The Venture Capital Risk and Return Matrix

This article is co-authored by Hans Swildens and Eric Yee.

One of our venture fund managers recently asked, “When you invest, what is a good expected return?” After thinking about the question, we concluded that the answer depends on the type of investment – is it a company or fund, and is it early-stage or late-stage? It is also necessary to account for factors we believe greatly impact returns and their relationship to the ways in which investors underwrite new investments.

Generally speaking, we found that the likelihood of achieving expected returns is not simply a function of high multiples. In fact, it varies depending on risk profile. For direct investments, loss rates and holding periods play a significant role. For venture fund counterparts, the same holds true, but exit strategies – whether through IPO or M&A – and capital-deployment timing also matter a great deal. Beginning with the summary below, we explore the various alternatives and how we think about risk and target returns.

Direct Investments

To simplify the analysis, let us first consider direct investments involving two types of venture businesses:

  • Start-up firms (i.e., those with less than $1 million in revenue) funded by early-stage venture funds;
  • Later-stage companies (i.e., those that have raised capital at valuations greater than $100 million).

As noted earlier, two key factors driving returns for this category are loss rates and holding periods. For the purposes of this article, we define the former as the likelihood of a return that is less than 1x invested capital, and the latter as the duration between the initial commitment and subsequent exit.

Start-Up Firms

In a 2009 blog post, Mark Suster of Upfront Ventures noted that his targeted batting average for early-stage investing is “1/3, 1/3, 1/3.” In other words, he expects one-third of his investments to be a total loss, one-third to return his principal, and the remaining third to deliver the lion’s share of overall returns.

Does Mark’s simple thesis reflect reality? The answer is “Yes.” As we noted in a previous article, “Winning by Losing in Early Stage Investing,” the typical loss rate for early-stage investments is 65% (i.e., two-thirds return less than the initial outlay). This means that 35% must generate gains much greater than 1x to achieve an acceptable overall result.

Our experience suggests that most venture investors seek a 30% gross internal rate of return (IRR) on their successful investments; according to the National Venture Capital Association, the average holding period of a VC investment is eight years. This means an early-stage investor would need to garner 10x plus multiples on the winners to meet his or her IRR target.

With that in mind, it is clear why holding periods and loss rates are important. A longer holding period will, by definition, require that the top third of investments generates a higher aggregate multiple to achieve the desired IRR, and vice versa. A higher loss rate will also boost the return multiples required from the winners to offset the loss-oriented skew.

Later-Stage Companies

Later-stage venture investing typically involves less risk than its early-stage counterpart. Among other things, more mature entities are typically generating significant revenue (though they may still be unprofitable) and have moved beyond the market and product development stages. They are also seen as less risky because the odds of a successful exit are higher. In theory, these investments should have lower loss rates and shorter holding periods.

In fact, hard data bears this out. According to Pitchbook, the loss rate for later-stage companies is less than 30%, in contrast to the 65% number for early-stage counterparts. By the same token, average holding periods are shorter – six years, on average.

Using the same analysis as we did earlier, we find that this segment’s return profile is somewhat different. Late-stage investors, generally speaking, target a 20% plus gross IRR on their winner investments. This means late-stage investors need to make 3x on the winners to achieve their objectives. Given that their investments are generally less risky and closer to prospective exits than early-stage alternatives, the lower multiple makes sense.

Fund Investments

When it comes to fund investments, things are a bit more complicated. What sort of return might an investor expect? As before, it makes sense to evaluate the issue from two perspectives:

  • Early-stage venture funds (i.e., those that fund start-up firms)
  • Growth venture funds (i.e., those that invest in later-stage companies)

Although the loss rate and holding period criteria noted earlier still apply, determining expected returns for these types of investments are more nuanced. Capital deployment timing, fund lives, expected exit timing and proceeds, and fund fee structure can all impact returns (from an IRR perspective, that is).

Early-Stage Funds

According to Cambridge Associates, net annual returns for early-stage funds averaged 21.3% over a 30-year span (through December 31, 2014). While this is near the IRR target for one-off start-up investments, the variance and risk associated with that return are lower.

For one thing, because there are typically 20 investments – where the average holding represents less than 10-20% of the fund – the downside risk is reduced through diversification. Moreover, because some exits may occur more quickly than the direct-investment average, the fund is exposed to positive cash flow optionality. Simply put, the expected IRR profile appears more reassuring, though the upside potential is less dramatic.

That said, how capital is invested and subsequently recaptured through exits can have a meaningful impact on returns. As it happens, our experience bears this out. To demonstrate the point, we evaluated Industry Ventures’ data on the average pace of capital deployments (i.e., cash inflows as a percentage of fund size) and exits (i.e., cash outflows as a percentage of fund value) across the numerous early-stage funds we committed primary capital to. Because the timing of the commitments varied by fund vintage, we assumed a 12-year normalized life for each fund. We also assumed that uncommitted capital and the unrealized value of assets were distributed equally in the remaining years.

