the CEO, especially in turbulent times? Matthew Szulik: Tremendous accountability must be placed on the CEO. I can remember numerous board meetings where we had difficult discussions with our board about moving the company out of Raleigh, North Carolina, because it would never get the market visibility, and out to Palo Alto, California, to “jump-start” it. Even during the fundraising process I can remember sitting in front of the partners at a prominent VC

Global venture capital insights and trends report 2009

firm and having them ask me what part of northern California we were based in. I told them it was Raleigh, North Carolina, and they teased me about NASCAR and about barbeque. So the CEO must have a compelling vision and be willing to bet and risk everything to pursue that vision. No one came to Red Hat because they dreamed of making big profits. Nobody had ever done this before; there was no status for open source in the computer market at that time. But we believed that we were on the verge of something great. For me personally, I was unwilling to move our business — one of our core commitments was to continue to take enormous risks and to build this business in Raleigh, North Carolina. At one point, shares were worth more than US$300; Red Hat was losing US$70 million a quarter and had a market cap of US$18 billion. Very shortly, the stock was US$3, and I went from being the smartest guy in America to the dumbest guy in America in less than 12 months. It was no different from most early-stage companies in that we were continuing to work hard to find solutions, but it took time to get all of the basics of business in place. That had to happen before we could hit our stride. We did do that, but there were some very lonely times. But you also need a team of great leaders. Over the last 10 years in my industry, the market has been very generous in financially rewarding many entrepreneurs, which has had the effect of removing them from the marketplace. I don't know what the refresh rate is of people that have the depth of experience, the know-how and drive to build

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“You will find that in periods of deep economic pain and recession, it usually has been a fantastic time for entrepreneurship.“ great companies and make the sacrifices that come with that. It can be a 24/7 job, and there’s great temptation to heed the siren song of taking an early exit that may not be at the optimal price but that will allow somebody to get off the treadmill. I worry that choosing to cash out too soon is reducing the overall talent pool in the marketplace. Ernst & Young: How did you build a team of great leaders at Red Hat? Matthew Szulik: First and foremost, there has to be an internal culture of risk tolerance. That acts as a great magnet for people with the kinds of intellectual talent and drive that we want. People want to work for a company that is willing to continue to take bold risks, even in the face of enormous failure, to achieve large results. I believe that the role of the CEO is to create a culture that never gets content and continues to search for new value creation. That’s especially true for a young, small company. It’s easy to lose that focus when the company is being successful and throwing off the kinds of cash that Red Hat ultimately was — in the last fiscal year, the company generated over US$240 million in free cash flow. After we started to see the economic model kick in, it certainly would have been easy to sit back and be content with this progress. But we continued taking

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large risks in investing in areas such as the One Laptop Per Child initiative and building our own internal apps store similar to what Apple has done with the iPhone store.

last 25 years — Michael Dell, Andy Grove and Larry Ellison — are able to create that culture and that vision. That is something that we worked very hard to do at Red Hat.

Ernst & Young: What were the key lessons — operational or strategic — learned from building a company in the last downturn? How are they applied at Red Hat today?

Ernst & Young: We are in the early days of this downturn, but do you have any perspectives on whether it is similar to or different from the one that we experienced from 2001 to 2003?

Matthew Szulik: You have to have a great appetite and desire for your vision — I think vision motivates a workforce. Whether it’s 10 people or 3,000, vision really starts with the CEO of the company. When you look historically over the last 100 years at the great sustainable companies like IBM, Johnson & Johnson and General Electric, at every step of the way, they seemed to produce a leadership model that created a compelling vision. Their people got up in the morning determined to do something great. You are going to experience failure in that process, and that failure can be lonely and dark. Even though Red Hat went from US$300 a share to US$3, I don't believe that our people ever lost sight of our vision to improve society through our actions, to really want to do great and compelling work. It was leadership’s job to create that culture, to say, “Yes, this is a dark time but our vision is intact, our customers are responding and we will navigate through this issue.” The great leaders in my business over the

From survival to growth

Matthew Szulik: The situation then was very much tech-specific, and people believed the solution was far more obvious than is the case today. The solution to the current problems is not entirely clear to most people in business globally. No one can really provide a clear and concise answer as to when “the recovery” will take place. This issue about availability of cash and credit is really making it very difficult across all sectors. The recession is very broad and very deep. I think that those characteristics are what make it much more distinct than 2001–2003. Having said that, in 2008 there was US$18 billion invested globally in entrepreneurial and venture-backed companies. So there is money being spent, there is venture capital being invested and there are quality leadership teams out there with compelling ideas that are getting funded. When you look historically over the last 125 years in North America, you will find

that in periods of deep economic pain and recession, it usually has been a fantastic time for entrepreneurship and for companies to search out funding. You’ll find the next Red Hat in periods like today. I can remember how difficult it was in 2000 to try to recruit a chief financial officer, due to the large amounts of money that were being thrown around by early-stage companies trying to rush out the gate and get public. Today’s environment means that there’s going to be some top-notch talent finding itself without employment. There will be people who realize they have one last shot at building something from the start. At the moment, there is an availability of talent which, coupled with a good idea, could make this a prime time to find funding. Ernst & Young: If you had to give an entrepreneur some advice on trying to grow a business in today’s economic environment, what would it be? Matthew Szulik: The best CEOs that I meet are great listeners. They realize that they don’t have all the answers. They put ego in their back pocket and they seek out subject matter experts that complement their skills. They look for sources of input to build wonderful, scalable business opportunities. The ones that I see fail are typically egodriven — they don’t really reach out and build a collaborative network of honest and

authentic advisors. They don’t get the benefit of collective areas of wisdom. Let me give you a great case in point. Red Hat was very fortunate to recruit a gentleman by the name of Dr. Steve Albrecht, Associate Dean of the Marriott School of Management at Brigham Young University. Steve is incredibly well known in the field of public accounting and was transformative to our business at a critical time. Although it was very difficult to recruit him to come from Utah to Raleigh, North Carolina, to sit on a board of a very immature company, we did it because we realized that we were moving from pro forma to General Accepted Accounting Principles (GAAP)-based accounting and that the right approach to Sarbanes-Oxley was going to become critical. We knew that Steve would not only be a great head of our audit committee but also a great leader. A young CEO or a CEO thinking about building a great company needs to seek out and be authentic in these types of relationships — not just to solve a tactical problem but to really establish the collaborations that will ultimately solve the many problems and challenges CEOs face today when building a great company. •

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Innovation finds finance despite market turbulence Despite challenging global economic conditions, venture investors and entrepreneurs with an eye on the future can take encouragement from the record of current market leaders financed during previous downturns

John de Yonge Global Research Director, Venture Capital and Cleantech Ernst & Young

In such challenging market conditions, you’d be forgiven for thinking that now is the time for survival, not growth. But historical data show that innovation will continue to find capital despite economic challenges, and that many VC-backed companies initially funded during downturns have gone on to become enduring market leaders. In the United States alone, there are 22 companies in business today that were first funded by venture capitalists during the recession years of 1990–92 and remain independent entities with market capitalizations of more than US$400 million. Of these, half enjoy market capitalization of more than US$1 billion. These billiondollar market cap companies include consumer brands such as Starbucks, Intuit and PetSmart among their ranks, as well as companies such as Microchip Technology, Onyx Pharmaceuticals and Nuance Communications. All have ultimately created significant shareholder value. Nor were the early 1990s unique for producing recession-beating companies. The 2000–2003 slowdown also produced current market leaders, not just in the USA but also in Europe, China and Israel. These “downturn babies” have market capitalizations measured in the billions or hundreds of millions of dollars. They are dominated by biopharmaceuticals in Europe; center on traditional, regional VC industries such as technology, consumer goods and industrial technologies in China; and are clustered around medical devices in the Israeli market. Some of these downturn-financed companies have rewarded investors with M&A and IPO

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From survival to growth

exit transactions in excess of US$1 billion. Skype Technologies in the UK (initially funded in 2002), which revolutionized voice over internet to home users, was acquired by eBay for US$2.5 billion. US-based Masimo (initially funded in 1991) pioneered lifesaving medical devices and went on to an IPO with a billion-dollar valuation. Likewise, Semiconductor Manufacturing International and Spreadtrum Communications (both initially funded in 2001) were trailblazers for the Chinese high-tech economy with IPOs that hit the billion-dollar valuation mark. The common ground shared by these companies is that they were quick to gain market share by harnessing trends that were lasting and fundamental to progress in their markets. Some were at the forefront of deep technological or biotechnological advances. Others recognized substantial new consumer market opportunities. And feedback from current investors suggests that the billion-dollar exits of tomorrow are likely to be positioned around such megatrends, with a focus on communication and the environment. Digital media, social networking and digital security (in particular, protecting personal data online) have been flagged as having strong investment potential. Cleantech and biotechnology companies are also likely to prove fertile ground. In particular, the green elements of stimulus packages in the US, Europe and Asia may lay the groundwork for future growth through incentives and rebate programs that promote investment in clean technologies, renewable energy and other energy infrastructure.

