They fail to reach their potential because a challenged or lacking of a clear “go-to-market” strategy. Simply, they have something new but really don’t know how to get it sold. I have seen this many many times over the years – this seems to be a constant challenge for almost all start-ups.

Further, given the world we live in today with the generally high requirements to go public (>>$50 million in sales, more likely approaching $100 million or more in revenues) the vast major of these venture-backed companies will not achieve liquidity via an IPO and are hence really “unadoptable”.

However, when strategically merged with the right company/partner these companies have a chance to grow and fulfill much of their original investment thesis – in most cases by bringing leading or emerging technology to the market. Many of these companies have value, but there is just this tremendous challenge for these private companies to capture it today. That is why you always hear about venture guys focusing on the latest “top-dog” technology (e.g., today that might be social media) because these companies are sold for strategy value not economic value (i.e., a function of their real revenues). The problem is, once a space is hot it is over-invested very quickly – call it venture capital markets myopia (all caught-up in the “top-dog” technology and very short-sighted in the market realities – creating investment bubbles, then bursting).

To daVinci, these unadoptable private companies can provide a wealth of strategic and economic value we can capture in building our platform/portfolio companies.  It is another, realistic way for private company investors and managers to both innovate and realize returns on their capital and efforts.

Our objective at daVinci is to help companies grow and become recognized by public market investors with higher valuations and greater liquidity. We are actively involved in this process as members of Boards, bringing additional ideas and resources to our portfolio companies. We are not short-term traders of stock, but investors seeking to build value.

But, we also have the objective and obligation over time to realize on our investments. How can this be done as affiliates?

Our approach to this issue is to have an arm’s length investment advisor (“IA”) to independently manage the realization of our investments over time following some initial general directions/rules. The IA is skilled and experienced in a variety of techniques to manage the process with minimal market impact. The IA process (including the resources of our prime broker) employs a variety of techniques to achieve liquidity while mitigating risks.

Our policy (which the IA must follow) is to never short sell a portfolio company shares – i.e., to never adversely affect our companies’ value, or “bet against them” as we are solely long investors. However, hedging against market indices and sector groups may be desirable through the process to accomplish liquidity and risk management goals for our investors.

In this manner we can continue to add value while realizing on investments according to our investment thesis.

The second fundamental is confidence with the game plan gained through mutual due diligence with our investment companies. We seek to increase value through a deep understanding of the current situation and the opportunities for growth. We are not “traders” motivated by short-term price/volume considerations, we are long investors.

The way we build partnerships and game plans varies. Sometimes, partnerships develop from of long-term relationships and several months of mutual due diligence. At other times, we may be more opportunistic and respond to a more rapid emerging and highly attractive situation.

However, in any case, we must be satisfied that we are in a true partnership for growth and that we understand the company, its markets and the future opportunities very well.

Our planned investments average $10 – 20 million in size and typically are structured as a direct private placement of initially restricted public securities. The form of securities could be common stock or convertible preferred stock or convertible debt, depending on the situation. The stock price (or conversion price) would typically include a moderate and reasonable discount to market, reflecting the initially illiquid nature of the securities and the large block purchase element. The private placement agreement would also specify access to ongoing company information and a board seat for daVinci as long as the stock is held by daVinci. We do not seek demand registration rights except under very unusual situations where these rights are justified, since we are not short-term investors.

Further, as the daVinci partner serving as a director would be considered an “affiliate” and be subject to rules regarding affiliates. And since the daVinci ownership would be likely over 10% of the total, the daVinci partner would not qualify as an “outside independent” director, and would not serve on the Compensation or Audit committees.

• Extensive personal networks of our four Principals
• Networks of consultants close to us and our staff
• Investment bankers
• Industry organizations, including frequent attendance at industry events
• Advisory firms, including attorneys, accountants and public relations.

