Local Finance Climate Improves By SHELLY GARCIA Senior Reporter Bankers are flush with cash. Stocks are gaining, and the IPO market is resuscitating. Could it be that good times are returning to the finance markets after several lumbering years? The Business Journal convened a group of investment bankers, attorneys and financial officers to try to answer the question. The panelists, Douglas R. Gonsalves, managing director of The Spartan Group, an investment banking firm in Glendale; Gordon Gregory, managing director of Mosaic Capital LLC, investment bankers in Sherman Oaks; Eric Larson, CFO, 5Square Systems Corp., a Westlake Village-based firm that recently completed a $12.5 million funding round, its first; and Brent A. Reinke, a partner at Reed Smith LLP, whose practice focuses on M & A; all agreed that the climate is improving, more for some types of companies and some types of deals than for others. Question: Expectations were high as we entered 2004 that the M & A; and finance markets were due for a strong rebound. What is your read of the climate as of the first quarter of the year? Reinke: I think there was an expectation that there was going to be a greater increase in activity than there has been, but I think it has picked up. I’m also seeing a lot more discussion about M & A; activity. Is it really turning into an M & A; transaction? Not yet, but I think a lot of people are talking about doing or wanting to do deals. Gonsalves: I think it has so much to do with the stage of the company. If you’re a $40 million or $50 million company it doesn’t get any better than it’s been over the last twelve months. Now that’s a pretty narrow window. Earlier stage companies I think it has been very difficult. If you look at the numbers that are coming out in Hart-Scott-Rodino filings, (required for mergers of a certain size) those are up 40 percent, in the first quarter from last year. So it’s a pretty bullish sign. Q: Why do you think there’s been more activity with the larger deals? Gregory: You have a huge pent-up demand of buyers, not only strategic buyers but private equity buyers and one of the takeaways from the private equity conference I attended Thursday was they’re now looking at internal rates of return in the 12 percent to 14 percent range, which is staggering, because there are so many buyers. There’s five buyers or 20 buyers for very seller. Now the question would be where are the sellers? We’re not seeing a lot of sellers today. Larson: I think there’s still a gap between expected valuation from buyers versus sellers. Just from speaking to other smaller, privately-held owners of businesses, what they think their business should be worth, what they think they can do over time and, if they’ve made it through all of this, they believe the upside is still in the next two or three years and they believe they should be paid for it versus the buyers. Until that gap comes together there’s going to still be a wait-and-see attitude. Q: What dynamics are you finding in the VC arena? Larson: I would say things have gotten better than what we’ve seen over the last six or nine months. If you’re a good company where you’ve got a seasoned management team, product that you can show works, there is a lot of interest and things are moving much faster than they used to. If you’re a startup that’s got maybe some first timers on the management team you’re still going to struggle. We’re fortunate in that we have a seasoned management team. Everyone’s done it before. And even with that, (we waited until we launched our product,) we knew it was going to be difficult until we had customers that the institutional community could call up and make sure the product really does what you say it does. Gonsalves: I think the VC market is only beginning to recover now for early stage. If you look at the VC market and you look at how capital is being deployed, you’ve got a bunch of VCs that look more like the private equity funds. They’re doing “C” and “D” and “E” rounds (advanced stage funding), but they’re not touching “A” and “B” rounds, and so there is no access for most companies to early stage capital right now. Reinke: (Angel investors) are saying they are seeing better deals now by far than they’ve ever seen before because a lot of the deals they’re doing were deals the VCs used to do. And even (angels) will not invest in a company for the most part unless it’s got a revenue stream and some customer validation to reduce the risk factor. Q: There have been more IPOs in the first quarter of 2004 than in all of 2003. How are those companies doing? And is the volatility we’ve seen in the stock market going to catch up to the IPO market? Gonsalves: How are they doing? Mixed. Is it going to catch up? If there was a correction in the public equity market does that kill the IPO market, we don’t know because the IPO market has so lagged. It’s now just starting to get some momentum, and it’s not open very wide. Q: What are some of the differences between the funding markets now versus the bubble of the late 1990s? Gregory: I talked to one fund that specializes in the food sector and for one of their funds that’s got about two years left they made a decision to return capital to their partners because (they found no investment opportunities) they have the next fund going and they did not want to do anything that was adverse to the interest of their investors. Gonsalves: Twelve to 14 percent internal rate of return hurdles are unprecedented for private equity. And it’s just supply and demand. I don’t think these guys are pleased to see their return hurdles dropping, it’s just that they have no choice. They have to deploy the capital. Q: First quarter earnings so far are looking good. Do you see the performance coming from continued cost cutting or from real growth, and how are improved earnings affecting the M & A; picture? Gonsalves: That’s the question. Is this the end of the cost cutting efficiencies running through the cycle or is it good healthy businesses that are starting to grow? I don’t know how that’s going to shake out, but I think it does play to the M & A; equation. If things continue to progress, they’re going to start looking to revenue growth and if they do that M & A; becomes one of your key tools in generating revenue growth. Q: Have exit strategies changed for investors since the bubble? Larson: I think now in the conversations it’s make sure you’re setting the company up not just to be a product but to be a true company, to be a standalone company you could take public and have a management team in place that could handle it. So I would say your exit now could be both (acquisition or IPO). Gregory: Plus if you’re planning early you can make yourself look just like what they want to own. For example this company we’re preparing for sale we’re putting in a new distribution center. We know the distribution centers for the three most likely buyers. We’re going to look just like a plug and play when we’re done. We want to make this as easy to be acquired and that reflects in value. Larson: I will tell you that in the raising money circles where your power point presentation would have focused on what are the exit strategies, what are the comps, what are the privately acquired at what price, I think the financial community is much more interested in the operational issues. We’ll figure out the acquiring group of companies once we know we’ve got a profitable cash flowing company. For you to come in and say our goal is to set ourselves up so we can go in to the Cisco sales channel and be acquired for $200 million, or whatever, they don’t want to hear about it. (Investors want to know) what is the highest probability that you are going to be a cash flowing good company before the cash runs out? That’s all they want to talk about. Reinke: Maybe when you get to that middle stage and you’ve got cash flow then (investors say) let’s start planning an exit strategy. Larson: At some point in time you do have to cross over into that and it does have to be a concern but I would still say public companies aren’t doing diluted deals. It still has to be accretive; it’s got to be a cash flow company. So I still think even in a little bit later stage, which is where my last company was, it still is very much focused on let’s get this thing so an acquirer would say this is accretive on day one. Q: There has been a lot of discussion about the concentration of VC activity in Northern California and to the South in Orange County and San Diego. Do you think for companies seeking investment that it matters where they are located? Reinke: What will happen with a lot of companies we work with is even if they have great technology, great management, the VC will come in and say we’re really interested but you need to go up north or relocate to San Diego because we don’t feel this area currently provides the infrastructure you need to take this company to the next stage. And the only way you get there is by having companies establish themselves here, developing a talent pool and then having it regionally based. So it’s been particularly hard to keep some companies in this area on that basis. Larson: The 101 Corridor does have some successes. Maybe not anything similar to Broadcom in Orange County, but I’ve been with several companies now along that area and you do see more startups; there is a talent pool. I still will tell you we’re still spending 50 percent of our time up in Northrern California. There is a larger venture community up there. We have an engineering development facility that we keep up north, and there is a little bit larger specialized engineering talent pool and there is still that north versus south thing, and sometimes getting engineers to come down is not easy.