Of course, the success stories of the past don’t prove that it is better for entrepreneurs to be financed during a downturn or that companies financed during downturns are more successful than others. What they do show, however, is that even during difficult times, genuinely beneficial innovation will continue to get financed. Understandably, difficult market conditions necessitate a longer exit strategy. Analysis shows that the median time from initial financing to IPO exit reached eight years in 2008. The same time measure for M&As was only slightly less — seven years. This increase means that business fundamentals such as cash preservation,

may be distressed and concentrating on survival, not growth.

sharpening the customer proposition and clear communications with potential investors are crucial to survival. At the same time, companies must not be so focused on “just getting by” that they are unable to pursue strategic, capital-efficient opportunities as they arise. Challenging market conditions naturally create some difficulties for these companies, and growth is unlikely to be simple or easy. But downturns do have positive market attributes for those positioned to take advantage of them. Physical assets and other inputs cost less and are more capital efficient. Talent is also cheaper and more readily available. In addition, competition

Difficult market conditions provide opportunities for investors to find great companies early and to be the first to benefit when the upturn arrives. And entrepreneurs can take heart that VCs are still investing. As long as you have a great idea, a great team and realistic expectations of valuations, the money is still out there. •

Selected companies that received initial VC funding in downturn years

Company

Country

Industry

Initial VC financing year

Total VC raised (in US$)

Current market cap* (in US$)

Current revenue (in US$)

Starbucks

US

Consumer services

1990

$30m

$8.3b

$10.4b

Intuit

US

Software

1990

$18m

$7.8b

$3.1b

PetSmart

US

Retail

1990

$17m

$2.9b

$5.1b

Microchip Technology

US

Semiconductors

1991

$14m

$4.1b

$1.0b

Onyx Pharmaceuticals

US

Biopharmaceuticals

1992

$41m

$1.4b

$194m

Nuance Communications

US

Software

1992

$33m

$3.5b

$868m

Masimo

US

Medical devices

1992

$85m

$1.6b

$307m

Semiconductor Manufacturing International Corporation (SMIC)

China

Semiconductors

2001

$3.1b

$871m

$1.4b

Riverbed Technology

US

Software

2002

$57m

$1.0b

$333m

Skype Technologies

UK

Communications software

2002

$20m

Acquired by eBay for $2.5b in 2005

Shanda Interactive Entertainment

China

Software

2003

$10m

$3.3b

Speedel

Switzerland Biopharmaceuticals

2003

$81m

Acquired by Novartis for $880m (CHF 907m) in 2008

$338m

*Market capitalization data as of 20 April 2009 Global venture capital insights and trends report 2009

19

Perspective from Europe Interview with Bruce Golden, Accel Partners, UK

Bruce Golden joined Accel Partners in 1997 and primarily focuses on investments in enterprise software and internet companies, with a particular interest in data management, analytic software, nextgeneration SaaS and open-source software companies. Bruce Golden Accel Partners

Ernst & Young: The VC industry is again facing a difficult exit environment only a short while after venture-backed IPOs and M&A activity had recovered from the dot-com bust. How are VCs in your area (Europe/ Israel) altering their investment strategies in response to this newly challenging exit environment? Comment on both early-stage and late-stage VCs. Bruce Golden: When looking at the current exit environment, two questions need to be taken into account: how long will there be limited IPO activity, and how long will the M&A market be depressed? They are relevant because multiples of private companies are constrained largely by what is happening in the public markets. Assuming that the exit environment, whether speaking about IPOs or M&As, will be weak for the next one to two years, or possibly longer, we are focusing on making investments where real value can be created over this challenging period of time. We think this is an interesting time to make very early-stage investments, especially those that are capital efficient, as these companies can make enormous progress and achieve significant valuation upside if they are decisive in delivering a strong new

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From survival to growth

product with a clear, compelling insertion point in the market. The current situation is a good crucible to build the DNA of great businesses because it forces a clear focus and discipline on market problems. Large established companies are typically very inward looking, and in times like these, they are not primarily focused on new innovations. So investing in very early-stage companies is quite attractive in the current environment and provides an opportunity to emerge in two or three years with exciting, disruptive, new approaches to large markets. We are also selectively looking at mature, growth capital opportunities in markets that offer potential for new companies to achieve category leadership. Ernst & Young: What lessons did the VC industry learn from the experience of the last downturn that can be applied to today's situation? Bruce Golden: In terms of lessons learned, the first is that new capital is incredibly expensive in this kind of environment and for some companies, unattainable. Therefore, cash must be preserved and utilized efficiently at all costs. Over the last one to two years, we have been particularly focused on ensuring that our companies are well

“The bottom line is that portfolio companies have to make sure that their value proposition is irresistible.”

capitalized and have cash on their balance sheets for the next 18–24 months. This comes from really understanding their cash positions and cash needs, which is critical. The second lesson is that the strength of the syndicates supporting companies can be the difference between survival and collapse: we have always focused on the strength and predictability of our syndicate partners. Specifically, we like working with like-minded, proactive investors who work collaboratively to anticipate issues and preemptively address them. This means finding people with a willingness to focus on facts and metrics to support whether a company is making progress or not. The third lesson highlights the importance of encouraging management teams to communicate frequently and in sufficient detail. This curtails the possibility of being taken by surprise and then being forced to deal reactively with major issues in a crisis. Ernst & Young: What advice are you giving to your portfolio companies? Does the current situation offer them opportunities as well as challenges? Bruce Golden: The first piece of advice is to watch cash. Companies have to make sure

they are well funded and doing everything possible to reduce cash requirements prudently and appropriately in order to get through the next two to three years. To control their own destinies, the most crucial issue is to make sure they have access to the cash needed to survive this period. Beyond that, we advise our companies to hone their sales processes carefully. For example, having a clean insertion point for products and ensuring that there is quick time-to-value for customers, who should therefore have a measurable Return on Investment (ROI), is a crucial success factor. In the current environment, people are buying things that drop in quickly, don’t require a lot of expensive Information Technology (IT) resources and offer fast time-to-value for customers. We work closely with our companies to ensure their value and sales propositions are tight and focused with carefully selected sales targets. Some portfolio companies, such as those heavily concentrated in financial services, may need to diversify their sales efforts. In an environment where banks are cutting costs dramatically, it is difficult for unproven early companies to break into the market. The willingness of banks to try new

Global venture capital insights and trends report 2009

technologies in the current climate is very limited. Companies that are horizontal must be prepared to penetrate new markets and focus on where businesses feel the urgency to adopt their products. The bottom line is that portfolio companies have to make sure that their value proposition is irresistible. At the end of the day, this is all about building killer products. It’s also important to ensure strong reference ability through positive public relations, word of mouth or other communication channels. Increasingly in our business, there is high-impact potential from causing a buzz around companies that create a lot of value or have developed interesting innovations, such as disruptive new approaches to market problems. Ensuring that there is a positive awareness of a company’s performance is crucial. This is also a time when, generally speaking, businesses should favor optimizing profitability and free cash flow vs. maximizing growth and investing in new geographies which could require significant incremental operating expenses. In summary, although capital is very expensive right now, young companies

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“This is actually a period of great opportunity for new companies. Talented, ambitious and tenacious entrepreneurs can create extraordinary companies in this kind of difficult environment.” with a really crisp value proposition, a clear insertion and quick time-to-value for customers can do very well. If we look at the operating performance of many of our enterprise software companies in the last 12 months, for the most part, it’s been very strong, in many cases generating growth of 50–100+% year over year. Their performance is a reflection of their innovative approaches to difficult problems. The most successful companies tend to offer a modestly priced product, have a faster ROI and require less IT hand-holding relative to incumbents. Ernst & Young: Many great venture-backed companies were founded during down economic periods. What segments today are most likely to generate new market leaders? Can you specify? Bruce Golden: The venture community is very focused on cleantech, which certainly offers promise, although the term is still quite fuzzy and acts as an umbrella for a range of market segments. It will take a long time for VCs to get clarity on the various venture opportunities in each market area. Cloud computing and SaaS, or specifically, the concept of delivering software on demand to any device from “the cloud,” are certainly areas of interest to many of us who invest in enterprise software. The underlying technology concepts, such as virtualization, offer the opportunity to radically transform the economics and technological complexity

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of business software. That said, there are enormous technical and business issues that have to be solved, and VCs have to try to focus on bets with the potential to yield big stand-alone companies. As we continue to digitize virtually all content, turning all this data into useful, liquid information continues to be an interesting topic. We are likely to see new opportunities in market data services, analytics and infrastructure for real-time information processing and management. Also, given that the way most organizations store information is very purpose-built around individual proprietary applications, there is an opportunity to democratize information to enable more people within organizations broader information access through new-generation user interfaces. New devices also create opportunities for new types of information delivery as well as broader audiences, especially when business software is designed to be more like consumer software in terms of ease of use and limited IT dependencies. Ernst & Young: What are the key challenges for the VC industry in your area and the likely industry response? Bruce Golden: Europe and Israel are much smaller venture markets than the US, especially Silicon Valley. Over the next few years, we will see a contraction of VC in these geographies, just as we will in the US. The asset class will be smaller, there will

From survival to growth

be fewer practitioners and there will be a number of smaller firms unable to raise new funds. As a result, there will be less capital available for start-ups, and increasingly, the global firms capable of helping businesses originating in Europe and Israel will have an advantage. Entrepreneurs should seek venture firms that can deliver value globally and have both expertise in their specific market area and deep connections with relevant ecosystem partners. Most of our companies have to compete globally if they are going to achieve meaningful scale. In Europe, there are few opportunities to build national champions that can achieve very significant market caps. Best practices show that companies need to try to be global as early in their lives as possible. Because the world is flat and people become aware of innovative solutions quickly, there can be copycat approaches and new competitive thrusts that require successful start-ups to stake their claims in the key market very early in the life of the business. This is actually a period of great opportunity for new companies. Talented, ambitious and tenacious entrepreneurs can create extraordinary companies in this kind of difficult environment because it’s the right crucible to force everyone in the company to focus on the issues that matter and to create value for customers and their business. •

Current topics for technology companies

Ernst & Young’s Global Technology Center (GTC) reflects our sustained, worldwide commitment to the technology industry. The Center connects clients, service professionals and account teams from our member firms around the globe. It facilitates collaboration and knowledge sharing and helps us provide consistent, seamless, high-quality service to our technology clients worldwide. The GTC brings together the resources of Ernst & Young’s global network of firms to address crucial issues facing technology executives and their boards. These include issues related to assurance, risk, tax and transactions, as well as finance and operations. The Center also helps our professionals draw on Ernst & Young’s proven methodologies,

Carpe diem: risk-rating change yields opportunity for technology companies Standard & Poor’s (S&P) ear-ier this year became the first of the 10 Nationally Recognized Statistical Rating Organizations (NRSROs)in the United States to announce the assessment of Enterprise Risk Management (ERM) in nonfinancial companies as part of its process for determining credit ratings. S&P is expected to report its ERM assessment findings as early as the second quarter of 2009. Other credit-rating agencies, such as Moody’s, are following S&P’s lead. This change is important for technology companies. Research has shown that transparent risk management and internal control are critical factors for many internal and external stakeholders (the board, audit committee, shareholders and suppliers). The result is that credit-rating agencies have made clear their intent to discuss ERM in their rating reports. Technology companies should seize this rating assessment change as an opportunity to clarify their risk management activities and deliver comprehensive and consistent messaging about those activities.

tools, learning systems, quality assurance and continuous improvement processes. These global resources allow our people to focus their collective industry and business knowledge on their clients’ unique challenges — anywhere in the world. The GTC connects our people to focus on today’s issues and anticipate tomorrow’s. Companies connect to our latest thinking on a broad spectrum of challenges, from industry-wide issues to specific technical, business, regulatory and compliance concerns. Following are three examples of recent GTC thought leadership publications focused on current topics in the technology industry today. Visit www.ey.com/technology to find out more about the Global Technology Center.