As you can see in the table below, our analysis indicates that the bulk of the capital calls take place within the first five years, while sizeable exits generally do not occur until year eight.

Using this data together with an expected loss rate equal to that of individual early-stage investments, we calculated the performance of a hypothetical $100 million fund with a 2% annual management fee (in the first 10 years) and 20% carried interest. We assumed the fund would be invested in 20 companies, where 65% returned 0.5x and the balance returned 10x. We concluded that our hypothetical fund would likely yield a gross expected return multiple of 3.8x and generate a net multiple of 3.1x, or an IRR of 20%.

As this example shows, various factors can impact expected returns. If 100% of capital had been called in the first three years, IRR would have gone down, but the net multiple would not have changed. Alternatively, if exits had only taken place in the final three years, IRR would also be lower. While diversification significantly reduces the risk of a total loss, estimated expected returns is more challenging.

Growth Venture Funds

For growth venture funds, the situation is slightly different. According to Cambridge Associates, the 30-year average annual net return for late and expansion-stage funds is a more modest 12.6% (through December 31, 2014). This is consistent with the funds’ lower risk profile, which stems, in part, from diversification. That said, the odds that they will witness exits as early as three years out are greater. In other words, though expected loss rates might not change, smaller deployment-exit gaps can have a pronounced effect on expected returns.

Using the same logic as above to assess the investments we have made in this space – and assuming that 30% of our pool returns 0.5x, while the remainder garners 3x gross – we found that the hypothetical fund generated an approximate 2.3x gross and 1.8x net return, or an IRR of 12%.

As expected, the average growth-stage fund net multiple is below that of the early-stage counterpart and the IRR is lower. Essentially, while the timing of capital deployments is similar, growth-stage funds experienced significantly quicker exits at much lower multiples.

So, what’s the moral of the story? When it comes to venture investing, there can be much more to expected returns than multiples alone.

There can be no guarantee that any investment strategy employed by Industry Ventures will be successful. The investments described herein are presented to illustrate examples of the types of investments Industry Ventures may have bought or the types of transactions it may have entered into as of a particular date. They may not be representative of any current or future investments, and the performance of these investments is not necessarily indicative of the performance of all investments made by Industry Ventures. It should be specifically noted that not all transactions entered into by Industry Ventures will be profitable or will equal the performance of the investments described herein. No guarantee of investment performance is being provided and no inference to the contrary should be made. Past performance is not indicative of future results.

Trust Planning for Founders of Companies

This article is co-authored by Sanjay Gandhi and Ian Weinstock.

As founder of a company, you have a zillion things to think about, many of which urgently need to be addressed for your company to survive and thrive. It may therefore be somewhat stressful to add to your list of things to think about anything that isn’t strictly necessary. But in the long run, one subject that you’ll probably be happy you thought about is trust planning. In fact, thinking about trust planning relatively early in the life cycle of your company could be one of the best decisions you make for the financial well-being of your family.

How can a trust benefit you?

  • A trust can facilitate a tax-efficient transfer of wealth to your family.
  • The concept at work here is to transfer shares in your company at a time when their value is relatively low, so the future appreciation escapes U.S. gift or estate tax (40% in 2017 with state taxation on top of that).
  • So, for example, if you give away shares in your company that are worth $100,000 at that time, you’ll only use up $100,000 of your gift/estate tax exemption ($5.49 million in 2017), and if the shares are later sold for $10 million, all of that $9.9 million of appreciation will have escaped gift and estate tax, potentially saving your family almost $4 million (or more, if state estate taxes apply as well). Clearly, then, the best time to give away shares in your company is when the value is low, and the value for gift tax purposes may, under the right circumstances, be even lower than you might think. The valuation of assets for trust purposes is typically significantly different–and more beneficial–than what you may think of in the VC or PE context of valuation.

Some background—what is a trust?

  • A trust is a legal arrangement pursuant to which one person—a grantor (a.k.a., settlor, donor, trustor)—transfers property to another person—a trustee—to administer on behalf of one or more beneficiaries according to the terms of the instrument governing the arrangement.
  • Trusts can be used to achieve a wide range of goals and in a variety of contexts. For our purposes, the focus will be on the estate and tax planning benefits of an irrevocable personal trust.
  • That said, one other point is worth noting. For founders who live in states (like California) where probate of a decedent’s estate can be challenging and expensive, another type of trust might also be relevant, namely, a revocable trust. A revocable trust is a vehicle through which you can hold assets, and while you are alive, it will be pretty much exactly as though you still owned the assets directly in your own name (subject to one caveat, which we will discuss at later). But at your death, the assets will be disposed of in accordance with instructions you set out in the trust instrument, and not through a court-supervised probate process. There are no tax advantages to a revocable trust, but there is generally a saving of administrative costs and hassles for your family after you’re gone.