Our deal flow network is very strong and results from our many years of experience in these markets. We are not only very well connected to the public markets (for example, through investment bankers), but we are also true Silicon Valley/Tech “insiders” with many years of trust with key venture capital. This places us in an ideal position to learn of opportunities that would otherwise not be shared with general private equity investors.

Our information source base is also very robust and facilitates efficient identification and evaluation of investment companies. And unlike venture capitalists that must evaluate hundreds of business plans before selecting an investment opportunity, daVinci need only evaluate dozens of companies to find good investments. Venture firms also have to sift through privately created business plans and presentations that often hard to evaluate without substantial independent verifications. In contrast, daVinci has the benefit of publicly filed SEC documents that must be completed with audited financial statements and meet stringent standards, such as Sarbanes-Oxley requirements. daVinci also has access to many other sources of accurate financial, sales, market, product and competitive information. These additional sources include databases (e.g., Capital IQ, Nasdaq.com, Bloomberg, Morningstar, etc.) that enable daVinci to concentrate its search in specific industry market segments rich with undervalued microCap companies. From there the Fund utilizes proprietary approaches to focus our efforts on companies that are good candidates for further evaluation.

Thus, daVinci’s approach can more quickly identify good opportunities and complete deeper due diligence in shorter time frames than in the venture capital or private equity worlds. This makes us active, nimble and knowledge-based investors in public companies.

We know that there are thousands of public companies that fall into this size range and thousands of venture-backed private companies that could be good strategic acquisition candidates for our public companies.

But what are we looking for in these “oceans” of candidates? Here are some factors:

1. Technology/Special Business Models. We are only looking for companies that participate in businesses with technology as an important component, even better if the investment candidate approaches the market with a novel business system concept.
2. Markets. There must be potential for growth within the market segments we look at and larger, stronger, companies must not dominate these markets. Growth factors for the business may include: technology changes, regulatory changes, demographics and other discontinuities. Availability of good strategic public or private acquisition candidates is a plus to the situation.
3. Valuations. We are interested in companies whose valuation metrics are at somewhat of a discount to larger companies in similar businesses.
4. Ability to Benefit by Additional Expertise. Many microCap companies do not have the management bandwidth to implement significant growth plans – daVinci can bring additional resources to bear.
5. Challenged at Present, but Capable of Change and Growth. Our investment candidates do not have to be perfect companies, and rarely would be so – but they must have the perceived ability to make positive changes and have problems that can be effectively addressed. For example, a attractive candidate may have good products but limited distribution channels, or established distribution channels but too narrow a product line or lagging competitiveness because of a missed a product cycle or a critical shift in technology. It’s also possible that a candidate may not have a competitive cost structure for any number of reasons including lack of economies of scale – this particular point may be remedied by strategic acquisitions.
6. Ability to Partner for Growth. We are ready to supply capital and ideas, but we can only do so if we are comfortable that management, the Board and us see the same forward direction. We will not invest in situations of conflicting views, and we will not take “Activist” stances to impose our positions.

We believe our ability to partner with a microCap company with our capital and other resources can create significant increases in share valuation and liquidity – benefiting all shareholders substantially.

• One of the Principals serving as the CEO of a microCap public company grew it five-fold to smallCap status; we have also served as COOs, Corporate Secretaries of microCap public companies;
• We have served as directors of private companies during their Initial Public Offering and beyond;
• We have served as directors and chairmen of public microCap companies, and participated on, or chaired the Audit, Compensation, and Governance committees;
• We have overseen private equity (PIPE) investments in our microCap companies and
• We, as independent advisors, have performed business planning and business optimization projects for public microCap companies and are very familiar with issues facing smaller public companies.

