CandidCapital

Venture investment agreements which once gave institutional investors a wide range of cumulative, preferred, participating rights went out of favour in the dot.com boom. As a result a number of investments made during that period persist as the ‘living dead’ – still solvent but unlikely to grow much beyond the life-style stage. Given how limited venture funds are in the UK, this is a waste. Investors must negotiate investment agreements that give them an activist role.

The Cold War is Back

‘What it all boils down to is this. I want the new closeness to continue. And it will, as long as we make it clear that we will continue to act in a certain way as long as they continue to act in a helpful manner. If and when they don't, at first pull your punches. If they persist, pull the plug. It's still trust but verify. It's still play, but cut the cards. It's still watch closely. And don't be afraid to see what you see.’

Reading these words from President Ronald Reagan’s farewell address to the nation from 11th January 1989 made me sit up and take notice. Not because of the seriousness of the issue (he was talking about negotiating with the Soviet Union’s newish leader, Mikhail Gorbachev), nor because of the extent to which the cold war seems to be back. No, at the risk of bathos, it was because what Reagan was talking about at the political level exactly described my new-found approach to negotiating with companies in which we as a venture fund have invested.

I have several friends who in their youth were devotees of fashionable libertarianism but who on becoming parents discovered their inner conservative with a vengeance, vengeance that became ever more ingrained as their offspring went to school. I suspect that I have done something similar where venture investments are concerned: at one time, I was an advocate of using the most simple, straightforward ordinary shares when making new investments; but after my recent experience in dealing with some legacy investments in our portfolio I can see the point of having as many investor special rights as possible.

Not Very Venturesome

The background to the argument runs something like this. Until perhaps 20 years ago, there were few venture fund managers in the UK and although the membership of the British Venture Capital Association grew during the 1990s, the BVCA came increasingly to parallel Voltaire’s quip about the Holy Roman Empire – it was neither holy, nor Roman, nor an Empire. Not only did BVCA members gravitate towards private equity (investing in established businesses with proven products and services) rather than venture capital – but even those who stayed at the venture end weren’t very venturesome.

Here the US and UK models are divided by an uncommon history. In the US, a significant proportion of the funds dedicated to unquoted equity has always been invested in young, technology-based firms; it is real venture capital and has been since the days when the very first VC fund (American Research and Development Corporation) was raised in Boston in 1946 by a team of management experts and applied technologists.

In the UK by contrast, the industry grew out of the banking sector. The Industrial and Commercial Finance Corporation was set up by the clearing banks and the Bank of England in 1945 to help fill the funding gap identified in policy circles since the publication of the Macmillan Report in 1931. ICFC’s approach to life was heavily influenced by its parentage: you can take the manager out of the bank but you can’t take the bank out of the manager. Many of the investment staff in the early days of this new Holy Roman Empire were from a financial or accounting background, with little knowledge of industry, strategy, marketing or technology.

For years ICFC concentrated not on the new industries favoured by its Massachusetts or Californian counterparts (High Voltage Engineering Corporation, Digital Equipment Corporation, Intel, Apple) but on restructuring established manufacturing businesses.

It Talks like a Duck, but…

The instruments ICFC used to make its investments came to be seen by many companies it funded as ‘having its cake and eating it’:
• preference dividends that ensure a secure income stream to investors as if the shares were really (perpetual!) debt with a coupon;
• multiple liquidation preferences, so that on an eventual disposal the institutional investors would get back several times their original investment before any other shareholders – including management – received any capital;
• rights to appoint board representatives or observers, charging the company quarterly fees;
• special voting rights, so that even if the institution only held a minority stake in the company it could still block many types of transaction, including capital expenditure;
• second charges over tangible security.

And so on. Funding of this sort in the 1970s and 1980s was only ‘equity’ in the sense that it did not technically come from high street banks, the main providers of debt. But though preferred participating and similar ‘shares’ might have been called equity, this was scarcely more than a legal fiction and many such investments could just as well have been called subordinated debt with warrants attached.

Such funding talked like equity but it didn’t walk like equity in the sense of being pure risk capital with an uncertain coupon.

Anyone for Webvan?

What does this have to do with either Mikhail Gorbachev or with my baleful legacy portfolio? When I first become interested in venture investing in the late 1990s, I swallowed much of the dogma of that unrepresentative age and in particular the view that VC investors should use the simplest possible shares. The new dogma was partly a reaction to the excess preferences and complexities of the previous decade or two and partly an outcome of the turnaround in perceived negotiating power.

The unventurous investors of the previous generation had been able to get away with belt-and-braces clauses because there was no significant competition to provide funding for firms whose requirements could not be met by the senior debt, working capital and invoice discounting facilities provided by banks.

By the late 1990s, not only was there much more competition but in the gold-rush freneticism of those years (when you feared that unless you moved fast you’d miss out on the next eBay) investors were prepared not just to invest at inflated prices but to do so on the least onerous terms. Pre-emption rights and liquidation preferences gave way to the imperative of simply getting a slice of the action.

The ex post facto rationalisation at the time for such a drastic change of investor policy was, of course, that the world had moved on, entrepreneurs were to be treated as trusted partners with investors, on terms of equality, and not disadvantaged by special rights retained by institutional investors.

But the outturn is now well-known: few of the investments made in the frenzied atmosphere of corporate speed-dating evenings (all of which, with what now looks like tedious inevitability, had wacky titles) proved to much more than one-night stands leaving investors with a bad hang-over and a worrisome itch.

Stop Drinking the Kool-Aid

Some investments made during the height of that party have been taking up most of my time recently. You will have worked out by now that they must be at least 7 years old, and for a fixed-life limited partnership (which is what most traditional venture funds are) such longevity just might imply good news: if we’ve held on to the investments so long, at least they are still alive; perhaps we’re just waiting for the right moment to decide between two competing offers from NYSE-listed West Coast corporations for our highly-successful portfolio companies?

Er, no. Granted, there is good news in the sense that rare among investments made in haste during venture capital’s unlamented Kool-Aid period, these two are still solvent. But as they know, our fund has a limited life and that term date is fast approaching.

When you have a clutch of likely success stories with a defined exit route (such a trade sale being negotiated, or advisors being short-listed for a stock-market debut) approaching our limited partner (LP) investors for an extension of the life of the fund is OK. But such a course of action is not attractive if the best I can say to our LPs is, ‘We have a brace of companies that over the past 8 years has gone nowhere very slowly, so could we please have an extension of the fund for a couple of years just to see if they manage to reach walking speed?’

Only LPs with a morbid sense of curiosity would follow us down that path, and the opportunity cost to us is too high in terms of time spent cajoling languid management teams who’ve found a comfortable groove in life and who will now do anything rather than rock their becalmed boat. The venture investment they received was not used as growth capital but as an expensive alternative to bank debt or research grants. Given how rare a commodity venture funding is in the UK, this is an inexcusable waste – and I accept that investors were as much to blame as investees.

This is where I can see exactly what President Reagan meant by ‘at first pull your punches. If they persist, pull the plug.’ Because with businesses which absorbed large amounts of real risk capital in 1999 and have since degenerated into life-style firms, it really is time to pull the plug.

Except that as minority investors with few of the special rights that went so badly out of favour in 1999, there is not much we can do to pull the plug other than be awkward to the point that the management team recognizes it will have to pay us some Danegeld to go away if it is to resume its long-term somnambulance.

And like the erstwhile Guardian readers who turn into fogeyish backwoodsmen as soon as parenthood is thrust upon them, I’ll make sure that the next investment agreement I enter into has every cumulative preferred participating right and ratchet in the manual: ‘It’s still play, but cut the cards.’

12 November 2007

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