Estate and tax planning:

  • Every American citizen or resident is potentially subject to a 40% Federal estate tax at death on assets he or she owns or controls. However, there is a very large exemption from Federal estate tax, $5.49 million, and double that for married couples. (States may have their own separate estate taxes, with their own—generally lower—exemption amounts.)
  • In addition, every American citizen or resident is subject to gift tax on assets he or she gives away during life, though with that same $5.49 million exemption. The exemption is an aggregate gift and estate tax exemption, so to the extent you use up the exemption on lifetime gifts, you won’t get the benefit of it when you die.
  • The key point here is that the estate tax is based on the value of assets at death whereas the gift tax is based on the value of assets when you give them away. So, giving assets away when the value is low is tremendously advantageous in reducing the future tax burden.
  • For founders who are neither American citizens nor residents, you’re only subject to estate and gift tax on your U.S. assets, but a company here qualifies as a U.S. asset for estate tax purposes. But it’s not a U.S. asset for gift tax purposes, so you can transfer shares without using up any exemption. Moreover, that generous $5.49 million exemption for American citizens or residents drops all the way down to $60,000 for non-citizen non-residents, making planning even more important.

Planning with trusts:

  • To whom should you give shares? That’s where trusts come in. You can create a trust for the benefit of your family—spouse, children, parents, siblings, or any combination of them—and give shares to the trust, and then the full value of those shares in the future, with all the appreciation, can be used to provide benefits for your family for many years to come without any further hit to your gift and estate tax base.
  • Although there are certain types of trusts where in theory you can be a beneficiary alongside your family, those trusts are more complicated and expensive to set up, and in any event you cannot count on getting money out for yourself. It’s therefore generally better not to set up a trust for yourself, but rather keep enough shares of your company in your own name, out of the trust, and let the trust just benefit your family.
  • There are some up-front costs to trust planning, of course—you’ll need a lawyer to draft the trust; you’ll need an appraisal of the shares you give to the trust; and you’ll need an accountant to prepare a gift tax return—but those costs are modest in comparison to the potential tax savings. And although the trust owns the shares after the gift, and not you, as long as you choose your trustee wisely, the loss of direct control over the gifted shares need not be of concern, particularly because you can give only a portion of your shares, retaining the majority for yourself, and you can give shares to the trust at different times, not all at once, though there may need to be a new valuation each time.
  • Note that the basic trust planning we’re discussing can save estate taxes, but it isn’t designed to save income or capital gains taxes. For example, when the company has a liquidity event, in general, you or the trust will still have to pay capital gains tax. There are certain more complicated types of trusts that may result in some income/capital gains tax savings, though, so if you have an appetite for complexity, it may be worth exploring more advanced planning techniques.

Look before you leap:

  • In thinking about planning with trusts, please keep in mind one caveat about capital gains taxes. If your shares in the company are qualified small business stock, certain transfers to trusts may result in a loss of favorable capital gains tax treatment.
  • That may not apply to you, and for various reasons it may not be a big deal even if it does apply to you because you may be keeping more than enough stock to get the full benefit from the favorable capital gains tax treatment.
  • Also, only certain types of trusts can hold S-corp. shares. Those trusts can be just as beneficial for saving taxes, but they do need to be set up more carefully.
  • Therefore, before you engage in any trust planning, be sure to discuss whether your company is an S-corp. or whether your stock is small business stock with your lawyer and accountant.

When should you start thinking about trust planning?

  • You should start thinking about trust planning as soon as possible, so you’ll be ready to implement a trust planning strategy at the right time.
  • The harder question is when is the right time to make a gift to a trust? You could make the gift when you first set up your company, but for many people, that’s premature, particularly if you’re single without children. Generally, the best time is when you feel secure enough to part with some of the shares, and you have a spouse and/or children whose futures you want to take care of. For each founder and for each company, that time may be different. The more funding rounds occur before you make the gift, the higher the value of the shares for gift tax purposes.
  • On the other hand, you don’t want to give away too much too soon, or else you might feel like you haven’t kept enough upside for yourself—being too successful at estate planning may be even worse than not doing it at all! Like Goldilocks, you want to get the planning just right.

For more information, contact Ian Weinstock at iWeinstock@kflaw.com. Additional background and a knowledge library is also available in the knowledge section of the Oxford Valuation Partners website (http://www.oxfordvp.com/knowledge) .

How to Build a Three-Year Startup Plan…The Right Way

Getting started is one challenge. More challenging, though, is having vision. Being able to do so in those early stages is what makes the difference between being the next startup success story, rather than a shuttered up also-ran.

In building a plan for going forth, you want to adhere to some key rules, measurements and targets as a skeleton to build on. The backbone of this skeleton is going to be your financial analysis of cash flow. You want to maintain adequate cash reserves to go the distance and grow. And like any healthy body, make sure to build in flexibility and joints.

The first aspect to put into focus is how far out to plan, and how often to check in with the plan.

Year One

With the initial year you want to check in monthly to see how your results line up with your understanding of product and mix. There will be many changes day to day; being able to benchmark monthly will give you the understanding of where the tires are hitting the road and moving you forward.

