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While the business environment for emerging technology companies remains challenging, respondents to law firm Foley & Lardner LLP's annual emerging companies survey revealed clear signs of optimism toward business growth.
For the past six years, Foley has surveyed top executives, investors and advisers in the emerging technology industry to gauge their attitudes and perspectives on the current business environment. This year's survey, completed by nearly 200 respondents, found that although tech entrepreneurs are facing a radically different financing environment and grappling with mixed economic indicators, they are optimistic in forecasting their growth over the coming years.
On the heels of very strong predictions for emerging company valuations in 2009, respondents expressed even more optimistic forecasts in the 2010 survey. An overwhelming majority of respondents (83%) now expect emerging company valuations to grow over the next two years, compared to the mere 38% predicting growth in 2008.
Respondents also continue to believe access to capital will improve over the next two years. While respondents were extremely pessimistic in regard to access to capital in 2008 (only 30% predicted growth), the 2009 and 2010 surveys saw a significant turnaround with 73% and 69%, respectively, expecting growth over the next two years.
Despite optimistic predictions for growth, entrepreneurs continue to experience a difficult financing environment with 45% extending their time frame in an effort to raise capital and 39% seeking capital from alternate sources. One respondent indicated that alternative sources are "the only realistic way for most early-stage startups to raise capital." Respondents also articulated several difficulties in seeking capital from alternate sources, including that "access is not as widespread" and they are "less interested in providing greater amounts of funding."
This year's survey also found that 80% of respondents believe investors prefer quick, safe investments and smaller returns, as opposed to risky bets on companies that could generate a significant return. As the venture capital paradigm continues to shift, investors seem to have less appetite for risky investments and are instead focused on smaller, more predicable returns.
At the same time, 62% stated that emerging companies are experiencing greater difficulty closing B-round funding as opposed to A rounds. As investors focus on quick in-and-out companies and safer returns, this finding suggests that some investors prefer A-round investments that require less capital, as well as late-round investments (that is, C or D rounds) that offer smaller, but more predicable, returns.
Current economic conditions are also influencing this trend. Many emerging companies have become more capital efficient during the recession, particularly by outsourcing business functions, and are able to utilize small amounts of A-round or angel-round funding to produce high returns for investors. In their written comments, respondents indicated that "established companies are being scrutinized at much higher levels" and that A rounds offer "more opportunities for diversification into multiple promising companies with low valuations."
On the other hand, B-round investments have been more difficult to secure because these rounds often require investors to commit additional capital to a business that may have stalled due to the economy with the potential for only moderate returns. Further compounding the problem, investors who have worked through a market of dismal returns are still nursing their wounds and, as a result, are understandably reluctant to put larger amounts of capital at risk.
It is interesting to highlight the fact that a noteworthy segment of respondents (38%) disagreed and felt A rounds are actually more difficult to secure. These respondents indicated various explanations in verbatim feedback, including that investors are: "looking for an established revenue stream," "protecting their A-round money" and "[expressing] little appetite for innovative ideas that need to have proof of concept established."
On the positive side, emerging company executives were very optimistic in hiring activity and predictions. A high percentage of executives indicated hiring both full-time (39%) and part-time (45%) employees in the past 12 months. In addition, nearly half (47%) expect to hire one to four full-time employees, and 31% plan to hire five or more in the next 12 months.
With small businesses widely considered to be a key engine for job creation in our economy, such optimistic hiring predictions are encouraging and indicate emerging tech companies are ready and willing to invest in business growth to meet and stay ahead of increasing demand.
Consistent with earlier surveys, M&A remained the primary exit strategy for the majority of responding executives (58%). Accordingly, respondents also continued to acknowledge the influence and prevalence of strategic buyers in today's market. The vast majority of respondents (82%) agreed that emerging company business plans continue to be influenced by the known needs of strategic buyers, which is consistent with the 77% of respondents who agreed with this notion in 2009.
Although entrepreneurs are no doubt influenced by the needs of strategic buyers, this year's survey suggested that they are not tailoring their growth and strategic plans to the same degree. While a majority (57%) of executives indicated tailoring to strategic buyers this year, this represents a significant decrease from the 71% who answered in this manner in 2009.
While the 2009 survey found emerging companies in distressed situations looking to the M&A market for survival, this level of desperation to sell was not apparent in the 2010 survey. With the private equity market resurging, executives seem to recognize strategic buyers and M&A as just one of many viable exit strategies. For instance, since 2005, the number of emerging company executives citing a strategic partnership as their likely exit strategy has steadily increased from 9% to 16% in 2010.
In querying views on the IPO market, this year's survey found a continued reluctance among executives, with only 5% citing an initial public offering as their likely exit strategy. However, some optimism emerged in forecasts for the overall IPO market in the near term. In 2008, only 1% of respondents predicted a robust IPO market over the next two years. However, this figure has steadily risen to 18% expecting growth in the 2010 survey. We expect this outlook to continue as long as the economy shows steady improvement and the technology sector, which typically serves as a leading indicator for the IPO market, remains robust. Groupon Inc.'s recent decision to forgo a rumored $6 billion acquisition offer from Google Inc. to instead potentially test the IPO market in the coming years is a potential reflection of this optimism.
Foley's 2009 and 2010 surveys have revealed clear progress in the business environment for emerging tech companies since we surveyed the market in 2008 during the peak of the economic downturn. The optimism around hiring and growth forecasts are important signs that the economy is improving, however, tech startups are now operating in a very different financing environment and have had to adjust their strategic plans accordingly.
Gabor Garai is chairman of Foley & Lardner LLP's private equity and venture capital practice, and Susan E. Pravda is chairwoman of the firm's emerging technologies industry team. For the past six years, they have coordinated Foley's annual survey of the business environment facing emerging technology companies and investors.