In Carpe diem: risk-rating change yields opportunity for technology companies, we address the issue of ERM as an opportunity for technology companies to clarify their risk management activities and deliver comprehensive and consistent messaging about those activities. Key points Opportunities associated with the creditrating change include: • Increased transparency into a company’s risk management and internal controls

Rick Fezell Global Technology Leader Ernst & Young

“It is our belief that technology innovation will continue to drive solutions to the most challenging issues of our times.“

Issue 2: February 2009

Top of mind Issues facing technology companies

Carpe diem: risk-rating change yields opportunity for technology companies Situation Standard & Poor’s (S&P) earlier this year became the first one of the 10 nationally recognized statistical rating organizations (NRSROs) in the United States to announce the assessment of enterprise risk management (ERM) in non-financial companies as part ofi ts process for determining credit ratings. S&P is expected to report its ERM assessment findings as early as the second quarter of 2009. Other credit-rating agencies, such as Moody’s, are following S&P’s lead. This change is important for technology companies. Research has shown that transparent risk management and internal control are critical factors for many internal and external stakeholders (the board, audit committee, shareholders and suppliers). The result is that credit-rating agencies have made clear their intent to discuss ERM in their ratings reports. Technology companies should seize this rating assessment change as an opportunity to clarify their risk management activities and deliver comprehensive and consistent messaging about those activities.

• Opportunity to influence shareholders with a strong and consistent risk management message • Strategic performance improvements • Use of ERM as a strategic growth tool

Global venture capital insights and trends report 2009

23

Technology industry global financial management and reporting survey: insights into leading practices of technology companies In response to the need for financial management benchmarking data, Ernst & Young surveyed senior technology industry finance executives about the following topics: the organizational structure of finance; management of the financial “close process”; revenue recognition accounting policies; and International Financial Reporting Standards (IFRS) adoption. Participant responses were summarized in aggregate and packaged in a quick-read reference report. Here is a sampling of the first survey’s findings. Key points* • Among the identified functions performed at shared service centers were the following: • Accounts payable was cited by 79% of the survey participants. • Statutory financial reporting was cited by 64% of the survey participants. • Revenue recognition contract review was cited by 47% of the survey participants.

24

• Almost a third (31% of the survey participants) recorded 10 or fewer corporate journal entries as part of their consolidation process. • The methods used to establish fair value were as follows: • Almost a third (31% of the survey participants) used Vendor-Specific Objective Evidence (VSOE). • More than a quarter (27%) of the survey participants used the “residual method,” under Statement of Position (SOP) 98-9. • The top three accounting issues cited as having the biggest potential impact on a company during its IFRS adoption process were as follows: • Revenue recognition was cited by 74% of the survey participants. • Taxes were cited by 45% of the survey participants. • Research and development costs were cited by 29% of the survey participants. *Multiple responses allowed for questions

From survival to growth

Revenue recognition in technology companies: the convergence of two standards As the adoption of IFRS becomes more likely in the United States, many technology companies are beginning to think about what their initial financial statements will look like when they convert from US GAAP to IFRS. Chief among these concerns for such companies is how their revenue recognition policies may change upon conversion. In the most recent edition of Ernst & Young’s Conversations: IFRS in the technology industry, we take a look at a number of revenue recognition issues that are of particular interest for technology companies, and provide an overview of how US GAAP and IFRS are comparable for those issues as well as where they diverge. The article also provides a perspective from the Boards’ (International Accounting Standards Board [IASB] and Financial Accounting Standards Board [FASB]) joint revenue recognition project. For each topic, we summarize the guidance of both US GAAP and IFRS and provide commentary on the implications of IFRS adoption for US technology companies. This publication also discusses our current understanding of the Boards’ revenue recognition project and how distinct revenue recognition issues (e.g., establishing evidence of an arrangement; evaluating separate contracts as a single arrangement; accounting for multipleelement arrangements; and accounting for arrangements with resellers) may be affected by a converged standard.

• The general revenue recognition principles of IFRS and US GAAP are more alike than different. • Emerging Issues Task Force (EITF) Issue No. 08-1, “Revenue Arrangements with Multiple Deliverables” (Issue 08-1), may more closely align IFRS and US GAAP accounting for certain multiple-element arrangements. • IFRS is less restrictive than US GAAP in relation to demonstrating evidence of an arrangement with a customer. • Under both IFRS and US GAAP, revenue recognition arrangements are accounted for based on substance, rather than form, when evaluating whether multiple contracts represent a single arrangement.

Issue 2: December 2008

Conversations IFRS in the technology industry

Revenue recognition in technology companies: the convergence of two standards • The general revenue recognition principles of IFRS and US GAAP are more alike than different; differences are due primarily to differing levels of specificity. • Current IFRS and US GAAP revenue recognition standards soon may be replaced by a converged standard — the result of the FASB’s and IASB’s joint revenue recognition project. • EITF Issue No. 08-1, “Revenue Arrangements with Multiple Deliverables” (Issue 08-1) may more closely align IFRS and US GAAP accounting for certain multiple-element arrangements. • IFRS is less restrictive than US GAAP in relation to demonstrating evidence of an arrangement with a customer. • Under both IFRS and US GAAP, revenue recognition arrangements are accounted for based on substance and not form when evaluating whether multiple contracts represent a single arrangement. • Elements of an arrangement may be more likely to be accounted for separately under IFRS than US GAAP. • Absent any change in their business relationships, it is likely that companies that use the sell-through method of revenue recognition for transactions with resellers under US GAAP will use a similar method when reporting under IFRS.

• Elements of an arrangement may be more likely to be accounted for separately under IFRS than under US GAAP. • Absent any change in their business relationships, it is likely that companies that use the sell-through method of revenue recognition for transactions with resellers under US GAAP will use a similar method when reporting under IFRS.

Key points Global venture capital insights and trends report 2009

25

Perspective from China Interview with Bo Shao and David Zhang

Bo Shao joined Matrix Partners as a general partner in 2007, with a particular focus on Matrix’s China strategy and investments. He is currently based in Hong Kong, and in addition to his venture responsibilities, he is also a cofounder and the Chairman of Novamed Pharmaceuticals and a cofounder of BabyTree in China. Bo Shao Matrix Partners

David Zhang is a founding managing partner for Matrix Partners China and oversees all operations in China. Previously, he was the Managing Director and head of the Beijing office for WI Harper, where he oversaw all investments, portfolio management and operations in both life sciences and IT in China. David Zhang Matrix Partners

Ernst & Young: How are VCs in China altering their investment strategies in response to the challenging exit environment? Bo Shao: The current downturn is going to be very different in nature from the dot-com bust. That was relatively concentrated in the technology sector. It spread out a little bit but was more or less concentrated in that one sector and then ended because the fundamental demand for various other kinds of products was still strong. It was the result of a wacky valuation of a particular sector. The downturn that we are currently facing is very widespread, and there is an almost unprecedented combination of a fall-off in both consumer and business confidence around the world — it’s the first synchronized global recession in our lifetimes. The impact of the current downturn is going to be much deeper and longer than most people think, even today. The second point is that if you look at the VC and growth-stage investments in China, activity is not limited to the technology sector. It’s fairly widespread, ranging from chicken farms to technology, to media, to regular consumer services and even education. It’s a very wide spectrum, which means that if it had been another dot-com crash, it would actually have been okay because China presents many different kinds of opportunities. But because this downturn is quite widespread, almost every sector that a typical private equity investor looks at in China will be impacted in a similar fashion. The third thing is the picture in terms of early stage versus late stage. For a while, late-stage investments were almost too easy — the market was hot. You picked a company that was one

26

From survival to growth

year or half-year before an IPO and boom. It was pretty easy for a while to double or triple your money by investing in late stage. That opportunity has more or less disappeared, and it’s now going to be very difficult to get out in the next two or three years. In early-stage investment, things are a bit different, as typically the time frame is three to five years. I would say for early-stage investment, today’s environment overall presents more of an opportunity than a problem because valuations are becoming more and more rational. I don’t think they have fully reflected the public market multiple decrease yet, but they certainly have been coming down in the past few months. Those who are disciplined and have the guts to continue to invest will be rewarded three to five years down the road. For early-stage investment it is, in fact, not a bad time at all. David Zhang: I just have a couple of comments to add. First, a lot of people nowadays are taking a wait-and-see attitude. Many of them have stopped investing altogether. Not a lot of new deals are getting done; not a lot of new term sheets are being issued. That’s across the board — in early, in growth and in late stage. However, as compared with the last bubble, what’s different is that there are more firms now with available capital and a stable team. So the competition is still there. For a good company in this environment — a leader in a subsector — a premium valuation is still possible. Many VCs are still interested in companies like these, so competition over a hot deal will still occur, albeit a lot more selectively. We are also experiencing something of a stalemate with lots of companies. This is

because the founder is still holding out hope for a higher valuation. Expectations are coming down, but not as fast as the capital markets. In our own case, we currently have three to five very good companies — sector leaders — where we have quite a large valuation disparity. Because of that, we may end up doing only one deal, or none, because I believe we must have valuation discipline. Ernst & Young: You said that a lot of funds are in wait-and-see mode right now. Can you estimate when this mode will change and we will see the pace of investments picking up again? David Zhang: It’s very hard to say. The period from last October until now is unlike anything anyone has really experienced in the past 15 or 20 years — certainly in my professional career. As long as the market continues to be so volatile, the adjustment period is still at least six months out. During this period of time, it’s probably safe to say that many of the VC firms will still take a wait-and-see attitude and are most likely to pull the trigger for growthstage investments in clear market leaders in well-known sectors — more traditional types of investments. There will be no early-stage investments. I see that continuing for at least six months or longer. There is a funding gap at the moment in China. The funding gap would not exist if companies had clear leadership and a reasonable expectation of valuation. The money and companies are out there — the problem is the investors are more hesitant and require larger margins of safety, and entrepreneurs are holding on to the old days of valuations. Where the founder’s valuation expectation has been adjusted downwards to reflect the market sentiment, the gap doesn’t actually exist. Ernst & Young: What advice are you giving to your companies in terms of current opportunities or the challenges they have now that they can turn into opportunities? David Zhang: We are really lucky to be in China doing investment, and from a portfolio CEO’s perspective, it’s a great place to be

starting a business today. The financial crisis has been quite fierce, but at the same time, China is ready to take off. We believe this is a unique period for all of us involved in creating and investing in companies. Across the board, there are opportunities in healthcare, internet, wireless and consumer services. The downturn gives you more breathing room and probably less competition, less noise and a better mind-set. Portfolio CEOs need to seize this opportunity. I think there is some truth to the proposition that great companies tend to be formed during the most difficult times. Bo Shao: Before the crisis, I had been saying that China had no shortage of capital; it had a shortage of good people. We’ve got 1.3 billion people, but there’s still a tremendous shortage of good entrepreneurs. Today, there is still a shortage of good people, but now there is also a bit of a shortage of capital because everybody is in fear and wants to hold on to their money. David Zhang: Regarding what segments today are most likely to generate new market leaders, we are looking at a lot more opportunities in early stage, which is where we see the greatest opportunities. We also see more opportunities in internet, in healthcare and consumer services. One sector I myself am very negative on is media. You will see a heightened shake-up of many media companies in the next six months to a year because of the wild success of Focus Media. That kind of added fuel to the fire and powered a lot of wasteful investment in the media space. Many of the top-tier VC firms have invested in many media companies. You will hear a lot more blow-ups in six months’ to a year’s time. Ernst & Young: We have seen five or six models of foreign VCs going to China. Are we starting to see the emergence of successful ones that will last much longer than some of the models that will result in separation?