To start off, tune into cash burn and know your acceptable rate. This first year is the test case to any investor of how well you handle resources. Just as important, if not more so, than assembling a top team, investors want to see you have financial projection accuracy. Demonstrating forecast competency is not only useful in attracting investors, but also in preventing over-dilution due to unnecessarily raising more capital than needed.

You want this time to be spent setting milestones and determining what amount of capital will be needed to accomplish them. Make these milestones as clear, simple and achievable as possible without unneeded dependencies in order to occur. This will be the time most likely to give feedback on any needed pivots or unforeseen market conditions.

Years Two and Three

For years two and three, checking where you are with where you thought you would be is best done quarterly. By the beginning of year two, you should already have a plan that’s demonstrated itself as a solid roadmap. At this point, your priorities are lined up and it’s more about vigilance and checking the competition. Checking in quarter by quarter will keep you on point without any unnecessary second guessing or micromanaging.

Reality Check

In our experience, 3 years is both lengthy enough to forecast and show potential to investors, as well as short enough to keep it practical and grounded. You might find people pressing for 4 or 5 year plans, but that far of a window is more speculative than worth putting the energy towards. Stay focused on realistic goal setting. Being able to identify your major assumptions and back them up is worth more than imaginary longevity.

Above all, remember that this plan is not set in stone, it is only the map. Your actual accomplishments and ability to navigate obstacles will shape the plan, not vice versa. Many events—anticipated and otherwise—will necessitate updating and reformatting the plan – whether it is a new round of funding, key hires or any necessary pivots.

Square 1 is Proud to be a Part of the Best Bank in America

Last month, Forbes announced its annual list of Best Banks in America, with rankings based on 10 metrics related to growth, profitability, capital adequacy and asset quality.

We’re proud to be a division of Pacific Western Bank, the #1 Best Bank in America. And the best part? We got here by serving you – the entrepreneurs, companies and investors who work tirelessly to find innovative, disruptive ways to improve life at home, work and play.

Thanks for giving us the opportunity.

Read the article here.



Tips On Selecting A Proper Board Member

Ask a CEO what early milestone they’re not looking forward to and it’s probably assembling a board to work with. After all, most entrepreneurs are used to being highly independent; the idea of diluting that with a committee structure can be…unappealing.

Early stage companies tend to run with just one or a couple of leaders driving it all forward. In the earliest days, firms tend to be so focused on establishing their market and growing their revenue rather than building an advisory board or a board of directors.

While it can seem tempting to forgo this until investor involvement makes it a next step that would be shortsighted. A well-assembled board can help demonstrate a commitment to longevity and growth that will influence investors. Adding a member who has previously been on the boards of companies that potential investors have sponsored is a solid tactical consideration.

Advisors vs. Directors

The key differences between which type of board you are assembling will shape who you want on it. A board of directors will have fiduciary responsibilities to the company, and offer broad, overall guidance in binding decisions. As such, you want members with a comprehensive background as well as depth of experience.

A board of advisors, in contrast, is non-binding in its recommendations. Advisors also are not typically compensated the way directors would be, so looking for synergistic and mutually rewarding scenarios is often needed. For instance, having a trusted former professor from graduate school as an advisor in exchange for keeping them up on frontline developments. When choosing advisors, you want to have specific issues and challenges that you bring them into the picture for.

Sizing and Involvement

One recommendation (if you are in the pre-investment stage) is to have three people. Odd numbers help avoid any disagreements from becoming polarized and stuck. In addition to the founder, you want two others to provide balance and extended views into potential issues. Working from the beginning with people you trust and respect is essential. Getting started in the early stages is simple, as it’s just a matter of the controlling shareholder voting in the candidate. Obviously, as investors come in, the situation will change.

With the addition of VC involvement there is likely to be a shareholders agreement. Within the agreement, one of the provisions will often be the right to place a representative on the board for minding the investors’ interests in the path forward. They may even have a specific representative already in mind.

You want to keep participant numbers manageable in order for the board to be optimal and functional and to make certain that meetings can come to order and stay focused. Resist the urge to grow the board more than necessary. Even with the addition of an investor-appointed director, a three-person board can be balanced by two founder directors.

At the next stage of growth, as investor control grows and founder control steps back, scaling the board can be considered. With this, an independent investor should be sought out. What should be sought from an independent director is the experience, connections and wisdom that the company can utilize without any conflicting existing allegiances to either founder or investors. An optimal number of members for the board at this stage is between five to seven for most startups.


In choosing the board member, you want to be able to honestly assess what strengths and make up are already in place. If there is deep technical knowledge, make sure to balance it with a person having sales or marketing strengths as well.

Beyond skill sets, it is crucial to have diversity of the sexes as well as cultures if possible. You want the profiles of your board to be nuanced and complimentary rather than homogenous. In an ever-expanding world, having a contracted view for guidance can potentially be a misstep.


Has your prospective candidate been on the board of a company that has been at the stage yours is? Being able to benefit from their experience is one of the key considerations. Another aspect to consider is what style of engagement did they come away with, and what style are they going to bring with them? You want to make sure that levels of assertiveness line up. An overly confrontational board member can be a burden. In the end you want to make sure that everyone chosen makes a suitable and strong council of elders – metaphorically speaking.


