Interview with Michael Patrick, Partner at Fenwick & West.

Yesterday's Buzz article featured the results of the survey by Fenwick & West entitled "Trends in Terms of Venture Financings In Silicon Valley (First Quarter 2009)" by Barry Kramer and Michael Patrick.  Today we are pleased to be joined by Michael Patrick, Partner at Fenwick & West.  Along with co-authoring his firm's quarterly survey, Michael focuses on venture capital financings representing both companies and venture capital firms, mergers and acquisitions and general corporate representation for a broad array of high technology companies in the information technology, life science and medical device industries. To view the entire Fenwick & West survey, or to sign up to receive the survey on a quarterly basis when published, please go to http://www.fenwick.com/vctrends.htm.

Michael, your recently released venture financings survey results offer both optimism and gloom. Will you give us your overall impression of the results of this survey?

The first quarter of 2009 was probably the worst quarter for the VC environment in a long time. It's the first time since the fourth quarter of 2003 that we've seen down rounds exceed up rounds and the first time since we started tracking valuation change data in 2004 that we've seen a decrease in the average change in valuations for companies receiving financing compared to their prior financing round. Having said that, there were some rays of hope. We saw that the percentage of up rounds did increase month by month over the first quarter. But it's too early to tell if this will continue.

The Silicon Valley Venture Capitalists Confidence Index reports the confidence level of Silicon Valley VCs at 3.03 on a 5 point scale, indicating an increase from 4Q08's reading of 2.77. As this is the first increase in the index in six quarters, should this number give us confidence that we are starting to see a turnaround in the VC industry?

It's hard to tell. As I noted earlier, there have been a few rays of hope in the venture financing numbers. But the increase in confidence levels in the VC survey may primarily be a reaction to macroeconomic developments. Major banks appear to have stabilized and the Nasdaq seems to be improving. This increased confidence may be more the result of people concluding that the general economy has finally hit the bottom and won't get worse, rather than concluding that the recovery is imminent. It could still be quite some time before the economy starts to recover.

We are hearing a lot these days about declining valuations, and your survey confirms this notion with down rounds exceeding up rounds 46% to 25%. This was the first time since 4Q03 that down rounds exceeded up rounds, and the largest amount by which down rounds exceeded up rounds since 1Q03. Do you feel that lower valuations are being driven by lack of competition among VCs, declining public company comparables, lack of an IPO exit option or all of the above?

I don't think there's a lack of competition among VCs. There are plenty of VCs in the market with money to invest in the right opportunities. But valuations have been driven down by macroeconomic concerns, reduced public company comparables and probably also by soft messages from limited partners to the VCs asking them not to be aggressive in making investments and capital calls right now. Certainly, a lack of liquidity events is an important factor in valuations. It means that VCs have to hold more of their funds in reserve for their companies that can't get liquid and because those companies can't get liquid the VC's have less time and resources to focus on earlier stage and new companies. Outside of life science companies, I think much of the focus right now has to do with who a company's customers are and whether, because of current economic conditions, the risks of those customers not buying a new company's products have gone up.

The Fenwick & West Venture Capital Barometer showed an average price decrease of 3% for companies receiving venture capital in 1Q09 compared to such companies' prior financing round, the first decrease since you began reporting the Barometer in 1Q04. Do you feel that there is a lag between corrections in the economy and private company valuations?

There probably is some lag. As the economy contracts, there are consequences that follow that take a bit of time to be felt, kind of like falling dominos. Banking crises trigger stock market drops, that affect consumer spending, that lead to reduced demand, that lead to layoffs, thus triggering further reductions in consumer spending, and so on. As I described earlier, venture valuations are influenced by these factors, albeit indirectly, and so it makes sense that there's a lag effect between general economic conditions and valuations.

Do you believe your survey results confirm the theory that the current lack of competition among investors gives VCs the ability to demand more favorable terms on their investments?

As I said before, I don't think there's a lack of competition. But it is true that VCs are being careful in how they invest their money right now. Their existing portfolio companies need more money to get through the bad times and the limited partners are likely encouraging the VCs to limit the size and frequency of capital calls right now. The bar has definitely been raised and it is certainly harder for companies to raise money. So it's not surprising that terms of investments are also getting a little more protective of the investors.

Your prior surveys have indicated the significant quarterly losses and gains in particular industries. Such specific industry information is not mentioned in your latest survey results other than to say that "the decline in investment was across all industries." Can you shed any light on trends that you are seeing in specific industries?

While the main trend was that all industries are down, it appears that in the last quarter cleantech companies were particularly hard hit, maybe because those companies are in a relatively new space where it's harder to predict future demand and there have already been significant amounts of investment in them. VCs may want to wait for awhile to see how economic conditions develop before investing significant additional amounts in cleantech. Life science companies seemed to be the least affected, which may be in part due to the fact that demand for their products, when they come to market, aren't as affected by gyrations in the overall economy. In addition, outside of life science companies, our anecdotal information suggests that those businesses that need less cash and are closer to break even have better chances of getting funded, presumably because they demand less of a VC's available funds and they represent less of a risk of needing more later.

Your report reminds us that there were no IPOs of venture-backed companies in the U. S. in 1Q09 while there have been two venture-backed IPOs to date in 2Q09. Your survey also points out that Nasdaq was down 3% in 1Q09 but is up over 10% in 2Q09 through May 26, 2009. Can we read any kind of trend or indication of a turnaround in these numbers?

Given the depth and breadth of the overall downturn in our economy, I think it's early to read too much into an upturn in Nasdaq and two IPOs. Solar Wind, one of the two companies that went public, is a 10-year-old company and profitable. Open Table, which was the other, is a relatively mature company that has been in business for eleven years and, although it had a loss in the fourth quarter, did report a swing to profitability in the first quarter. So it's not clear that the IPO market is likely to open to a broader array of companies. But these IPOs and the lift in the Nasdaq are positive signs and do make it easier for acquirers to consider increasing acquisition activities and for consumers to spend more.

As has been noted in your previous survey results, the downturn in the economy has shaped venture financing terms. It is becoming more common to see downside protection such as multiple liquidation preference, redemption rights, more aggressive anti-dilution rights and 'pay-to-play' provisions. Will you comment on the trends you are seeing in this area and how it is affecting VCs as well as founders and management?

Clearly, deal terms have gotten tougher in this downturn. But they aren't nearly as tough as the terms we saw after the dot. com bubble burst. After that bubble burst, lots of hard terms had to be imposed to correct for the excesses of the boom. The good news is that the VC and entrepreneur communities learned from that experience and so didn't repeat many of the excesses of the dot. com era. As a result, the corrections we're seeing now are much less dramatic. I don't think the downside protections we're now seeing dramatically change the risks and rewards for VCs, founders or management. The most important determinant of the outcomes of VC investments for all parties continues to be what the company achieves, not what downside protection terms are negotiated in the financing.

Michael, we thank you for your time and for sharing your insight into the survey results.

Source: http://vcexperts.com/vce/news/buzz/archive_view.asp?id=680&referrer=rss