Monday, November 17, 2008

Time for Management BuyOuts of VC Companies?

The numbers are clear: since 2007, hundreds of millions of dollars have been invested by VCs in new companies, or follow-on investments made in existing portfolio investees. Equally clear is that a number of VCs are in stasis; either they are not succeeding in raising new money, or they are winding down their current fund and shuttering operations to wait out the current market. Either way, the implications are clear: a number of portfolio companies must either grow organically without new funds, or find an entirely new investor syndicate to (a) support further growth, and (b) battle with incumbent VCs who will wish to retain their stake. In parallel, investees may find themselves with an entirely new set of investors if a retiring VC sells it sposition in the secondary markets - probably at a discount.

A question I am increasingly asked is whether, given the circumstances, it makes sense for management to pursue a buyout of a VC investment, rather than wait to see who shows up at the next board meeting. For later stage investees, I can understand the appeal. If a VC has limited follow-on funds to support its investment, management must slow growth and bridge the business through cost cutting and hardship. (This leads to what I've come to call the fundamental "Achievement Gap" between Canadian and American venture capital - backed businesses.) In this scenario, it makes more sense for management to perform if they own signficantly more of the business. Likewise, if a VC is discounting its equity position as part of a portfolio liquidation, managemetn may well want to offer the same money for better autonomy.

The key driver of any MBO is a belief that a placing more equity in the hands of management will drive more value in a business, through a combination of financial engineering (cost cutting) and strategic growth. At a thousand-foot level, it's easy to see how this might appeal. And, until teh market collapse this fall, the TSX Venture Exchange was a regular vehicle fo choice for achieving liquidity for VCs and increased holdings for management. Now, private debt might be necesssary. Certainly there are a number of companies that might have the early revenue, together with leverageable assets, that might attract the kind of debt that would finance an MBO. How will this play out? Something to watch.

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