VC Hold Times: Healthcare Shorter Than Technology?

This article was originally published by Top Tier Capital Partners here on January 31, 2017.

As a Fund of Funds manager, we at Top Tier focus on constructing our portfolios with what we believe are the right types of managers (healthcare/tech), investing in the right stage (seed, series A-C, Growth), in the right geography (New York, San Francisco, LA, other) for the current market. We also consider our manager’s ability to exit their investments.

As we dug into the distribution/exit data from our portfolio, we came across some interesting statistics on the average hold periods of our underlying managers.  Generally, our healthcare investments have shorter hold periods than our technology investments by over a year! Just over 30% of these distributions were in-kind, the rest were cash, including public stocks sold by the GP and proceeds distributed in cash.

A note on the data: the data set comprises distributions from January 1, 2015 through August 31, 2016 from funds in which TTCP has committed, totaling 437 distributions across 351 companies from 104 venture funds with vintages 2005 through 2014. Hold periods are measured as the first investment date until the date of distribution. In the case where there are multiple distributions of the same company, we treated those as different hold periods.

Our healthcare managers have shorter hold periods. Accounting for 23% of the distributions (our portfolios contain 15-25% healthcare), we found that average hold periods for healthcare were unexpectedly short, 4.3 years, when compared to technology companies at 5.5 years, irrespective of stage. There are many possible explanations for this, including the shift in healthcare venture investing models over the last several years away from investing in pre-clinical companies and holding through to FDA approval. We’ve seen more healthcare managers either sell up the food chain (invest pre-clinical and selling at Phase IIB) or invest later in life (invest at Phase IIB and hold through approval). Also, we’ve seen more investments in healthcare services, a segment of healthcare which can have shorter investment horizons than that of pharmaceuticals.

Furthermore, one would assume that managers investing in early stage technology would have slightly longer hold periods, as these young companies may take longer to gain traction.  Based on our internal data, this is true, as the average hold period decreases by nearly 2.5 years with late stage tech funds versus early stage tech funds. Regardless, hold periods of slightly over 5 years across the board for both healthcare and tech managers across all stages is much shorter than we expected to see.

By exiting investments in short order GPs can focus their time on existing investments, wrap their funds in their intended life span, and lock-in returns – ultimately distributing capital back to their LPs.

Readers of this blog are not to construe it as investment, legal or tax advice, and it is not intended to provide the basis for the evaluation of any investment. Readers should consult with their own legal, investment, tax, accounting, and other advisors to determine the potential benefits, burdens, and risks associated with any transaction involving any issuer referenced herein. This blog does not constitute an offer to sell or the solicitation of an offer to buy any security; it is neither a prospectus nor an advertisement, and no offering is being made to the public. Offers to sell any interest in a ttcp-managed investment fund shall be preceded by distribution of a private placement memorandum the contents of which shall supersede any information provided herein.

Minding the Care Gap

This article was originally published by Baird Capital here on September 14, 2016 by Michael Bernstein, Andrew Ferguson, Brett Tucker + Alex Kessel.

Baird Capital’s Outlook on the Global Behavioral Healthcare Market

Around the world, the behavioral health, mental health and addiction sectors are growing significantly in terms of needs, challenges and opportunities. In the United States, the societal cost of mental health and addiction is $650-700 billion annually,1 with an estimated one out of four Americans over the age of 18 suffering from a diagnosable mental condition.In the United Kingdom, nearly 10 million people are dealing with mental health problems, accounting for 23 percent of the National Health Service activity and £19 billion in public sector spending, according to a report by Queen Mary University of London. In China, the psychiatric health market is projected to grow 16.7% from $4.5 billion in 2014 to $10 billion in 2019.3

While the trends and supporting data vary by country, common investment themes have emerged across Baird Capital’s global footprint. To a certain extent in each of Baird Capital’s target geographies, the approach towards addressing behavioral health challenges has evolved into highly fragmented and poorly integrated providers that have failed to demonstrate improved clinical outcomes, scalable practices or sound economic advantages to the key players. There is opportunity to invest behind the best providers in these fragmented markets – specifically in the addiction and autism markets – where the macro trends provide an opportunity for the highest quality programs to appeal to the payer community which we consider ideal for growth and prosperity.

United States: Primed for Parity

Previously, mental health was covered differently than conventional medical health services, leaving a gap to be filled by private pay. In 2008, the Mental Health Parity Act, along with the Affordable Care Act (ACA), expanded coverage improving the payer mix for many organizations by shifting patients from out-of-pocket to either Medicaid or commercial payers. Behavioral health organizations who previously prospered by serving patients that could afford to pay the extremely high costs out of their own pockets have been challenged to adapt to a third party payer environment where discounting and administrative demands make the economics of operation more complex. In this new, post-ACA environment, behavioral health providers must upgrade their leadership and infrastructure to operate more like the most successful institutions in the medical provider arena.