According to the WSJ, “the softening stance follows the venture capital industry’s decade of poor returns. The average return for venture capital funds fell to 14% for the 10 years ended June 30, down from 34% for the 10 years ended June 30, 2008, largely because the venture returns generated in the first half of 1999 dropped out of the calculation, according to research firm Cambridge Associates LLC.” ⁽¹⁾

This is supported in a 2006 Venture Capital Study where it was shown that a fund with the normal distribution of success and failures but with one IPO could generate top venture quartile Net Internal Rate of Return for its Limited Partners. However, given that same success/failure distribution, but no IPOs (i.e., our recent past and today’s market conditions), but only M&A exits, that same fund might generate only a high single-digit Net Internal Rate of Return for its Limited Partners. More specifically, it was found in an average of 10 deals between 2002 and 2004 that IPOs generated 5-6x cash-on-cash, where “Good Acquisitions” (13 deals) would generate 3-4x and “Overall Acquisitions” (some 80 deals studied) would generate <1-1.6x cash-on-cash ⁽²⁾ – and with investment holding periods ranging from a few years to well over a decade. Further there is the risk of no return on many of the deals in a venture portfolio.

daVinci’s goal is to exceed the traditional top quartile returns of 25% Net Internal Rate of Return for its Limited Partners with far shorter holding periods and mitigated risk. We are targeting cash-on-cash returns of 3-6x on an original daVinci investment, the cash-on-cash return of the portfolio is expected to exceed 3x.

These returns, along with enhanced liquidity, shortened time to exit, and lower failure rates (remember these are established companies – with proven technologies, tangible products and existing customers), should yield superior risk-adjusted returns with overall returns comparable to historic “decade plus” venture capital model. .

(1)    November 29, 2009 Wall Street Journal article titled, “Venture Funds Sweetening the Terms”

(2)    2006 Doll Capital Management Study and others

Stewart Massey an endowment consultant at Massey, Quick & Co. asserts, “… endowments and foundations are going through a period of restructuring where the foremost thing on their minds will be liquidity, even if that means giving up return and taking in some losses.” ⁽¹⁾

However, the traditional Venture Capital Industry has not been able to deliver on solving liquidity needs or addressing ways to mitigate the effects of illiquidity…

But it’s still not a good time for “exits,” as VCs call them, when they reap their returns, despite the uptick in mergers and acquisition and Wall Street offerings. Onset Venture’s Shomit Ghose put it this way: “For private equity, the exit market still feels a little like the Eagles’ “Hotel California”: You can check in anytime you like, but you can never leave.” ⁽²⁾

Overall, venture-backed companies generated $17 billion in IPOs and mergers and acquisitions in 2009, down 34% from $26 billion produced in 2008, according to VentureSource. ⁽³⁾ And already 2008 was a bad year for exits in itself. And while Q1 2010 has seen 8 venture-backed IPOs, the market still seems very fragile to many – while the average 2010 IPO has risen 11%, many of these deals were completed well below their filing range.

And this in turn has affected investor sentiment…

According to the WSJ, “many investors are reluctant to put more money into venture capital, especially amid the liquidity crunch from last year’s market turmoil.” ⁽⁴⁾

Investors, i.e., Limited Partners, want predictability in their investments’ liquidity, this is more important than ever before in these economic times.

This thinking and more has led to the liquidity-oriented investment strategy of the daVinci Capital Group. As seasoned, hands-on venture capitalists with strong operating experience, daVinci’s hallmark strategy in mitigating liquidity risk is to select and actively invest in public microCap companies and to drive strategic growth combinations with other public microCaps and late-stage private companies.

In this way, daVinci provides realizable value throughout the investment process, facilitating earlier and predictable liquidity. As well, by driving these microCaps into smallCap status any potential trade volume limitations are eased which further enhances liquidity. It is important to understand that these are established companies with proven technologies, tangible products and existing customers.

(1)    February 17, 2010 Wall Street Journal article titled, “Harvard Tests Market for Its Property Bets”

(2)    October 29, 2009 San Jose Mercury News article titled, “VC Confidence Flat, but What Does It mean?”

