mercato takes a practical approach to venture capital
peHUB - Thomson Reuters, Posted on: June 2nd, 2009
Much ink has been spilled over the “broken” venture capital model. Several years ago, Greg Warnock reached this same conclusion while at vSpring Capital, deciding venture capitalists weren’t being adequately compensated for the risk of investing in pre-revenue deals. So he started a new firm to do the opposite of that.
Warnock, alongside Alan Hall, the former CEO of MarketStar Corp., formed Mercato Partners to invest exclusively in revenue-producing startups with the goal of finding companies “grappling for their first foothold,” and bolstering their sales force from ten to 500. That strategy has performed for the firm thus far. Two years and four investments into its life as a firm and its IRR is in the low triple digits, meanwhile the revenues of its portfolio companies grew 50% last year.
I asked Warnock a few questions about Mercato’s strategy and how it fits into today’s VC market.
How does Mercato’s strategy compare with the prevailing attitudes of venture capitalists today? We’re seeing them hunkering down and triaging their current holdings, trying to drive businesses to profitability because they’re concerned about long holding periods and lack of cash or available debt. We don’t use debt, so we’re driving our returns out of growth. Companies are generally close to profitability when we enter so we don’t have to compromise investment decisions.
Given the longer hold times and talk of ‘radically reinventing’ the venture capital model, are more venture capital firms moving toward a sales-driven model? The feeling is concern for the industry in general. Some venture firms would find it very difficult to shift strategy in this way. When I look at some firms that have historically made early stage investments, they have 20-30 companies that have scarce follow-on financings, and the value is down, and they’re not profitable. I’m not sure how you would shift it to a growth model. It’s a daunting task for a firm to move from traditional venture to growth equity. Not impossible, but there’s so much baggage in early stage that it’s difficult to be nimble. I will say that growth equity as a strategy has become more prevalent.
What kind of deals do you look for? We like tech companies that have the possibility of developing a sales channel. Companies that sell to small businesses through the VAR (Value Added Reseller) channel. You often sacrifice some margin to the channel because the VARs need to make money too, but at that time in a company’s life cycle, it is really a value creating move.
Has this environment yielded a strong deal flow for your type of investing? We’re seeing a lot of interesting opportunities in part because debt financing for growth is less available than it was historically, so it pushes more opportunities to equity investors. If you are a fast-growing company, you’re desperately trying to hold onto equity. High flyers are being forced to look at equity to be opportunistic, so we’re seeing more conversations that wouldn’t normally happen. We are going to do larger investments in a smaller number of companies; we’re not looking for a big portfolio.
How do you source deals? We start with the channel and work our way backwards, rather than try to identify products. We then find suppliers who will fill the need and identify the products and companies. We ask 1,000 VARs, “What can you sell and at what price?” It is not investing in a company to develop a product and then revealing it and saying “Tada!” and then realizing no one wants it. The VARs are our mercenaries. They want to sell the products, so we use that as a way to guide the search. MarketStar is a sales force outsourcing business, and the former CEO and current chairman is an MD at your firm. What exactly is the relationship with MarketStar? Is the company an investor? There is lots of knowledge sharing, and Alan has connections there, but I wouldn’t say every deal has to have a relationship with them. We like having connections there to assist us in our diligence. It provides an inside look that many VCs would struggle to gain.
What’s your fund status? We closed our first fund in November 2008 with $52.5 million. We’ve deployed less than half of it. Our typical investment is in $5 million to $7 million in equity. We might think about our next fund in 2010.