Today, the addiction treatment industry in the U.S. is replete with small, founder-run organizations, which has led to significant operational deficiencies. A lack of metrics driven data and decision making means missed opportunity to ensure the business is operating at appropriate levels of capacity utilization. Outcomes data also tends to be lacking while the rate of recidivism is very high. This becomes especially problematic as these facilities look to navigate the world of big insurance. Proving their clinical protocols are efficacious and cost effective has strained the ability of the largest provider organizations, let alone the proliferation of the founder-run businesses. This shift toward a traditional business model has posed significant challenges, yet many can be mitigated with proper operational expertise including a metric-driven commercial sales and patient monitoring engine.

Within behavioral health, autism has emerged as the most prevalent disability in the Intellectual Development Disorders space. According to the Centers for Disease Control and Prevention (CDC), one in every sixty-eight children in the United States falls on the autism spectrum. With diagnoses growing in the last five years to more than a million American children, there is an enormous demand for Applied Behavioral Analysis (ABA), an intense, consistent regimen provided by an individual therapist. Economic costs for autism in 2015 in the U.S. were estimated to be $367 billion and are expected to reach up to $1 trillion by 2025, a compound annual growth rate of 11 percent.4 However, the influx of covered patients is not being met by adequate supply as most companies have not yet reached appropriate scale to address the demand.

United Kingdom: Reforms Are Shifting Access, Quality

Historically mental health services have generally been of a lower quality than those for physical health, with lower funding relative to need, and a focus on containment rather than recovery. Today, demand for secondary mental health care is rising at a time when services are suffering from reduced funding and less accessibility. There remains extensive unmet need for mental health care in the market.

Children and young people are particularly impacted, as one in ten children aged 5-16 has a diagnosable mental health problem and many of them are unlikely to have access to treatment. Specifically, parents of children with autism face severe challenges in accessing adequate services in the UK, according to a 2014 report by Queen Mary University of London. There are more than 600,000 people living with autism in the UK today, which translates to an estimated annual cost of £32 billion in lost earnings, care and support for all of those involved. To help address this challenge, the Children and Families Act 2014 introduced the most significant reforms in decades to the framework for children and young people with special educational needs or disabilities. The reforms refine the coordination between the National Health Service (NHS), local authorities and Clinical Commissioning Groups. Effective implementation is improving the way needs are identified and support is provided, with the goal of securing better outcomes for children and young people with special educational needs or disabilities from 0 to 25 years of age, including those with autism, and their families.

Providing care for addiction in England has also recently undergone reforms. Provisional expenditure on these services in 2013-14 was £572.3 million for adults, with a further £75.6 million being spent on services for young people. Drug treatment in the UK is largely NHS delivered and encompasses a range of available primary and secondary treatments and services. In February 2014 the Care Quality Commission published new proposals for expert inspections and subsequent ratings of substance misuse treatment services, with new guidance and model rolled out to all providers in April 2015.

China: Demand is Driving Growth in Private Institutions

The mental healthcare market in China is RMB29.9 billion and highly fragmented. Combined revenue from the top ten healthcare groups accounted for 8.2% of the total market in 2014 and combined revenue from the top ten hospitals accounted for 7.2% of the market.5 Regionally, Beijing, Chengdu and Shenzhen are the biggest players in terms of availability and quality of mental health resources in the country.

As with the U.S. and UK, insurance coverage and access are major challenges. Even though almost all of China’s population is now insured, patient out-of-pocket expense remains high at 36% due to strict reimbursement caps. By 2019, the number of mental health outpatients in China is predicted to reach 68.3 million and the number of inpatients is predicted to reach 4.5 million. However, in 2011 there were only 1.47 beds per 10,000 persons, which accounted for only about 15 percent of patients. It is clear that as the demand for mental health services grows, not only will more healthcare professionals and institutions be required, but more inpatient facilities will also be needed.

Unlike other developed countries and regions where private hospitals dominate the market, demand for mental health services in China primarily has been met by public hospitals. However, the overall market for private institutions in China is growing rapidly at a projected rate of 21.8% from an estimated RMB6.2 billion in 2015 to RMB13.6 billion in 2019, surpassing the corresponding growth rates for public institutions. Due to higher average patient spending in private psychiatric healthcare institutions, private providers accounted for a higher percentage of total revenue in the psychiatric healthcare market than public institutions on a relative basis.

The Road Ahead

Looking forward, Baird Capital is actively seeking opportunities to work with behavioral healthcare entrepreneurs in the U.S., UK and China as they strive to grow their businesses in a way that enables them to survive and flourish in this changing environment. As we explore new investment opportunities, we consider the scalability of the business, human capital competencies, effectiveness of the clinical offering, and how these businesses generate referrals. We are intrigued by the prospect of leveraging our global platform, significant network and deep sector expertise to help build their infrastructure and professionalize their processes to meet compliance standards, and look to build meaningful partnerships that could positively impact behavioral healthcare.