a very young industry. As we have all rushed to China, there have been a lot of hastily arranged marriages to get a fund set up. Not enough attention has been paid to the culture of each firm. These marriages will probably fail because, basically, the partners haven’t dated long enough before getting married — and a partnership is like a marriage. That’s a big challenge facing the industry today as a lot of firms start with a fairly low common ground in culture and personal relationships, and that gets aggravated as the market turns down. Inevitably, there will be a portfolio problem and issues with the time expected before exit. If a marriage starts with poor foundations and then gets shaken by money problems, there are always going to be issues. As for success — what is the definition of success? Is making money in the short term a definition of success? Is making money after 10 years the definition of success? Is it building a brand or knowledge? Depending how you define success, different models will be different. For example, if you say you ultimately want to build a team in China that can last for 10 or 20 years, then obviously, it is not going to work if all the decisions get made in the United States. Those decisions have to be very local because decisions are best made on the ground. Good people will not go to work for a fund where decisions are not made locally. If people can successfully invest and build good companies and raise successful funds, I would say one criterion here is local decision-making. This is for several reasons. One is that entrepreneurs — particularly, good entrepreneurs who are in demand — don’t want to have to explain themselves at midnight to general partners who live in another country and who do not understand their business. Second, local decision-making is the best way to attract the investment team you need. The best people are not going to work where they are not deeply involved in the decision-making process. •

Bo Shao: I want to emphasize particularly the issue of the team. The VC industry in China is

Global venture capital insights and trends report 2009

27

Perspective from the United States Interview with Deepak Kamra

After an 11-year career growing technology start-ups into successful global leaders, Kamra joined Canaan in 1991 and now focuses on investments in digital media and software. He led Canaan’s early investment in DoubleClick, the internet’s first and leading online advertising solution; Match.com, the most popular dating site worldwide; and BharatMatrimony, the world’s number-one online matrimony site. Deepak Kamra Canaan Partners

Ernst & Young: How are you responding to the financial crisis? Deepak Kamra: It’s a tough time, and we’re trying to set a tone of partnership and coaching with our companies. But there definitely is a sense of triage, and having lived through 2000–2003, you understand that acting quickly is important. I think that in 2001 and 2002, people just thought the market would come back and didn't worry about it. They remained in a bubble mentality for a long time. People who went through that have learned that even if the market comes back, things change. You need to pick which companies are going to make it and cut out the ones that aren’t — quickly helping people find jobs if possible. Then make sure the ones that are going to make it, but need cash, are funded for the next 12 to 18 months. A while ago, we started telling our companies to figure out how they’re going to get through the next 12 to 18 months and make sure the cash is in place for that, whether that means going out to raise money or pursuing alternative means. Ernst & Young: What is your view of the current challenges in the exit environment? Deepak Kamra: A key challenge will be the IPO market because there’s a structural and

28

From survival to growth

not a cyclical issue. We have never got back to the kind of IPO activity we had before the bubble. For about seven years before the bubble, we had around 150 IPOs a year, and in the seven years after the bubble, we’ve had more like 50. There’s definitely been a change, and you can’t blame Sarbanes-Oxley for everything. Certainly, in the investment banking world, you had to try to get Goldman Sachs or Morgan Stanley on the cover of your prospectus. I think that mentality’s going to have to change, and we’re going to need to go back to some of the smaller investment banks. There are lots of small banks. I hope they survive, because there haven’t been a lot of M&A or IPO fees lately. The big guys like Goldman and Morgan aren’t going to be able to be as aggressive as before. I think it’s also a time when the venture community just has to say, “We need to support these smaller banks because if we get smaller banks, we don’t have to wait for a really large IPO like Goldman and Morgan Stanley can do.” A lot of hedge fund buyers have gone away. So we may see a move back to the more traditional kind of investment banking industry. That would be a great thing. There are also other structural changes, namely that research analysts are paid for by trading, not traditional banking. If you’ve got small companies, they may not generate enough

“We are encouraging our companies to go and do partnerships, and partnerships are still happening without cash changing hands.” revenue to pay the analysts. But you still need analyst coverage somehow. Ernst & Young: Are you seeing companies securing strategic money, whether equity investments or through partnerships? Deepak Kamra: It’s still strictly financial. The strategic guys have been totally frozen as far as we can see, both in terms of acquisitions at any meaningful level and financing. We are encouraging our companies to go and do partnerships, and partnerships are still happening without cash changing hands. For example, Original Equipment Manufacturer (OEM) deals or ventures, or getting a larger company to sell your product because those larger companies are the ones that may want to buy you in 12 to 18 months. There are companies that are more mature, that are cash flow positive or close to it. And it’s a nice position to be in. And the companies that managed to raise money last year before the market shut down are sitting quite pretty. Cash is going to have a lot of value over the next coming year. If the exit and/or financing droughts last longer than 12 to 18 months, then we’ve got to do a reset on this. But at least those with cash flow positive are in a good space.

Still, even those guys need to adjust their product strategies to the time. For example, we have a company called ON24 that does webcasts. They also have a new product called Virtual Trade Shows, and that has just taken off because no one wants to travel to trade shows anymore. They did that in anticipation of tougher times. That’s just one example of how to adjust your strategy. We have another company called Blurb that allows you to design and print your own book online. They raised money even though they were cash flow positive. And they were singled out by some media who said they shouldn’t boast about it because they said, “Hey, we raised cash even though we don’t need it.” Well, I think you should boast about that in this market; if you can raise money, you should.

nice sector, mainly because people don’t want to pay 20% for their credit cards or they can’t, and this is a more reasonable way to borrow and lend because you take the banks out of the middle. We are still excited about things like digital media and search. Search is still a big growth market, we have companies that are doing semantic search that are doing well. Biotech is another area — the next generation of antibiotics and cancer treatment drugs. In cleantech, we try to stay away from the deals that take exceptional amounts of capital and look for storage efficiency, smart energy usage in buildings and in grids, more software as opposed to building huge plants. You have to identify the niches that will continue to grow, even within a general downturn. •

Ernst & Young: We know many great venture-backed companies were founded during tough economic periods and are all looking for the future market leaders of today. What is your perspective on that? Deepak Kamra: You need to look for things that’ll do well in tougher economic times. A year ago, we invested in a company called Lending Club, peer-to-peer lending, where people lend and borrow money from each other online. That’s turned out to be a very

Global venture capital insights and trends report 2009

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How to manage cash by Steve Payne and Al Sardo

Steve Payne Americas Leader of Working Capital Advisory Services Ernst & Young

Al Sardo US Leader of Working Capital Advisory Services Ernst & Young

In good times, VC investors and portfolio company executives focus on revenue growth and the drive toward profitability, often leaving balance sheets on the back burner. Now that the global economy is slowing, senior executives need to make sure their businesses know how to conserve cash. Accurate cash flow forecasting is a vital component of any cash management practice. It requires input not just from the finance team but also from operational areas of the businesses. This input should answer the question, “Who really controls where my cash is going and how it is coming in?” Focusing on cash flows in this way should produce a clearer picture of a portfolio company’s sources and uses of funds. It also will help managers make more informed decisions about how to improve cash flows. Even in the best of times, cash from working capital is the preferred source of liquidity. But in a global downturn — when credit, market capitalization, growth and profits have all slowed dramatically — preserving cash through disciplined working capital management is becoming essential. Companies often meet their quarterly cash goals by driving inventories down to an unhealthy level that endangers customer service quality, postponing receipts from suppliers until the first day of the new quarter, delaying supplier payments and bombarding customers with payment notices to collect aged receivables.

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From survival to growth

Despite these efforts, companies continue to leave significant dollars locked up in working capital. Many companies deploy the usual and classic tactics — many of these methods revolve around quarter-end — to reduce working capital but still reach a performance plateau. For sustainable improvements, the objective should be to liberate cash each day so that it can be redeployed and not to focus on cash flow at the end of the quarter. What steps can venture capitalists and their portfolio companies take to accomplish this goal? Companies should focus on their balance sheets, specifically their inventories, payables and receivables, and procurement processes to uncover additional opportunities, and ask such tough questions as: • Do our metrics and variable reward program emphasize the importance of cash or focus on sales and EBITDA? • Is our inventory at the stock-keeping unit level imbalanced, leading to excess inventory in some products and shortages in others, thereby exposing us to product obsolescence? • Do we have good insight into our customers’ evolving needs for our products/services or are we reactively responding to their purchase orders?

Sometimes companies can focus on cash simply by looking ahead. Smart executives will pay more attention to cash flow forecasting. • Are we buying the same supplies from too many different sources? Would it be more cost effective to consolidate our spending with fewer suppliers, negotiate better terms and take advantage of volume discounts? • Have we examined supplier payment terms as well as payment triggers and schedules? • Have we segmented our customer base to understand better where we need to focus collections efforts based on relationships and customer payment behavior? To take advantage of working capital best practices, VC firms can leverage the best practices in one portfolio company and apply them across all. By sharing knowledge and processes, everyone benefits. Start by taking a closer look at their collections process. Smart companies make certain bills go out accurately and on time, giving customers no easy excuse for slow payment. They also work hard to understand their customer base and tailor collection strategies to the payment behavior demonstrated by individual customers. Improvement can also be achieved by scrutinizing payables. A surprising number of otherwise sophisticated firms are chronic early payers. In the current environment, when your own customers are likely to pay more slowly, negotiate more favorable terms when possible and do not pay until the due date. Supplier segmentation allows companies to “move out” payments for commodity suppliers whose products can be

sourced cost-effectively from one or more alternative vendors with little risk that the supply will be interrupted.

governance through more frequent monitoring of internal controls relating to cash.