(3)    March 9, 2010, Wall Street Journal article titled, “Venture-Capital Firms Caught in a Shakeout”

(4)    November 29, 2009 Wall Street Journal article titled, “Venture Funds Sweetening the Terms”

However, many microCap companies are good businesses with good prospects despite a lack of broader scale investment attention. Often their valuation ratios are trapped well below larger companies in similar business sectors. They are unable to demonstrate to investors an ability to grow revenues and profits at double digit rates because they often lack the sufficient depth of management and often specialized know how, experience and capital to achieve these results.

All of these factors translate to an investment opportunity, and this is daVinci’s niche.

Very simply stated, daVinci seeks undervalued companies that have the prospects for growth, but may lack resources to achieve dramatic growth. daVinci provide capital and assists our portfolio companies in obtaining other missing ingredients to succeed with a growth plan.

Our ideal investment candidate certainly has the capacity and desire for growth and understands that changes will be required for growth – this is a prerequisite. Other factors do not have to be 100% perfect, but may include good products, technologies and market positions, and good prospects for growth via business combinations with other companies.

We call these candidates “platform companies” because they represent solid foundations for both organic and external growth.

Our platform companies may be in any number of technology business sectors. But, sectors we particular like are the medical device, semiconductor and software industries which are populated with a large number of small public and private companies and not dominated by a mid- or large- Cap company who may have already consolidated the market area.

Our preferred potential platform company candidate will have a good basic business, but with valuation ratios (e.g., enterprise value to free cash flow) significantly below larger comparable companies and sufficient stock float without concentrated ownership. Its business model may be challenged, but is not fatally flawed, and deficiencies can be attributed to addressable issues.

A good investment candidate should be strong in at least two of the following areas: 1) product line management, 2) customer base, 3) channels of distribution, 4) technology differentiation with Intellectual Property (IP) protection, 5) opportunity to become a dominant player, 6) balance sheet, or 7) gross/profit margin opportunity. Most importantly the executive team and/or the Board of Directors must be willing to adopt a growth plan and understand the changes that may come with it. Their commitment must be, like ours, to increase value for shareholders. Once we decide to complete an investment, we are dedicated to assist in every way we can to help a portfolio company achieve the objectives of the growth plan.

daVinci’s strategy is to invest in already public microCap technology companies and help them grow to higher valuations and liquidity. These companies are generally undervalued compared to smallCap or midCap companies in similar industry and market sectors. daVinci finds companies, which are not “broken” with failing products or extinct technologies, but where the Management Team and Board are motivated to improve their companies and are willing to receive new input and accept change for the benefit of their shareholders. We are not interested in “lifestyle” companies unwilling to take these steps.

daVinci’s Principals work with Companies in a variety of ways and seek to form solid working relationships driven towards improving shareholder value and liquidity. One way is the mutual creation with our portfolio companies of “platforms” for growth, or “platform companies.” The advance planning for this effort could range from a few weeks to several months. But, regardless of the time effort involved, we will feel very comfortable that the people, technologies, and markets are right for us before a significant daVinci investment is made.

In cases where a detailed analysis is jointly undertaken, we work with outside consultants, company officers and board members to truly understand the business and its strengths, weaknesses, opportunities, and threats. We focus on opportunities for optimization and growth of the current business and identify synergistic public and private companies, which could become part of a “roll-up” within the platform company’s niche.

A typical platform company might have a market capitalization of less than $100M, with revenues of $50M – $150M, and a corresponding Price/Revenue of 0.5x – 1.5x. In contrast, typical top-quartile technology companies have Price/Revenue of 2.5x to 3.0x. Platform company acquisitions would typically triple or even quadruple revenues over a period of 2 to 3 years; while business optimization would move the company to sustained profitability of 10%⁺.

In summary, the daVinci Capital Group carefully selects an undervalued microCap company as an investment platform and then, from its board positions, actively helps a platform company to optimize the base business and grow organically and externally through acquisitions of synergistic public or private companies. This results in expanded product offerings and/or expanded distribution of products into new markets.