1 National Institute on Drug Abuse
2 National Institute of Mental Health
3 Frost & Sullivan
4 Journal of Autism Development
5 Frost & Sullivan

Square 1 Bank Announces Credit Facility to Recursion Pharmaceuticals

Square 1 Bank, a division of Pacific Western Bank, today announced that it has provided a $4 million credit facility to new client Recursion Pharmaceuticals, Inc., a leading pharmaceutical discovery company. Proceeds from the facility will be used to purchase new equipment and supplement Recursion’s recent $15.05 million Series A round of funding.

Based in Salt Lake City, Recursion Pharmaceuticals employs an innovative platform that leverages advanced biological science, computation and artificial intelligence to efficiently discover treatments for rare genetic disease and other conditions which can be modeled in human cells. In 2016, the company received national recognition for its commitments towards President Obama’s Precision Medicine Initiative, a national effort to develop patient-specific treatments which take differences between individuals into account.

“Square 1 has been a great banking partner in every sense of the word; professional, experienced and willing to develop a tailored solution to meet our needs,” noted John Pereira, chief operating officer at Recursion. “They understand how early stage companies operate and the fast pace at which we work and innovate. I’m excited to have their support as we grow.”

“In three short years, Recursion’s strong management team and innovative platform have established the company as a true leader in its field,” added Rilus Graham, senior vice president in Square 1’s life sciences practice. “Square 1 is excited to continue to grow our presence in Salt Lake City through our support of Recursion and its mission to treat 100 diseases in 10 years.”

About Square 1 Bank

Square 1 Bank is a division of Pacific Western Bank, a Los Angeles-based commercial bank with over $21 billion in assets. A full service financial services partner to entrepreneurs and their investors, Square 1 provides clients flexible resources and attentive service to help their companies grow. Square 1 offers a broad range of venture debt, treasury and cash management solutions through offices in top innovation centers: Atlanta, Austin, the Bay Area, Boston, Chicago, Denver, Durham, Los Angeles, Minneapolis, New York, San Diego, Seattle and Washington, DC. Pacific Western Bank is a wholly-owned subsidiary of PacWest Bancorp (NASDAQ:PACW). For more information, visit www.square1bank.com.

About Recursion Pharmaceuticals

Recursion Pharmaceuticals is a Salt Lake City-based drug discovery company. Recursion combines experimental biology and bioinformatics with artificial intelligence in a massively parallel system to quickly and efficiently identify treatments for any disease which can be modeled at the cellular level. From its initial and continued focus on drug repurposing to treat rare diseases, Recursion has broadened its platform to probe rich data from high-throughput automated screens for a number of indications, including aging, inflammation, infectious disease, oncology, and diagnostics. Learn more at www.recursionpharma.com, or connect on Twitter (@RecursionPharma), Facebook (www.facebook.com/RecursionPharma/), and LinkedIn (https://www.linkedin.com/company/recursion-pharmaceuticals)

Media Contact:
Square 1 Bank, a division of Pacific Western Bank
Dee McDougal

LLC to C-Corp. Conversion: Pitfalls to Avoid – Part II

This article was co-authored with Christopher S. Edwards and Richard Martinson of the law firm Reitler Kailas & Rosenblatt LLC.

In our first installment on LLC to C-corp conversions, we discussed reasons why businesses choose to convert and mechanisms to consider before initiating the process. Here, we will outline why capitalization and valuation matter and post-conversion requirements that shouldn’t be overlooked.

Capitalization and Valuation Matters

In order to convert an LLC into a corporation, confirming the LLC’s capitalization, its members’ capital account balances and the LLC’s valuation is required.

Pre-Conversion Capitalization

First, it is essential to ensure that the LLC’s capitalization is clear. If it is unclear how much LLC equity is outstanding or who owns it, then it will be difficult to confirm who needs to approve the conversion and what equity will be issued upon conversion, and the corporation could be subject to claims by former LLC members that they received incorrect amounts of equity in the new C-corporation.

To ensure clear capitalization, ownership of all securities issued by the LLC, such as membership interests and profits interests, should be correctly documented. The LLC’s capitalization table should be cross-checked against correct equity issuance documents, such as subscription agreements, and they should match.

Capital Account Balances and Post-Conversion Capitalization

Second, it is critical to ensure that capital account balances of the LLC’s members are updated until immediately before the conversion. This is required in order to confirm the capitalization of the corporation after conversion.

Economic Equivalency – A Critical Test

One of the key requirements in a conversion, to maintain the non-taxable status of the transaction, is that there must be economic equivalency between the securities held by a member of the LLC and the securities that each member receives in the form of C-corporation stock.

A fundamental rule of conversions is that an LLC’s equity interests do not necessarily convert, on a 1:1 basis based on numbers of securities outstanding pre-conversion, into similar numbers of shares of stock in the corporation. Rather, an LLC’s equity is converted on an “economic equivalency” basis, meaning that equity holders in the LLC receive equity of equivalent value in the corporation.

