Tuesday, October 2, 2012
How TVC Aims At Acquisitions, Not IPOs, with Jeb Spencer
Story by Benjamin F. Kuo
Southern California's technology community--despite all of the recent excitement around Silicon Beach--continues to be underserved in terms of capital, with a lack of venture capital funds (with money), and other private technology investors. One issue has been a difficulty by indigenous funds to raise their own capital from their limited partners. One of the few local funds to recently raise a fund is TVC Capital (www.tvccapital.com), which just closed TVC Capital II, a $75 million growth equity and buyout fund. We thought it might be interesting to talk with one of the fund's managing directors, Jeb Spencer about the fund's success in technology investments, plus how it managed to raise another fund in this kind of environment, plus its unique goal of getting companies to an acquisition--and not an IPO.
As a reminder to our readers, can you talk briefly about TVC and what kinds of companies you invest in?
Jeb Spencer: We consider ourselves a private equity firm. We are focused on the investment in and acquisition of software firms that are generating $2.5M to $10M in revenues and are tracking towards profitability. These companies have built a leadership position in the market they serve, and they meet a mission critical need of their customer base. They've grown their businesses through word of mouth more than through a large, established sales organization and they have done that by building a software product that is very well received, and unique in their particular niche market. In about 80 percent of the deals we do the companies have raised very little money and have mostly been bootstrapped. The management team is used to running the company without significant capital and they are big believers in capital efficiency. This mentality allows them to grow without significant additional capital into our targeted revenue range. Our day to day focus is to work very closely with our companies to help them grow to $15M to $25M in revenues in about three to five years, at which time we'll likely seek an exit to a strategic acquirer.
You've just raised a new fund, very rare nowadays here in Southern California, can you talk about why you have been able to do so?
Jeb Spencer: Institutional investors have only one way to judge emerging managers such as us and that is through past performance and the number of exits you have achieved. Our 2011 exits of Accordent Technologies and Del Mar Datatrac (DMD) put us in the top decile of performance for 2007 vintage year, private equity funds. The second reason is that we are a hybrid fund with a unique strategy. There are components of venture capital and private equity in our strategy, but we are differentiated compared to other funds. We raise small amounts of money, invest small amounts of capital, and focus on overlooked companies that are never likely to be the next Zynga or Linked In, but will yield attractive returns upon exit. Our portfolio companies are likely to grow to $20M in revenues, and likely to be attractive to a public acquirer, but they're completely unlikely to get to an IPO or to an excess of $100M in revenues. Because of that, most of the deals we do are not "sexy" enough for venture capital, and on the private equity side, are below the $10M in revenue that these firms would typically seek.
We also have an approach of working "in the trenches" with our management teams, and believe that those operational inputs, and our extreme focus on capital efficiency helps differentiate us from many of the other firms out there. In addition, we had very strong support from our existing limited partners, and we were also able to attract new investors who saw our performance and saw that we were unique among the 1,900 other funds out there trying to raise money right now. I will also add, and this is hard to quantify, that my co-founder and TVC partner, Steve Hamerslag, is just an animal when it comes to establishing new relationships and getting our name out there across the country. His targeted marketing efforts really helped us find funds that invest in vehicles like ours, and we were able to raise our fund without a placement agent.
When it comes down to it though, more than anything, it's all about exits. That focus on exits is what is causing so many problems for funds across the country out trying to raise money. Many 2006-2008 vintage year funds are behind schedule in achieving exits due to the macro-economic environment we have all faced over the last five years.
How much involvement you have had as a fund to make those exits possible, and how hands on are you in that process?
Jeb Spencer: A critical piece of our due diligence process, before we invest or acquire a prospective company, is to identify the likely buyers of this company. We say--okay, they're doing $5M right now, and we believe we can get them to $20M by building out their sales force, marketing team, and by establishing channel sales and building out the product. So, if they're able to get to our target revenue number, we believe the likely buyers would be company X, Y, or Z. We initiate relationships with those likely acquirers sometimes only a year into the deal, because it often takes longer than you think to get an exit for a company. Our in-the-trenches approach then involves working with the management team to help them professionalize the company across all of their functional areas, which results in building a stronger company and ultimately helping make them attractive to a large, public acquirer. There are four reasons an acquirer would see a company as a good fit: customers, product/technology, new market expansion and revenue opportunity. Those are the four areas that we are working on, from minute one of our involvement, to make sure we're building something of value for the long term.
Given that you're aiming at an M&A and not an IPO, does that affect how much you're willing to invest in a company?
Jeb Spencer: We often lose deals because we are only able to pay M&A multiples on our valuation upfront. Knowing that our exits are all likely to be achieved through acquisition, we have built a comprehensive database of software transactions that have happened in the last fifteen years. We know at a very granular level, by software sector, what a likely acquirer is going to pay. We can look at that data and determine that the M&A multiple is, for example, 3X revenue for this particular type of company, so the upfront valuation must be 3X or less. After all of the crazy valuations people read about, our initial valuation can sometimes be shocking to the entrepreneur, but once we show them the quantitative data for their software sector, they usually get more comfortable. Secondly, one of the reasons we like that most of our companies have been bootstrapped, is that it shows us that this particular management team is able to a lot with the little capital they have had. They've built their leadership position with a small amount of money, and by focusing on making their product the best product out there among the alternatives. Take the Accordent deal. One of our major competitors had raised $75 million. We raised only $4M, but our team was laser focused on always building the best product out there. The Accordent team spent less money on PR, fancy trade show booths and expensive management team members. Instead, they always stayed ahead of customer need, and were experts in predicting what those customers would want six months into the future.
That's what allows you to win in the end. You don't need to dump $75 million, $100 million into these companies. You just have to be very careful about where you spend every dollar, and make sure that if you are spending $1, you are getting a 2x or 3x return on that investment. We're really methodical about that approach. We call our deals execution plays verses a "build it and they will come" strategy. We see it as systematic effort to take a company from $5M to $20M through a series of steps that instills best practices, professionalizes the company and expands it, over time. I saw a deal yesterday where the company had raised $35M to date, and they're out trying to raise another $15M, but they've only gotten to about $5M in revenue. Plus, they've changed their strategy twice over the last five years, and acknowledged to me that the $35M to date has basically been a waste. That's not the kind of deal that is interesting to us. That is the kind of deal where the investors are unlikely to ever see a return on investment and it just amazes us that companies like this are ever able to raise money. I saw a statistic last week that three quarters of venture funded deals never return capital to their investors and I believe it.
What have you learned about getting a company to successful exit?
Jeb Spencer: It comes down to two key components. The first is having a unique position in your segment of the industry, and a daily emphasis on doing everything you can to keep building that uniqueness and differentiation over a period of time. Secondly, when we first started getting into this business, we thought that even if a management team might have a weakness, well that was no big deal and we could just step in and help. Since we had been CEOs of public and private companies we could always just help out, but that doesn't scale. Over the course of time, we have concluded you must have a very strong management team from minute one of your investment or acquisition. Ideally, those teams would be comprised of individuals who have been through a round trip before -- people who have built companies, gotten them sold, and already learned quite a bit from the mistakes they made in their previous effort. So those two things, uniqueness and a strong management team, are absolutely essential to building something of value -- something that will be attractive to an acquirer in three to five years.