Baker Tilly professionals work on a project overlooking the city
Article

VC cash is adding rocket fuel to startups and disruptive businesses

Making the last steps of the home delivery process more customer-friendly. Finding a parking space in a large lot more easily. Using 3D-printing technology to create safer rocket fuel. What do all of these have in common? They represent the work of new businesses seeking to disrupt an existing market with a better idea — and all are being helped by an infusion of cash by venture capital (VC) firms.

While the COVID-19 pandemic caused massive worldwide economic distress in early 2020, there was a sense of optimism early on that it would be a short-term disruption. As conditions eased in the summer of 2020, investors looking to deploy capital (and thinking of the fiduciary obligation to put that capital to work) had almost a sense of panic about how to work through the deal flow backlog. At the same time, visionary entrepreneurs and VC firms have seen the past two years as a time of fantastic opportunities due to the way the pandemic reframed how multiple industries interact and serve their clients, and individuals changed the way they worked, shopped, went to school and socialized.

Firms involved in information technology have been the focus of most merger and acquisition activity in 2021. (See, for example, California regional M&A update: H1 2021 and Texas regional M&A update: H1 2021.) VC firms are intrigued by companies driven by innovation, disruption and evolution and are looking to invest in businesses that are launching disruptive products and services in multiple sectors of the economy, targeting a variety of customers.

From the perspective of the business owner or entrepreneur, all types of investors are looking to get involved at every stage of a business life cycle — startup and angel investors; friends and family; seed round investors; all the way through to more mature and sophisticated VC funds looking to help a company go public. VC firms are ready to participate in fundraisings from $1 million to more than $100 million.

Preparing for new investment

Prior to the pandemic, we took a deep dive into things a business needed to consider when they reached a stage of their operating life cycle where there was a need to source outside capital (see Preparing your business for a capital raise, including tax considerations, February 2020). While the basics discussed in this article have not changed too much, the pandemic has seemingly driven more momentum than ever before for funding early-stage investment opportunities.

Investors seem to place a premium on company targets that have a solid accounting and finance function. In the past, potential investors may have shown more tolerance and flexibility funding a target that had not properly built out its back-office accounting function to support growth. With many target companies to choose from these days, however, investors are showing less patience and interest in funding companies that have not taken the time to invest in upgrading and automating their accounting and tax planning systems.

Generational curiosity

Legacy family offices are seeing a new generation of family members that have a higher risk tolerance and an appetite to provide more early-stage venture capital to nontraditional businesses. In Texas, for example, families whose wealth was created through the oil industry are seeing younger family members diversify their investments, which means startups that in the past may have felt the need to look to Silicon Valley or the East Coast for their next round of funding are increasingly finding willing investors closer to home.

That is also allowing startup companies to remain closer to their sources of investment — in this case, Texas — instead of relocating to another part of the country.

Newer VC firms also seem to be looking through a social consciousness lens, intrigued by clean energy type technologies and community-focused healthcare ventures. These firms know they have to balance an effort to make a positive impact against the return expectations of stakeholders who are investing their capital. Funds have a fiduciary duty to try to make good deals.

Disruptive businesses

One of the reasons the broad category of “information technology” is attracting so much VC money is that the definition is expanding of what an information technology company is. Professional services firms, food delivery services and professional sports teams are increasingly depending on technology to serve existing and new markets. Investors in some multigenerational family offices are looking to be key players in areas far removed from where their families invested in the past.

In the case of some family offices, there is so much “dry powder,” so to speak, that a $1 million investment in a company offering a disruptive product or service is exciting to the family member making the deal and, ultimately, a low risk to the family fortune in case the investment does not pan out.