Many companies have made inventory management harder by sourcing parts and products from lower-cost suppliers in Asia. The distance and supply chain risk involved may compromise oversight and control. Inventory is the buffer between supply and demand, and low-cost sourcing means companies need to thicken that buffer. Ideally, firms will try to improve forecasting over the extended future. They will also look for opportunities to build flexibility into product configuration so its final appearance can be changed easily and cost-effectively to meet customer demand.

Also, where applicable, venture capitalists and their portfolio company executives should review credit facilities and covenants and step up communications with key credit providers. Companies may also want to focus efforts on improving bank account structure and banking relationships. Redesigning the bank account structure may increase visibility and provide better access to cash. Reevaluating bank services and fees can also lead to significant cost savings. Companies could renegotiate with their lenders to achieve favorable and standard bank fees. Where it is beneficial and practicable, VC firms may consider collectively negotiating better rates for their portfolio companies.

Sometimes companies can focus on cash simply by looking ahead. Smart executives will pay more attention to cash flow forecasting. In addition, they’ll look at customers, suppliers and creditors to see who else might be at risk and then develop contingency plans. Finally, it can be helpful to make certain that incentives are aligned with prudent cash flow management. When business is profitable, other issues take priority, leaving cash and inventory management to become less disciplined over time. Companies can remedy this situation by immediately creating cash-focused performance measures and applying them from the top of the organization to the bottom. VC firms should take additional steps. For example, venture capitalists can encourage companies to strengthen corporate

Global venture capital insights and trends report 2009

In summary, it’s important to make all possible efforts to make certain that working capital management is a topic of attention for all VC-backed boards and management teams. • Visit www.ey.com for further reading on capital management strategies from Ernst & Young: “Unlocking cash: where are the opportunities,” PE Insights, Vol. 1, No. 1, 18 March 2009 “Transaction insight — Liquidity and working capital management: cash is king,” InterChange, Vol. 22, November 2008

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Perspective from Israel Interview with Chemi Peres

Chemi Peres is a managing general partner and cofounder of the Pitango Venture Capital partnership. In 1992, he founded the Mofet Israel Technology Fund, an Israeli VC fund publicly traded on the Tel Aviv Stock Exchange, which he managed until 1996, when he cofounded Pitango. Nechemia (Chemi) J. Peres Pitango Venture Capital

Ernst & Young: The VC industry is again facing a difficult exit environment only a short while after venture-backed IPOs and M&A activity had recovered from the dotcom bust. How are venture capitalists in Israel altering their investment strategies in response to the return of this challenging environment? Chemi Peres: The number of companies seeking additional financing rounds, across all stages, is increasing by the day. With the IPO market at a standstill, a long line of good companies that could have been IPO candidates is forming, creating a huge bottleneck and leaving these companies with just a few options. The first option is to explore exit opportunities via acquisitions. The hunger for innovation will grow, the interest of strategic players in acquiring companies will continue to grow and they can take advantage of the current situation to buy companies at relatively low valuations. The second is to achieve profitability as quickly as possible — sometimes by sacrificing growth and becoming more financially efficient. Getting to a positive cash flow will enable a stand-alone business, sparing the need for additional equity or debt financing. Ultimately, the company can continue its growth toward a later stage, when an IPO opportunity emerges or an attractive proposal is on the table. Companies that are not able to reach this stage fast enough will be forced to complete mergers between themselves in order to achieve a critical mass. Combining

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businesses will yield a sizeable company that can continue to grow to a later stage where options become viable again. These basic options are true across geographical boundaries, Israel included. Ernst & Young: What lessons did the VC industry learn from the experience of the last downturn that can be applied to today's situation? Chemi Peres: The main lesson learned is that certain of the VC-backed companies did not have a long-term sustainable model for reaching profitability and positive cash flow without having to rely on external sources of capital. Additionally, the time to exit might be very long. Therefore, companies must make sure they are equipped for a marathon run, focusing on management, capital efficiency, revenue generation and realistic assumptions while planning ahead. The current crisis is a continuation of the previous crisis. The VC sector in both cases was forced to adopt the point of view according to which businesses need to be built for the long term rather than the short term. These times demand a paradigm shift: focus on building companies to last, rather than building companies to exit. Ernst & Young: What advice are you giving to your portfolio companies? Does the current situation offer opportunities as well as challenges to your portfolio companies? Chemi Peres: Times of crisis are also times for new opportunities. Obviously, we advise

“It is important not to become stagnant or too conservative and to seize opportunities that exist.” our portfolio companies to try and preserve resources and raise capital that they need now in order to extend the runway as much as possible. We advise them to examine their plans, assumptions, opportunities and potential threats and risks. We ask them to brainstorm and not to take anything for granted — business models should be challenged, and the same applies to current strategies. Having said that, it is imperative not to lose the risk-taking opportunities: it is important not to become stagnant or too conservative and to seize opportunities that exist. Those who are alert enough to act will find that they can use market opportunities and gain breakthroughs. I also suggest that companies reevaluate their market, competition, financing plans and management teams, making sure that the entire team is adjusting to the new situation and everyone is on the same page. No company should underestimate the value of conducting face-to-face strategy discussions and meetings, which are now more important than ever before. Ernst & Young: Many great venture-backed companies were founded during down economic periods. What segments today are most likely to generate new market leaders (e.g., cleantech, cloud computing, software as a service)? Can you specify? Chemi Peres: The pace of change of industries is fast, making room for new ideas and new ventures in the coming years. We see new convergences between traditional information, technology and communications

sectors and new emerging industries. The current technologies will accelerate the growth of tomorrow’s ventures. We are witnessing the emergence of innovative solutions in the fields of renewable and alternative energy sources, water desalination, purification, storage and conduction. We also see a new era in biotechnologies and life sciences developments, safety and homeland security, new education methods and platforms, nanotechnology and green technologies that are revolutionizing the use of our natural resources. We will also continue to see innovation in the more traditional areas such as IT, communication, internet, media, software and so on. Ernst & Young: What are the key challenges for the VC industry in Israel and the likely industry response? Chemi Peres: Some of the key challenges are preserving leadership and competitiveness in a technological world that is shifting gears in an accelerated way. We need to rethink the old discipline’s food chain, beginning with school education through research institutions and universities, national encouragement and investment in R&D and promotion of entrepreneurship, innovation and financial resources. We need to create a supportive and enabling regulatory environment and make Israel not only an innovation lab, but also a beta site for implementation and consumption of new technologies.

Global venture capital insights and trends report 2009

Ernst & Young: Pitango is one of the few Israeli funds that invested in a Chinese company — why, and is it a part of your strategy? What are the lessons learned by the Israeli VC industry? Chemi Peres: The China-Israel relationship is very unique, having much in common and complementing Israeli technological development with the creation of new technology in China. We recently invested in a later-stage Chinese solar energy company. We were very impressed by their abilities and their pace of development. Leadership in many energy fields will expand across the globe, with China being a major player in the development of silicon manufacturing. Pitango invests primarily in Israeli companies; however, from time to time, it invests in global ventures with local partners. Aside from financial backing, we invested time and resources to learn the Chinese and AsiaPacific area as it is strategically important to our portfolio companies as well as to us. We think the Chinese economy will become more integrated with the global economy, for better or for worse; China is a prominent market opportunity and also a place that will produce leading companies. The same can be applied to India, Russia and other areas around the world. Venture capital and innovation are becoming more and more globally integrated. •

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Perspective from the United States Interview with Noubar Afeyan

Noubar Afeyan is managing partner and CEO of Flagship Ventures, a firm he cofounded in 2000. He is also a senior lecturer at the Massachusetts Institute of Technology in both the Sloan School of Management and the Biological Engineering Department. A technologist, entrepreneur and venture capitalist, Afeyan has cofounded and helped build 20 successful life science and technology ventures during the past two decades. Noubar Afeyan Flagship Ventures

Ernst & Young: What is your assessment of the current state of Venture Capital? Noubar Afeyan: At the moment, everyone is being very careful with their words. People are saying we are in a crisis and avoiding any mention of a depression. I would say that crisis is probably not the right word because it implies the ability to manage the situation and reasonable steps to take. Crisis almost assumes that you have a mental model of what the world looks like after the crisis. And usually, after the crisis, you return to what the world looked like before the crisis. The overriding thinking throughout is that you’ve got to survive the crisis, then afterward, you can get back to how things were. For instance, the internet bubble bursting was viewed as a crisis. I think that, at the moment, we don’t have a crisis — we’ve got chaos. Managing in chaos is a very different concept. In fact, I don’t know what it even means to be an expert on how to manage in chaos. So it’s extremely difficult to tell you how to survive or how to be better positioned for the recovery. At the moment, we’re going to keep doing the same thing for as long as we think things might return to the way they were — more or less. But we don’t know if things will return. No one does.

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We have a situation that is unlike any I have seen in my professional career. It’s not clear what might happen, where we might end up or how long it might take. Ernst & Young: What advice are you giving to your portfolio company management teams? Noubar Afeyan: We’re in an environment where I think it’s all going to be about how to get nonequity or nondilutive capital. Our advice to our companies is, where possible, to favor strategies that don’t require them to raise much capital. Right now, we don’t see signs of a step change in portfolio companies. If anything, I would argue that this environment is initially advantageous for start-ups because startups, by their nature, tend to be disruptive to the status quo. In the current environment, the status quo has been shattered for everyone, both newcomers and incumbents. As a result, incumbents now have few of the natural defenses to mount against little companies as they did pre-chaos. Another observation that we make with our management teams is that they are usually impatient. They are often racing, but it’s not clear against whom they are racing. It’s very

“We want to avoid racing ourselves into oblivion — using up all our capital thinking there’s a race and then finding out there wasn’t one in the first place.” clear that everything they previously planned simply won’t be done in the next two years — if only because the other companies will also be having a hard time raising money. We want to avoid racing ourselves into oblivion — using up all our capital thinking there’s a race and then finding out there wasn’t one in the first place. What do you control as a management team? You control your firm, the decisions to forge partnerships, the team that you have and the things you choose to focus on. You have to ask yourself as a management team: “Where are the appropriate set-points of each of these things in view of a chaotic environment?” You must identify what the right set-points are and how frequently you should go back and look at them. One good analogy is being sick. How often do you measure your temperature? If you measure it too often, you feel sicker and sicker, so there is such a thing as measuring it too often and making yourself feel psychologically like you’re losing the battle. Since survival will precede success, think of cash burn rate as a more immediate-term focus versus a very long-term focus. Those are the things most good management teams

are doing, and I think that’s what boards should encourage them to do. On a practical level, people shouldn’t lose track of goals and objectives. A lot of boards and venture capitalists go to their teams and tell them to cut their burn. Management comes back with a set of cuts aimed at cutting burn rapidly but fails to revisit the goals committed to last year, to restate what targets it will and won’t be possible to hit. If the team can’t tell you what objectives it’s not going to meet because it cut the burn, then it didn’t really do it or it has too much slack. Any time I tell a team that what is needed is to burn less money, I immediately insist on also seeing the things it is simply not doing or will not be able to continue doing. Ernst & Young: Are there different expectations of VC funds now than there were before the financial crisis?

