What are the prospects for raising capital for education technology companies in the current financial meltdown? Last week at the SIIA Ed-Tech Business Forum a panel of investors tackled this question. The panelists presented some solid and detailed advice for investors and companies seeking capital during the recession.
- Many investors are seeing Education as a safe harbor in a turbulent market, it is seen as relatively recession resistant. Education’s profile is rising as a marquee investment arena for the next 10 years – it is a good time right now for education.
- Take in as little as possible at as light a valuation you can get because valuations are going to be low for a while.
- The strong are going to win big in this downturn. Access to capital is going to be an important differentiator in this market.
- Most venture firms are not looking at new deals, they are focused on down rounds and propping up existing investments. They are also all moving up the deal chain to safer investments than they make in normal times. If you are raising money be aware of this.
- It is all about being profitable per customer in this market. Hope isn’t a strategy – go get paying customers and drive a lifetime revenue model
- Focus down on the core of what you have to provide and strip the organization down to doing just that. Have a crystal clear picture of who your customers will be, how they will find the money, and what are the essential features.
The panelists were:
- Moderator – Chris Curran, Managing Director Berkery Noyes
- Frank Bonsal III, Partner New Markets Venture Partners
- Kevin Custer, Founding Partner, Arc Capital Development
- Lou Pugliese – President Learning Diagnostics
Chris began with an overview of the market trends. Many investors are seeing Education as a safe harbor in a turbulent market, it is seen as relatively recession resistant. He noted that there is a huge capital overhang – investors have lots of funds but are making few investments. In education fundraising is actually up this year but we are seeing deals that are over capitalized. Later on Frank made the case that this is a bad deal from the entrepreneur’s side.
Most investment groups are setting the bar higher for new deals. Investors are looking for $10m Revenue and $2m EBIDTA which leaves out most K-12 Ed-Tech companies. Companies at this size need capital to invest in Sales and Marketing to scale up. Lots of education companies with good products in the last 10 years have failed because they couldn’t get past this hurdle.
His slides include a list of the private equity investors in education and a list of 100 deals that have been done in the education space in the past two years.
Follow below the fold for details on each panelists comments and the audience Q&A.
The panel then turned to the individual panelists for their perspectives.
Frank Bonsal – Partner New Markets Venture Partners
He urged companies to avoid getting overcapitalized in this market – it leads to all kinds of problems. He thinks that resource constraints provokes good design and decisions (and I for one agree wholeheartedly). Take in as little as possible at as light a valuation you can get because valuations are going to be low for a while.
Most venture firms are not looking at new deals, they are focused on down rounds and propping up existing investments. New Markets Venture Partners are normally series A and B investors – but now they are doing more growth stage investments because they can get it at a deal now.
His general advice to education investors boils down to:
• Invest in people
• Syndicate risk to several partners
• Tranche in money to spread the risk over time
Frank also noted that the highest returns in the education space are in Higher Ed. But he strongly made the point that K-12 is the bigger pie and the inefficiencies are much higher in this segment.
Kevin Custer, Founding Partner, Arc Capital Development
Kevin stated that the need for focus is more urgent than ever. It is all about being profitable per customer in this market. Hope isn’t a strategy. If you go get paying customers and drive a lifetime revenue model the capital markets will open up to you. Arc is seeing an increase in investment opportunity and they are pulling deals out of Angel Networks.
From a market opportunity perspective Kevin spoke to the mindset of School Districts and where they are likely to continue spending in a recession when their budgets are being cut. They see four themes;
1. Districts will cut budgets and because staff are 80% of expenses they will let go teachers. Don’t be loud about your big sales right now.
2. School Districts need to protect their income stream by keeping more students in schools. Solutions that help with attendance and graduation rates will do well.
3. Save them money by making their operations more efficient or by saving teachers time.
4. Show performance improvements – be able to demonstrate success.
He encouraged entrepreneurs to conserve money so they can get their products good enough to solve these needs. Focus down on the core of what you have to provide and strip the organization down to doing just that. Have a crystal clear picture of who your customers will be, how they will find the money, and what are the essential features.