Here are some examples of “disruptive” businesses where VC investors and family offices are providing critical funding:

  • Accounting software. Automating what has historically been a manual process with individuals working on data manipulation, data entry and tax return preparation, and freeing up professionals to focus on client business needs that will help grow the business.
  • Caregiver support network. Taking a traditional, literally hands-on service industry of caregivers for children, seniors or people with disabilities, and using technology to create an ecosystem that will support both caregivers and those who need different types of health services.
  • Package delivery. Companies like FedEx and Amazon revolutionized the way people shop, but throughout the pandemic, the number of packages delivered has risen at an exponential rate. Community mailrooms that had 10 or 20 packages a day now struggle with managing hundreds of deliveries each day. So services are developing that will accept packages at a central, local site, then customize the delivery method to the customer’s door at their convenience.
  • Parking technology. Instead of venues like stadiums, arenas or airports venues depending on humans to direct drivers where to park, increasingly sophisticated technology exists that leverages motion-sensing activity to identify open spaces in real time and directs people to the right level, section and spot using lights and arrows.
  • No checkout shopping. Amazon and other companies have created a grocery store shopping experience where technology tracks shoppers as they move through the store and remove items from shelves, and as they leave, the store automatically tallies what they have “purchased” and deduct that amount from the customer’s credit or debit card.
  • 3D-printed rocket fuel. Solid fuel rockets use highly combustible and dangerous fuel. 3D printing technology is being used to produce rocket fuel, almost like a candle, which isn’t combustible until it’s contained within a launch system.
  • Esports. The past few decades have seen an expansion of the ecosystem around esports that are starting to account for a larger segment of the entertainment and sports entertainment market.

All of these services and technologies represent entrepreneurial ideas nurtured in classrooms, laboratories, garages and basements that have now reached a point where significant amounts of capital funding are necessary to bring to market or expand a customer base.

Expanding VC ecosystem

In recent years, venture capital has been slowly migrating from coastal communities into central Texas, in particular Dallas and Austin. Businesses are drawn to Texas because of traditional “cost of doing business” benefits — low taxes, access to talent (through the state university system), and lower costs of living for residents compared to other regions such as Silicon Valley. (Some are beginning to refer to the state as Silicon Prairie or Silicon Pasture.) It's a business-friendly ecosystem. Groups like the Capital Factory are looking to homogenize the startup and VC ecosystems across different geographies in the state, breaking away from a tradition of individual firms in disparate areas of the state working independently.

The startup and VC ecosystem also includes professional services firms that can offer traditional accounting as well as sophisticated tax planning and strategic advisory services to both sides of the transaction. These firms are helping to drive meaningful combinations between businesses looking for the right partner to get funding and the VC firm trying to figure out the best places to invest capital.

Starting a business from scratch is a daunting task, and so having an ecosystem of entrepreneurs, investors and advisors creates a sense of community that will accelerate and foster the success rate of some of these businesses.

Conclusion

The fundamentals of trying to get a transaction done are still similar to what they were before the pandemic. There has to be a desired partnership between capital sources and the business. Company valuations are still based on some multiple of EBITDA.

VC investors are cognizant of possible corporate and capital gains tax law changes, which could impact the timing of deals. But investors should never let the tax tail wag the deal dog; if a deal isn't otherwise a good deal or imminent on the horizon, a new deal shouldn’t be rushed into merely for the tax benefit.

Homogenizing ecosystems of VC firms, disruptive companies and professional services firms, like what has existed in Silicon Valley, New York and Boston and has been developing in Texas, will continue to be powerful for the next generation of startups, entrepreneurs and investors, allowing for more consistent deal flow and better exits for business owners.

The way we live, work and interact in 2021 is dramatically different from how we lived our lives in early 2020. People can run so much of their lives just from their smartphones. The startup ecosystems that exist and are developing in different parts of the country are helping to fuel this innovation.

The pandemic has seemingly poured gasoline on the startup fire and has created a sense of excitement around the innovation ecosystem like never before. We could be in for a wild ride for years to come.

Chase Murphy
Partner, CPA
Flexibility Act could provide expanded federal funding opportunities
Next up

Potential flexibility in ARP Fiscal Recovery Funds highlights importance of strategic planning for state and local governments