JULY 23, 2003 VENTURE CAPITAL
By Gabor Garai


The Return of Trickle-Down Funding?
If Corporate America's mergers-and-acquisitions revival gathers strength, VCs will have more cash for startups


By Gabor Garai
Gabor Garai

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Why should startups care about recent large-scale acquisitions, such as EMC's (EMC ) purchase of Legato Systems (LGTO ) and IDEC Pharmaceutical's (IDPH ) deal for Biogen (BGEN )? Because that activity in the software, medical, and other arenas may well signal a resurgence in venture-capital investing. Here's why:


When mergers resume after an economic downturn, history tells us that they usually begin at the high end of the corporate food chain and are followed, sooner or later, by an increase in activity among midsize and smaller outfits. Such an upturn sends a positive signal to venture capitalists on several fronts (see BW Online, 7/23/03, "What the Real World Is All About").

REDUCED RISKS.  First, it increases their confidence that they will be able to cash out of new investments within a few years and walk away with sizable gains -- the reason they invested in the first place. Along with initial public offerings (IPOs), divestiture is a key way for venture capitalists (VCs) to cash out. Also, a vibrant mergers-and-acquisitions (M&A) market helps reduce a VC's risks. Over the last few years, in which we've witnessed a moribund M&A market, VCs have been unable to transform most of their existing investments into cash. This has meant that they have been obliged to reinvest in their existing holdings, rather than turn over their stakes to acquirers or the public markets.

Second, an active M&A market provides both VCs and entrepreneurs with vital data for valuing an investment. Much like real estate professionals, VCs are always on the hunt for "comparables" -- similar deals that can guide the process of placing a value on a young business. Such valuations determine how much of a company an entrepreneur must make available to investors, and at what price. One of the major difficulties entrepreneurs and VCs have encountered when negotiating the value of startups over the last few years has been the relative absence of these yardsticks.

So, once the M&A market has truly picked up, VCs will enjoy more opportunities and a more accurate means of establishing the value for new ones. Beyond providing relief for venture capitalists, the prospect of a renewed venture-investing marketplace promises to increase the amount of funding available to new companies. With venture capitalists better able to cash out of their existing investments, the money generated will be available for new deals.

COMPARE AND CONTRAST.  What can entrepreneurs do to take advantage of any improvement in the venture-capital climate? One important step would be to monitor those M&A deals being made by publicly-held companies, and to do so with a special view to pricing trends in the entrepreneur's particular industry. Such deals are usually based on a multiple of sales and/or earnings, among other factors. As one example, if you are starting a company to provide a new generation of data-storage devices, then you could reasonably look to M&A deals involving publicly-held data-storage companies to support your own valuation arguments. Believe me, nothing does more to validate a valuation than a current set of comparables.

Of course, it's possible that the recent spurt of corporate mergers is just a temporary blip, one that won't trickle down. But whichever way the M&A market goes, the smart entrepreneur will be following its trends and taking notes when attempting to determine the financing strategy that best suits the conditions of the moment.


Gabor Garai is a partner in the Boston office of the national law firm Epstein Becker & Green, specializing in the financing and growth requirements of small and midsize companies.
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