VC Surge Shifts Clout to Managers

As venture capital flows increase, start-up entrepreneurs gain some bargaining power.

Capital financing for start-up companies is making a comeback. After the dot-com bubble burst in 2001, the flow of venture capital into early-stage companies had all but dried up. Recently, however, investors have been returning slowly but steadily, according to a report that tracks quarterly venture-capital investments.

Released in early April, the study by Cooley Godward, a law firm, covers 73 venture deals that closed in the fourth quarter of 2005. Investment in those deals reached $916 million, a moderate rise from the $895 million recorded for start-ups hatched during the third quarter. But it was a sharp upturn compared to the decline of the previous year’s same period, when private company investment tumbled from $1.2 billion to $823 million.

The fourth quarter financings were smallish, averaging $12.5 million per transaction. That’s probably because 45 of the new companies were in their first or second rounds of funding, which tend to draw fewer dollars than later rounds do. Overall, the study examined companies within their first four rounds.

Last year wasn’t the first time the post-boom venture capital-spigot started to flow again. In fact, “a lot of dollars were raised between 2002 and 2003,” says Jim Fulton, a lawyer with Cooley Godward, “but much of that money was going to bolster companies that were on the rocks,” By 2005, however, 71 percent of the venture capital raised was funneled into early-stage companies—a sign that investors were once again ready to finance new blood and not just throw money after sputtering companies.

The investment climate for privately-held startups is in a “Goldilocks” stage, says Fulton. “It’s not too hot, not too cold, it’s just right.” And after living through the irrational exuberance of the bubble and the hangover period after it exploded, Fulton welcomes the idea that private company investment is now “in balance.”

There are other signals of increased investor confidence in the private start-up market. Consider that the enterprise values—the theoretical takeover price of a company—of startups receiving late-stage financing climbed to about $50 million for the fourth quarter, up from about $31 million in the previous quarter. “Folks that invest in pre-IPO companies feel more confident that there will be a liquidity event” like a merger or an initial public offering, explains Fulton. “Investors believe that when it’s time to sell, there will be somebody ready to pay a higher price.”

Further, at least 97 percent of all deals that closed in the fourth quarter contained a liquidation-preference provision, underscoring that investors anticipate a strong market for an IPO or merger. Initial investors pay a premium for the provisions, which ensure that they’re first in line to receive their payouts should a liquidity event occur. It would put them ahead of company executives or common stockholders.

That kind of investor confidence is a good thing for the entrepreneurs whose companies are backed by venture capital. Fulton points out that higher company valuations and high usage of liquidation-preference provisions mean that company executives may be in a better negotiating position with investors today than they were two years ago. The study cites other deal features that illustrate a similar shift in bargaining power.

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