Startup fatality rates, gene pool and exits

- a commentary on current VC trends

By Bipin Parmar

Popular wisdom and an ideal model for most VC funds in recent years has been the following benchmark: out of a gene pool of around 10 portfolio companies, three will be stars (ripe for IPO, M&A exits), three will be also-rans (walking dead) and four will be dogs (dead). Judging by the recent data from the Ernst & Young and VentureOne Insight Study, issues related to corporate scandals (governance and transparency), together with the need to demonstrate clear visibility towards profits (or at least break-even) before contemplating an IPO, a slightly different trend is suggested going forward.

M&A, and IPOs - Europe has greatest potential for growth

On average, 6.1 percent of the USA pool was acquired or merged, compared to only 3.4 percent from the European pool, clearly demonstrating that European M&A merchants have a lot of potential in their own backyard. Greater tenacity, collaboration, focused effort and expertise needs to be expended in this potentially lucrative area. The number of companies in IPO registration is higher in the USA due to its sheer size, but in percentage terms, the USA and Europe have the same percentage of companies that exit via IPO - namely 0.3 percent.

Percentage of exits due to outright closures

The number of venture-backed company closures for USA in 2003 was 8.5 percent, compared to a European figure of 8.8 percent, from a pool of 4,497 companies. The 396 closures in Europe burned through 3 billion euros. The average capital injection into a European company is only 7.3 million euros, compared to an average of 20 million euros for USA venture-backed companies. This could signify that either more of the European companies are at an earlier stage (Chilli S3, R1), or in our opinion, it's that European companies are managed on a starvation budget, hence explaining the lack of more successful exits in terms of outright numbers.

The Insight Study indicates that out of a pool of over 6, 623 venture-backed companies built over a five-year period, on average 10 percent went out of business on a yearly basis. Clearly, if no new companies were created or follow-on financing was not forthcoming, the total pool of companies would disappear in 10 years time. In reality, this is not the case as new companies are always being added to the total pool and a sizable number from the pool are getting additional rounds of follow-on capital.

Fatality ratio

The long-term sustainability of a given domain sector is dependent on how many companies went out of business, versus how many new ones were added to the pool. At The Chilli, we refer to this as the Annual Fatality Ratio. From the initial figures taken from the Insight Study, healthcare is on a sustainable curve, but the worst is information services at only 0.27, followed by communications at 0.33 and software at a respectable 0.91. The ideal ratio would be between 0.8 and 1.2, where weak companies are coming off the list, but new ones are added at a steady pace. But one must watch out if the ratio exceeds 1.5, as this may signify a possible build-up, which could lead to a bubble. Of course, the ratio cannot be looked at in isolation; it must also take into account the original size of the pool to begin with. There are 3 times more technology (communications, software, electronics, semiconductors) companies in the pool, as there are in the healthcare sector, signifying the different build-up rates and the previous fashionable sector.

Follow-on financing

Clearly, the underlying health of any sector also depends on the follow-on financing rounds, and the sector's ability to continue pulling in new investment capital. Taking 1996 as a starting baseline, out of the average number of companies that were eligible for follow-on financing, only 23.5 percent received their follow-on funding. The technology sector faired slightly better with communication at 29.5 percent, electronics at 28.7 percent, semiconductors at 28.8 percent and software at 24.6 percent.

This doesn't necessarily mean that the remaining companies will go bust, but it indicates that the mean period between coming up for more air (new funding rounds) is stretching from an average of 12 months to a 18 to 20 month period, with the trend growing towards the 24 month period. This will subsequently have a major impact on potential exit times, which are also stretching out further. Entrepreneurs, founders and CxOs preparing their plans should bear this in mind when calculating their burn rate and expense lines.

The other interesting finding from the Ernst & Young/VentureOne Insight Study was that for the technology sector, most of the follow-on funding is from existing investors, as opposed to the healthcare sector, where the majority of follow-on funding is from a new set of VC investors. Could this be related to the fact that existing VCs in healthcare have a better insight in the shortcomings and are willing to pass the higher risks to a new set of investors, while in the technology sector, existing VC are more intimately involved with their portfolio companies and want to reserve their seats at the dining table for the feast that is likely to take place upon successful exits?

As Uncle Thakur has realised, too many people at the dining table will spoil the ambience of the experience, and weaken the appetite.

Q4 2003 trends

The biggest sector for VC investments was still biopharmaceuticals, followed by software, communications, semiconductors and electronics. In terms of stages, the majority of investments - 54 percent - were at the R3, R4, CF1 stages while R2 commanded 21 percent, and S3, R1 (early-stage) commanded another 22 percent.

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© Chilli Publishing Ltd 2004

19APR2004