But we hear from limited partners that, objectively, there’s often no merit in making a new commitment to many of these funds. Performance against benchmarks is a more reliable basis for decisions. But after a decade of poor performance across the venture industry, beating low benchmarks will likely not be sufficient. Venture firms will need to stand out based on many factors and not rest on their laurels. I expect to see changes to the relationship between limited partners and general partners because this is just such a traumatic period. We’re all going to have to earn our living. As an entrepreneurial firm with only three funds under management, we have to rely on our current performance rather than solely our brand and performance during the ‘90s or ‘80s. I expect that in the current environment, funds will need to re-earn their brand every single day. •

Noubar Afeyan: The limited partner community has historically invested based, in part, on reputation. The same inclination that prompted people to invest in a bunch of hedge funds that have recently been in the press, also caused “safe” investments into venture funds with long track records.

Global venture capital insights and trends report 2009

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Perspective on corporate innovation and collaboration Interview with Steve Meller

Steve Meller is on the leading edge for the global open innovation programs at Procter & Gamble. In this role, he serves as Chief Innovation Catalyst and leads the global technology innovators and entrepreneurs “community of experts,” the North American and Latin American open innovation hubs and several key business and technology platforms across the company, including Venture Capital (VC)/ Small and Medium-sized company (SME) strategies and the global bioscience and industrial biotechnology platforms. Steve Meller Procter & Gamble

Ernst & Young: What is your perspective on big corporates’ need to interact with VC funds and portfolio companies?

devices, diagnostics, nonpharmaceutical, health, beauty and wellness areas, enabling technologies.

Steve Meller: SMEs are the largest-growing source of innovation globally today. VC organizations and private equity are a very important route to gain access to those companies.

All of those areas have significant impacts in some, or in some cases many, of our business areas. By educating the venture community about what we’re looking for, we can gain access to their portfolio companies.

In particular, many venture capitalists are investing in “higher-tech” SMEs — those that have some very fundamental information related to health IT or sustainability, for example.

Also, companies that may come across their desks, that they may choose not to invest in, could be of interest to us. Developing relationships that allow that sort of information flow is important to us — we want a two-way street dynamic that allows those VCs and the portfolio companies to better tailor what they’re doing.

Being able to develop relationships with a wide variety of VC organizations around the world is an important plank for us in finding access to the right types of portfolio companies. To do that, we’ve become much clearer with the outside world on what our needs are and where we’re really looking to play. Many of the areas that a consumer products company would look into don’t overlap very well with the large buckets the VC industry typically invests in. We need to help the venture community better understand those types of platforms that are of high interest to us — such as nonpetroleum alternative energies, nonpetroleum alternative materials,

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From survival to growth

Companies sometimes come along that have a technology that is of interest, despite it not being directly related to our business. For example, with biofuels. We do not work in fuels. But we are heavily involved in the purchase, and use of, materials in which ethanol and diesel are involved as intermediary molecules. That means we’re interested in these biofuels companies for a different reason than that originally intended — but we can still add value. We want to be the partner of choice for the VC community. We want people to think of us both because of the integrity of our

“Last calendar year, there were about 3,700 specific opportunities that came in through the portal, and we have some very specific ways we go about assessing and evaluating them in a systematic way within the company.” collaboration and the way we choose to do business. Even if a VC isn’t directly interested in a company it becomes aware of, we want it to think of us and pass the company across if it thinks we might be interested. Ernst & Young: What are some of the plans and programs that you have in development at P&G to access the VC community and create those effective partnerships? Steve Meller: We have a variety of things in place already today, both organizationally and connectivity-wise. We have a very robust external business development organization of 40–50 people who are experts at connecting with outside companies, as well as building relationships within our company. We’ve been building that network for around a decade. That’s an avenue for us to get the message out. The same thing is true in the R&D organization as we continue this connect-and-develop approach that’s been successful for us. There is also a similar group or network of people — about 30 to 40 or so — in different parts of the world whose full-time job it is to be out there creating and maintaining relationships with all aspects of the part of the world they’re operating in. One of the things we’re doing at the moment is really spending time shaping what our

message track is, asking “How do we want to interact with venture capitalists and SMEs?“ We’re developing forums and open days to allow us to interact with the communities we’re looking to work with, along with some really good web portals that bring people into our world and allow them to see what we’re about.

So we looked for a partner, and it was sold to Meridian — a Georgia-based, privately held company — and Meridian has actually been developing that technology further for themselves. It may be something that we would then ultimately license back as a fully developed technology in our product portfolio.

As each year has gone on, we’ve had significant success. Last calendar year, there were about 3,700 specific opportunities that came in through the portal, and we have some very specific ways we go about assessing and evaluating them in a systematic way within the company.

A second example is a recently announced partnership with ConAgra. We struck a deal where we shared a whole host of our packaging, product and material portfolio with them primarily in the food technology area. ConAgra can now leverage all of those individual technologies, packaging knowledge and expertise within the company, to be able to further develop their portfolio products.

Ernst & Young: On the other side, how are you making technology developed inside P&G available to the venture and private equity communities? Steve Meller: We have a large portfolio of patents in the company — roughly 36,000 of them. We certainly don’t use all of those in terms of their technology and product development. For example, we spent some time developing an alternative renewable material approach for resins that we called Nodax. We took it to the point of a proof concept of what it would do and how it would do it. But we're not a resin manufacturer.

Global venture capital insights and trends report 2009

And again, as we have less of a focus today in food technology than we have had in the past, it makes perfect sense to partner up and leverage what we already have and know with leading companies out there. We'll be a part of the continuing development of those types of relationships — of sharing things with that community. As we share a need, we can also be sharing examples of how we work and the types of opportunities that we as a company could work at collaboratively with the venture community. •

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Perspective of a corporate investor Interview with Nino Marakovic

Nino Marakovic is the senior vice president of SAP Ventures, the corporate venture investing entity of SAP AG. He is responsible for the worldwide strategy and overall performance of the venture funds. Marakovic has a strong track record of technology venture investing since 1999. Prior to joining SAP Ventures, he was a partner with meVC Draper Fisher Jurvetson and IVF Ventures in Palo Alto. Nino Marakovic SAP Ventures

Ernst & Young: What are the key challenges for the VC industry today? Nino Marakovic: One challenge is this idea of momentum investing. For example, we might invest in a feature that’s going to generate around US$10 million in revenues, which you can count on selling to some product or platform company that will absorb that feature. But the feature by itself could never really be profitable because you can’t really build a sustainable business around it. In a hot market, it’s rational for companies to pay a significant multiple for it because they can sell it as part of their platform. But in times like this, when you have to get your product cash flow positive quickly to have a sustainable business model, investing in these momentum features is just not viable any more. So I think you’ve got to go back to basics and really invest in businesses that have an opportunity to become big, sustainable, stand-alone companies. And that’s a skill set and discipline that we haven’t really seen for a long time. The need to make the hard calls early is one of the key lessons I have learned from the last recession. I had to deal with a portfolio of 30 to 40 companies that had been backed at the height of the bubble. It’s irrational to keep doing the same thing and expect a different outcome, especially in a worse environment. I think making dramatic changes cutting

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the losers shows your support for the firms you stick with. It is just the prudent portfolio approach right now. Ernst & Young: Do you think that we are seeing corporates on the sidelines just because of a belief the valuation is still going down or is it that there is no rush due to lack of competition? Nino Marakovic: It’s both. There is no urgency. Companies are just running out of cash. They are going to be cheaper. I work closely with the M&A team here, so I get a much closer perspective than most to one of the key buyer’s mind frames. While it sounds great that all these companies are available for half-price, and the corporates are just there on the left and right willing to buy companies, the reality is much more nuanced, and the corporates are not dumb. They are not going to pay much money for just a technology without revenue. They know they are not competing with many other people right now. They know that companies are running out of cash and available for very little. And there is also the corporate side of the equation. Don’t forget that half of these companies’ market caps got cut in half. They are all cutting budget; they are all concerned. Internal dollars have gotten much more expensive, and everything is getting

reevaluated three times from Sunday, so it’s gotten harder for companies to get deals approved. Ernst & Young: How do you view the current challenges in the exit environment? Nino Marakovic: The exit environment question is obviously one of the key issues. There are two aspects to the story. There is a temporary exit environment issue — the fact that we are obviously in a recession and there is a dramatic downturn in public market valuations, which affects exit expectations, both on the M&A and IPO side. But I expect that to be temporary — around two years or so. I am more concerned about the permanent structural changes in the exit environment affecting the venture market. There is the general issue of what’s happening with the investment banking industry and the whole support system around raising capital and underwriting IPOs, providing research so that institutional investors can actually buy some of these companies. Ernst & Young: How do you think the industry will change, or should change, so that when we work through the current problems, there is still a working banking infrastructure? Nino Marakovic: First, there’s going to be a hole for a couple of years in the analyst

coverage, in investment bankers interested and willing to visit start-ups and do business with them, and in terms of interest from institutional investors in buying into any kind of new market issue below a certain threshold in revenue and significance. Over time, I suspect that the large players will be somewhat marginalized and a new set will evolve, much like it did 20 to 30 years ago. Big banks never used to pay attention to small start-ups. It’s going to be the new set of small boutique players that are going to build up the capability to support the small businesses. But it will take time. The other thing is just as bad, if not worse. The buyer universe has just shrunk. A whole set of buyers who could pay US$100– $US300 million for a start-up company has gone. That’s the other structural issue that I think is going to take a little bit longer. And in conjunction with that, there’s got to be a healthy IPO market to entice the strategic buyers to actually pay more for these companies. Because if an IPO is not an alternative, there is a limited set of buyers, and they can afford to wait and pay less.