Of course this advice should apply to entrepreneurial ventures in just about any market – but all of us need to raise our game in this climate.
Arc Capital’s goal is getting companies to $5 million in revenue and positive EBITDA – you will not raise money right now without meeting these metrics.
Lou Pugliese – President Learning Diagnostics
There are some new investors entering the market now because this industry is perceived to be recession resistant. Education’s profile is rising as a marquee investment arena for the next 10 years – it is a good time right now for education. It is a great environment for savvy investors.
All investors are moving up the deal chain in their investments to lower their risk profile. Existing funds with investments in quality companies are putting more money there as a survival tactic rather than making new investments.
In Lou’s view the strong are going to win big in this downturn. Access to capital is going to be an important differentiator in this market. A strong balance sheet is now more important than normal (he said 10 times more important than normal). This makes a profound difference in valuation multiples right now.
There are incredible opportunities to hire talent right now. Lots of people out there and it is a good time to strengthen your team.
Successful companies looking for a 2nd and 3rd round have presented a good case for the short and long term profitability and exit strategies. Good companies that raise money well understand how to articulate their business model at the other end of the downturn – what will the company look like when we emerge from this downturn.
Most later stage investors understand they will not exit as quickly – which is driving more syndication. So start building your syndicate relationships well before needing capital.
His theme – “We’re open for business… but don’t enter in a Tuxedo with your zipper down.”
Chris – He asked the panelists to respond to the following concept. The structure of deals has moved away from cash only deals to things that involve what he called “invitations to litigation” – earn outs, stock swaps, seller notes, etc. You can do deals at similar multiples to what has happened in the past couple of years – but the deals have a lot more hair on them.
Frank – Cap tables are getting flushed out in this environment but you do need to protect management.
Kevin – Valuation is the ultimate battle for companies that are under $5 million. The trend is really strong to taking care of management whatever is going on. Deal structures in early stages are being done as a note into the company as an 8-12% return convertible to equity at a discount to whatever the first professional money is. The goal is to get to the point where professional investors can do real valuations (25%-50%). They understand these deals and are comfortable with this. Then management and investors are all focused on going and building the value of the business.
Q – When will the investment markets loosen up for Education Technology companies?
Lou – If you look at 98-99 there was a 10 year recovery. Most organizations now are focused on surviving the next 15 months.
Keven – in 2000-2002 there was a v shaped recovery – drop and rapid rebound. They don’t see this – Arc Capital expects a 3-5 year swing because so much equity has disappeared which will trickle down from the investment banks to early stage investments. People are going to invest in cash flow, not ideas.
Frank – It is a triage runway. Companies selling to the Fortune 500 are getting whacked right now – they just need to figure out how to survive. His firm expects to take some write offs from these investments. Frank because he is focused on Education has a different (more positive) perspective.
Q – What is the impact of the recession on due dilligence?
Chris – This has increased exponentially in the past few years regardless of what is happening elsewhere.
Kevin – It is easier now to do this with on-line deal rooms where all the documents are available easily. If you are raising capital – you need to show all of this easily as part of your preparation. It is an expectation.
Lou – Investors are seeking a more explicit depiction of NPV.
Q – Are there patterns of success in good companies in markets where they do well?
Chris – Look at the big publishers – they are looking at massive disruption. If you have a tool that gives information back to a school that helps them manage the schools – 09 is going to be a big year for those kind of companies. Smaller companies always contend with the channel development issues – but this may be an opportunity to get in with the big guys.
Kevin – Schools in CA are not paying on done deals. Stay away from there for 6 months – they are in a total freeze because they don’t know where the budget cuts are coming from. If you can’t see the next six months you are not going to make it. Look to Texas and other markets.
Lou – States are extending terms on all business – this will put pressure on cash flow.
Question – Federal dollars are still flowing and they fund a lot of education technology. Is this still a stable source?
Chris – yes and the Obama administration is positive on tech as well.
Frank – are you better off focusing on state or federal funding? Federal is pretty clear for a short term focus.
Kevin – Companies under $5m in revenue have trouble seeing the Federal Funding – they don’t understand their customers well enough. If you can master this you will have a leg up on your competitors.