multiple exit, you’ve basically got to become a big company. The last implication is that VC is just incredibly expensive right now. If you look at what the demand and return expectations are for some of these bonds — relatively safe bonds — then look at the required return to invest in something with the risk premium of VC, it’s just incredibly expensive right now. What does all that mean? It means you have to get invested at much lower valuations. You absolutely have to invest in more capitalefficient models. The idea of relying on others to give your company more money just to keep growing profitably is just not appropriate any more. It means generally pursuing a more conservative growth path, meaning getting cash flow positives from existing money and growing profitably, rather than relying on outside capital. Fundamentally, it’s going to be much more important to be frugal and not necessarily be as fast to market. That’s okay in this environment because if your competitor is not strong financially, it won’t be in the race either. •

Another key challenge is tied to liquidity: you can pretty much count on liquidity requirements going up. In terms of size required to exit to meet somebody’s threshold, and for you to put money and get a decent multiple return on a low-revenue

Global venture capital insights and trends report 2009

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Perspective on biotech Interview with Alex Barkas

Alex Barkas is a managing director of Prospect Venture Partners. Prior to cofounding Prospect Venture Partners, he was a partner at Kleiner Perkins Caufield & Byers from 1991 to 1997, focusing on healthcare-product company investments. Previously, Barkas was a founder and CEO of BioBridge Associates, a healthcare industry consulting firm. Alex Barkas, PhD Prospect Venture Partners

Ernst & Young: How do you view the current difficult exit environment? Alex Barkas: In biotech specifically — and it’s also true in medtech — we are actually continuing to see a robust environment in terms of M&As and the opportunities for both deal-making and exits. Historically, most biotech companies went public initially, and maybe some time later were involved in M&A activities. The direct path to M&As for private companies, as well as for public companies, is a relatively new phenomenon in biotech. And it’s one we find to be a very significant positive for both the biotech industry and for the wider venture industry. This is a reflection of the fact that the big companies have recognized that gaining access to a highly productive biotech R&D engine is actually very much in their interests relative to the inefficiencies they’ve seen in their own internal R&D organizations. Ernst & Young: A lot of great venture-backed companies have been founded in downturns. Where do you see the potential for great future companies to be funded initially at the present time? Alex Barkas: I don’t know whether I could cite you the statistics on when great companies were started, but it’s very rare that you know they are great when you start them.

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From survival to growth

It sometimes seems as if companies emerge from obscurity and all of a sudden, they get very interesting to people. You need to ask what companies are going to be gamechanging. You will discover that they are out there and were started a few years ago. We try to have some of those in our portfolio. Some of that is luck; some of it, we hope, is related to the processes that we have in place to try to identify them. At the same time, there are opportunities to deploy capital right now that are extraordinary because there are an awful lot of companies that need to finance, and valuations are likely to be very attractive for the near term and maybe longer. We think there are really good opportunities to identify companies, some of which may be the real thought leaders and industry leaders of the future and some of which will just be great investments. We are definitely screening to find both kinds of companies. In terms of where there is going to be real excitement and enthusiasm going forward, from an investor standpoint, later-stage assets are quite interesting to people. But later-stage is an interesting concept because people tend to think that must mean they are close to profitable or they are about to get their product approved. I think what it really means is they are about to get to a value inflection point where people will be more likely to recognize the value in those companies.

“As consolidation occurs and as people in the large companies recognize they can’t even afford the pipelines they have, they are going to be divesting things that will represent really interesting opportunities when combined with the right teams.”

That can happen at varying points along the way. We think, for example, that there is going to be real excitement in the whole area of genetics and genomics again. You may remember that in the 2000 time frame, there was huge interest in the human genome. For the first time, we sequenced a human genome, and that was very exciting to people. Since then, there have been a dozen or so additional genomes sequenced, and we are now going to move into a period when, over the next five years, there may be a million genomes sequenced. Obviously, the companies that are involved in doing that, at all levels, are going to push forward the frontiers of our understanding of the genetic basis of disease enormously. There are going to be multiple winners in that space: the people who are providing the technology for sequencing, the people who are interpreting the results and the people who are applying that to a new generation of interventions and therapies. So we think that is an important area in medicine going forward. There is an interesting set of private companies right now that is coming up on the radar screens of the bigger companies. Medtronic has announced a couple of acquisitions of development-stage companies. Why were they interesting? They were interesting because they were converting an open surgical procedure into a

minimally invasive procedure. And we have companies in our portfolio that we think are going to do that for important areas in spine and in cardiovascular. There is a better understanding of where optimum points of intervention are likely to be and what things may work in the future. There are a lot of creative engineers out there who are designing next-generation devices to take advantage of that. As consolidation occurs and as people in the large companies recognize they can’t even afford the pipelines they have, they are going to be divesting things that will represent really interesting opportunities when combined with the right teams. Creative kinds of spinouts and restructurings of various kinds, we think, are also going to be an interesting area for investment.

from the standpoint of balancing the asset classes they are going to have to work through. I expect that’s going to get worked through this year. What kind of environment we encounter after that remains to be seen. There are going to be very attractive opportunities to deploy fresh capital in the venture business because valuations are going to be particularly attractive going forward. There are some very experienced teams of people out there who are quite well equipped to deploy that capital efficiently with the likelihood of good returns. I do think it’s often at this point in a cycle when the best returns can be generated. •

Big pharma is actually focusing its efforts toward some areas and away from others. There will be opportunities to take advantage of that, and partnership with the big companies will be possible. Ernst & Young: From a VC industry standpoint, what are the biggest challenges now? Alex Barkas: There are both short-term and long-term answers. I think in the short term, limited partners are still trying to calibrate, to understand what they have in their portfolios. They are under various kinds of pressure

Global venture capital insights and trends report 2009

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Perspective on US cleantech policy Interview with Timothy Urban

Timothy Urban leads the Washington Council Ernst & Young energy practice and has represented a variety of clients on energy issues, including tax credits for electricity from renewable resources, investment incentives for purchases of solar energy property, production tax credits for biodiesel and proposed incentives for investment and production associated with cellulosic biomass ethanol. He has played a key role in developing renewable energy tax policy and working with Congress and the administration to enact energy legislation. Timothy Urban Washington Council Ernst & Young

Ernst & Young: What is your assessment of the American Reinvestment and Recovery Act (ARRA) in terms of its impact on innovative cleantech companies? Timothy Urban: The ARRA has the potential to be game-changing for some cleantech industries. There are certain groups of companies and industries that really came out with significant benefits in this bill. However, there are many other important issues that were put off until future legislation. First of all, the enactment of H.R. 1 should be seen as merely the first prong of what I think may be two years of a steady consideration of various legislative vehicles. In terms of cleantech, this bill focused largely on green electricity. It does delve into the many pressing federal policy issues related to biofuels or sustainable bio-based materials. So I think that there is much yet to come. This is merely the first instalment. The ARRA contains a couple of noteworthy changes to the US Internal Revenue Code. It contains a provision called the Credit for Investment in Advanced Energy Property. This provides a 30% investment tax credit for advanced energy manufacturing property. These would be assets that a manufacturer would purchase when building a new plant, for example, to make solar cells, wind turbine blades or impellers for use in a hydroelectric facility. It’s a very significant piece of

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From survival to growth

legislation because it’s a manufacturer’s credit for purchasing assets used in manufacturing. If you think about the way our current tax incentives for renewable energy are structured, we usually provide either production credits for the generation of the energy or investment incentives for the purchase of assets. The Credit for Investment in Advanced Energy Property is different because this is investment in the upstream assets that manufacture the property, the various large pieces of equipment that are then used by the firms who build the renewable energy facility. This provision is important because cleantech and renewable energy are among our significant potential areas for business growth nationally, even in the current recession. And what we are finding is that a lot of the individual pieces of equipment that are required to build a renewable energy facility are being built overseas. Anything that we can do to maintain our domestic cleantech equipment manufacturers or attract manufacturers to establish facilities in the United States is obviously a priority for our lawmakers and something that should be encouraged. To obtain the credits, taxpayers will have to file an application with the Treasury Department, and the proposal has to fit within the various criteria named in the

“When there are these relatively short-duration provisions, the technologies that lend themselves to being erected in a hurry within a year or two tend to soak up all the tax incentives.” statute. There is only just over US$2 billion worth of credit available to be allocated, so not every applicant will get the credits, and there is a process by which the Department of Energy and the Department of Treasury will filter the applications and try to identify the ones that provide the most public benefit. Ernst & Young: What about the more traditional tax equity provisions? Timothy Urban: The ARRA also reflects the Obama administration’s work with the Congress to try to rescue the renewable electricity developers from the almostcomplete doldrums the industry had encountered during the last quarter of 2008 due to the lack of tax equity financing. Renewable energy developers found themselves in very difficult times because all of their development plans relied upon the appetite of large investment banks and other entities for their tax credits — many of these institutions were now distressed or worse due to the financial crisis. The development of wind facilities, large utilitysized solar facilities and other major projects almost ground to a halt. There were still some entities interested in pursuing these transactions, but the terms in which they were willing to engage to get the credits were actually much less beneficial to the developers.

As a result, the administration, the House and the Senate were besieged by renewable energy trade associations and their member companies who were making the point that the collapse of the tax-equity monetization process had essentially defeated the intent of the very significant extensions of the renewable energy credits approved by the last Congress. Early in the year there was a long and protracted discussion between the new administration, the House, and the Senate energy and tax committees. In the end, the conference report they agreed to was actually very thoughtfully conceived, and it stands to have a pretty dramatic effect in terms of rescuing renewable electricity development here in the United States. What they did first was to allow taxpayers who were developing renewables facilities to elect to take either the Section 45 credits that they would be generally eligible for or a Section 48 investment credit. This is very significant. In so doing, they created tax parity for the various technologies that are listed in Section 45(d) — wind, closed-loop biomass, open-loop biomass, geothermal energy and incremental hydropower, etc. Under the Section 45 rules, there are two tiers of credit rates that have been the subject of carping from some of the recipients of the lower level of tax credit.

Global venture capital insights and trends report 2009

This 30% investment tax credit acrossthe-board election for all of the eligible technologies under Section 45(d) put everyone on the same playing field. Then the second step of the two-step process was to create a process that allowed renewables projects to go forward even in the absence of a partner willing to monetize their tax credits. This is the provision that provides for Treasury grants in lieu of tax credits. This is a significant departure from current law and a very dramatic response to the economic downturn. Without it, there would have potentially been many credits generated and no market for them. But this provision essentially says that if you are eligible and submit an application to the US Treasury, the government will send you a check when the facility is placed in service. This provides a lot of certainty to the developers and likely enhances their credibility to “green light” projects and obtain financing. Now the next important provision constitutes a very inspired bit of drafting and something the administration and the Congress should be very proud of. They had to grapple with some way to create technology neutrality, i.e., find a way to ensure that the provisions treated the various different technologies fairly. In its earliest conception, this refundable credit was envisioned to run for only two years as a stimulus measure — any

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“The take-home point is that this combination of provisions for renewable electricity developers was far beyond the normal run-of-the-mill legislative process and that Congress had to break long-standing tax legislation taboos.”

eligible facility that was placed in service before 1 January 2011 could receive a check. There is a problem with this structure though, because renewable energy technologies are not monolithic. Their facts and development timelines are very different.

the end of the window within which to place the facility in service and still be eligible. So, for example, if you start a concentrated solar facility before the end of 2010, you have until the end of the expiration of Section 48 for solar, which is the end of 2016.

Timothy Urban: Regarding the renewable electricity credit, there is going to be a certain amount of lag time, not because the system isn’t working but because it takes a while to take a renewable facility that’s on the drawing board and place it in service.

And as we have seen repeatedly over the years in the development of federal policy aimed at renewables, when there are these relatively short-duration provisions, the technologies that lend themselves to being erected in a hurry within a year or two tend to soak up all the tax incentives. On the other hand, some of the other technologies — which may also provide dramatic public benefits and could constitute significant potential contributors to our overall energy mix — miss out. It is very difficult to permit and build a biomass plant, a geothermal plant or a concentrated solar facility in two years, for example.

The take-home point is that this combination of provisions for renewable electricity developers was far beyond the normal run-of-the-mill legislative process and that Congress had to break long-standing tax legislation taboos. The whole idea of tax credit refundability is something that most members find objectionable. Generally, the idea of providing a grant in lieu of a tax credit to an entity where there are no taxes paid is something of which they usually are tremendously wary. So the fact that they were willing to go to such extreme lengths to make this process work again for renewable electricity producers is, to me, one of the big stories of this year.

Now, clearly, there are going to be some people that are going to qualify under these programs who are just going to be, frankly, lucky — they started planning and permitting some years ago and just happened to fall within the window.

What the Congress achieved with the Obama administration in this bill was the creation of a two-part eligibility period. First of all, if you place a facility in service in 2009 or 2010, whether it’s biomass, wind, solar, etc., you are set. But if you cannot meet these deadlines and if you begin construction in that period, you then have a period beyond

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Ernst & Young: There is a tremendous amount of optimism in the community about these developments — how soon are companies going to be able to take advantage of them? How soon are they are going to get rebates, checks or be able to apply for these credits?

From survival to growth

But the projects that this bill was aimed at are at least a year or two out. But it is important that there is a tremendous amount of green employment and economic activity that goes into these facilities long before they are placed in service. There are contracts that have to be let with component manufacturers, whether it’s turbine or windmill blades or solar cells. There is a tremendous amount of economic activity that we are hoping will play its part in reinvigorating our economy. The theory is that as we vigorously try to ramp up these green, cleantech manufacturing jobs, to some degree, these high-wage jobs may be able to replace jobs that are going overseas and jobs in sectors in which the US may no

longer be as competitive. It’s very important that green manufacturing, green facility development, the green economy in general, pick up the slack from these other industry areas that we may never get back. Ernst & Young: Cap-and-trade is currently on the legislative agenda. What are the dynamics of the policy debate related to putting a price on carbon, whether through cap-and-trade or a carbon tax? Timothy Urban: While different groups have very different objectives, the majority of business people just want some clarification around the issue — they want to know what this is going to cost. The challenge that is usually thrown at the carbon tax option is that our scientific knowledge of greenhouse gases and greenhouse gas reduction is terribly limited right now. It is hard to believe that any gifted group of scientists, academics and lawmakers could somehow come up in advance with a magical carbon tax rate number that would then generate a certain desired empirical reduction in the gas. Thus, the main critique of the carbon tax proposal is that we may very well set a carbon tax, only to discover in the end that the realized reductions resulting

in the tax are insufficient to achieve the environmental goals. The sponsors of the cap-and-trade approach point to the fact that a cap-and-trade regime can be better structured to achieve a specific environmental benefit. You enact a system that will automatically continue to adjust the cap until you obtain the desired reductions in greenhouse gases. And so this option may be more appealing to the environmental advocacy groups, because their objective may be to reach some targeted goal.

States participation in multinational summits, the initial signals from the Obama administration indicate that they want to have a very active international role. It’s not clear whether Congress will approve a climate change this year, or whether our new and more aggressive participation in upcoming international climate change summits could end up catalysing our legislative process. •

The counter-argument from some in the business community is that that an unchecked cap-and-trade program could inadvertently create unforeseen and damaging economic impacts. One of the things that I consistently hear from domestic manufacturers is that, if we unilaterally impose a strict cap-and-trade program on American manufacturing while leaving other similar operations sited in other countries relatively untouched, we may possibly drive a lot of our manufacturing capacity offshore. The one important dynamic I will point to is that while the Republican administrations were very cautious on greenhouse gas measures, especially with regard to United

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Perspective from the United States Interview with Jeffrey Glass

As a managing director at Bain Capital Ventures, Jeffrey Glass focuses on wireless, digital media and consumer marketing technologies. Prior to joining Bain Capital, Jeff was president and CEO of m-Qube, a Bain Capital Ventures portfolio company recently acquired by VeriSign. In 2006, Jeff was voted Ernst & Young Entrepreneur Of The Year® in New England and named to the Boston Business Journal’s “40 under 40” list. Jeffrey Glass Bain Capital Ventures

Ernst & Young: How do you view the current difficulties in the exit environment? Jeffrey Glass: I think it is important for folks to distinguish between the different impacts of the poor exit climate and the overall slowing economy on venture capital. With respect to the slowdown in M&As and the shutdown of the IPO window, the lack of a supportive exit environment certainly has a negative impact on venture, but not a lethal one for well-capitalized, strong companies. It slows down the time to exit, which has a negative impact on Internal Rates of Return (IRRs). But that alone does not negate the fact that even today, amid all the chaos in the world, there are transformative companies being started right now that in several years will create tremendous equity value. The companies that should be exiting today were created four to eight years ago. At that time, no one could have known that when they were mature and ready to go public or to be acquired, we would be in the middle of a really tough time right now. Similarly, markets were hot the last few years, and there are a lot of companies that had great exits during those years that benefited from market conditions you couldn’t have forecast five years or seven years earlier.

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I really believe that venture capitalists can’t be in the business of forecasting the capital markets but need to stay in the business of identifying great entrepreneurs and emerging markets and providing patient capital and sensible advice to bring those two together. The companies that should be exiting right now have built good business models, they’ve got strong intellectual property and they will use this market to get stronger. While it may or may not have a negative impact on their IRRs, depending on how long things stretch till they see liquidity, they will ultimately in a binary sense still be successful. For early-stage companies, it becomes more important than ever to be well capitalized and not to depend upon being purchased in a pre-profitability state — this is always good advice. But as sales cycles get stretched out and revenue plans get delayed, it has a cash impact, and most venture-backed companies, at least at the early stage, are not profitable. So it’s all about cash. You have to be more prudent than ever because that cash is either more difficult to come by or more expensive. There is a tendency to think that everybody needs to cut their burn and hunker down. For some companies, that’s true. But for others, the downturn is clearly an opportunity to gain ground on their competitors. For a

“Venture capitalists are working even harder right now to figure out which of their companies should get more aggressive and which ones should take costs out.” small early-stage company, a handful of new customers can be all the difference between a bad year and a great year, an unprofitable business and a profitable one. I think the seasoned venture capitalists are working even harder right now to figure out which of their companies should get more aggressive and which ones should take costs out. Ernst & Young: What advice are you giving to your portfolio companies? Jeffrey Glass: Build a company-specific strategy, not a generic strategy based on everything you read in the newspaper. For some companies, the right strategy is to get more aggressive — take more money, even at a higher dilution, because you can really accrue value. Others haven’t figured out their business model and might be a little bit ahead of themselves with respect to spending. That’s generally a bad thing to do, regardless of the economy, but the cost of being wrong right now is even greater because the cost of capital is higher. Those companies really do need to hunker down. Investments should be thought about with respect to the value creation expected versus the cost of capital. In some ways, it’s a very simple formula, but more attention is being paid to it now because of the bad market

conditions and difficulty in raising funds. You need a higher hurdle rate with respect to how much value creation you will get from that incremental fund raising. In difficult times, all business decisions get harder to make. Everybody becomes more cautious and thresholds are higher. The same is true for venture-backed companies. The threshold is higher on whether we should hire that incremental couple of engineers to build out that new product idea. We think it will be big, but who knows? The cost of capital has risen so we want to make sure that our cash lasts just a little bit longer. That is true for all. An area that I always focused on as an entrepreneur and now push my portfolio companies on is to make sure they are at the top of their game from an execution standpoint and are really able to succinctly and precisely prove why their product or service has ROI/economic benefit. Companies or consumers aren’t willing to take many fliers in the current economy.

The interesting opportunities are related to the characteristics of the businesses, irrespective of industry. To the extent you are selling a product based on ROI and/ or cost savings as opposed to a new way for somebody to spend more money, you certainly have an easier pitch. We see it in digital. We see it in healthcare where companies are building solutions to help healthcare providers bring cost down. We see opportunities for companies that are building solutions to threats in both physical and digital security. We even see it in infrastructure software where real ROI has never been more valued by enterprises. I feel a little reticent to say this, but I feel very fortunate and optimistic to be a venture capitalist investing right now. I certainly prefer to be investing in these current market conditions than at the top of the market. We are not always perfect, but we try to be grounded in good times and bad times. •

Ernst & Young: Many great venture-backed companies were founded during down economic periods. What segments today are most likely to generate new market leaders? Jeffrey Glass: I don’t think the right way to think about it is on a sector or industry basis.

Global venture capital insights and trends report 2009

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From survival to growth

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© 2009 EYGM Limited. All Rights Reserved. SCORE No. CY0057 This publication contains information in summary form and is therefore intended for general guidance only. It is not intended to be a substitute for detailed research or the exercise of professional judgment. Neither EYGM Limited nor any other member of the global Ernst & Young organization can accept any responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this publication. On any specific matter, reference should be made to the appropriate advisor. The views and opinions of third parties set out in this publication are not necessarily the views and opinions of Ernst & Young. Moreover, they should be seen in the context of the time they were made.