The Need for a Valuation

Internal Revenue Code Section 704(b) requires that an LLC maintain capital accounts for its members. The number and type of shares issuable by the corporation upon conversion need to be based on those relative capital account balances, but only after the capital accounts have been booked up to reflect the current fair market value of the LLC and its assets immediately prior to the conversion. To properly book up capital accounts, it is necessary to obtain a valuation of the LLC immediately prior to the conversion. The valuation will typically be necessary for both the equity as well as separately identifiable assets of the LLC to show the current fair market value.

Further, an LLC’s “profits interests,” which are a type of membership interests often issued to employees, advisors and consultants, do not generally convert into stock options, which are equity issued by corporations for similar purposes. Rather, if there has been an increase in value of the LLC between the profits interests’ grant date and the bookup date, they may typically be converted into restricted stock. The rationale for this is a function of how profits interests work.

When profits interests are issued, there is a “hurdle rate” attached to them which is equal to the value of the company on the date they are granted. This hurdle rate is important so that the issuance of these interests is not taxable as immediate income. If the LLC has increased in value since the date the profits interests were granted, then they would have an unrealized paper gain, which is recognized by the IRS. If you convert these into options of a C-corporation, on an economic equivalency basis, they would be “in the money” options and you would fall afoul of IRC 409A – namely, you would be creating an immediate tax event for all recipients of those options. External expertise can be useful in navigating these nuanced LLC valuation pitfalls.


Once the LLC has been converted into a C-corporation, the corporation will need to undertake organizational steps similar to those of any newly-incorporated corporation, such as approving bylaws, ratifying officers and issuing stock certificates. You may also need to notify your bank and the IRS of the conversion and the corporation’s name.

If the corporation is issuing options, you may need a valuation to establish the strike price of those options under the new corporate structure.


An in-depth analysis of the tax treatment of LLC conversions is beyond the scope of this article. However, please note that conversions of LLCs into C-corporations are usually not taxable events. There are circumstances in which the transaction may be taxable however, and a rigorous analysis of the facts surrounding the conversion should be made by a tax expert. For example, if the LLC has third-party debt outstanding (other than trade creditor debt), including convertible notes, the transaction may be taxable.

Further, you may need to file a tax return for the LLC as soon as it is converted into a corporation; otherwise, tax penalties may accrue.

For more information, contact Christopher S. Edwards at cedwards@reitlerlaw.com (for corporate law matters) or Richard Martinson at rmartinson@reitlerlaw.com (for tax matters). Additional background, and a knowledge library, is also available in the knowledge section of the Oxford Valuation Partners website (http://www.oxfordvp.com/knowledge).



Winning by Losing in Early-Stage Investing

This article is co-authored with Nate Leung of Industry Ventures.

One of our limited partners recently asked, “What are the normal failure rates for early-stage venture capital investments?” After digging through our data, we estimate that early-stage fund losses range between approximately 35% and 70%.

How did we determine this? We reviewed 20 funds that made early stage investments between 2006 and 2011. Among this group, which invested in more than 500 companies, 45% of their investments failed to return 100% of capital, while 34% returned less than half. The median loss rate was 39%, the median multiple on invested capital (MOIC) was 1.9x, and the internal rate of return (IRR) was 13%.

Admittedly, there was an element of dispersion in our results. In the case of two top performers, for example, “Fund A,” a 2007 vintage, had a 4.4x MOIC and a 66% loss rate, while “Fund B,” a 2008 vintage, had a 5.8x MOIC and a 38% loss rate.

That said, we discerned an interesting relationship between losses and returns. At one end of the spectrum, a VC fund with a 67% loss rate, the highest in our data set, returned 0.6x capital. At the other end, a fund with a 14% loss rate, the lowest among them, returned 1.1x capital.

Taken together, these results suggest that funds with loss rates near the lower or upper bands of the 35%-70% range tend to underperform because they take too little or too much risk, respectively.

To see if our hypothesis was on target, we compared our results to those reported by others, including Adams Street Partners. They concluded that 55% of invested capital was allocated to losing deals, with a capital-weighted loss rate of 45%.

Cambridge Associates conducted its own research and published results that were somewhat similar, as illustrated by the chart below.

We compared the various findings above to those from a 2013 analysis of Union Square Ventures funds by Fred Wilson (who has also written about the losses and returns at his AVC blog). He reported that USV’s top-performing 2004 fund had a loss rate of 40%, near the lower end of our range. Perhaps not surprisingly, that loss rate was consistent with that of Fund B, detailed earlier.

Finally, we note the work of our friend Trevor Kienzle’s firm, Correlation Ventures, which analyzed 21,000 financings for the period 2004-2013. They found that 64% of all VC investments lose money.


Simply put, venture funds should be taking risk to generate acceptable returns. Based on past experience, a loss ratio between 35% and 70% would seem to signal a healthy balance between risk and reward. No one likes to see losses, of course, but it is important that LPs not be fixated on investments that don’t work out. Great managers, like great athletes, should be able to deliver good results by remaining consistent, focused and disciplined, regardless of the (expected) hiccups along the way.

Needless to say, that doesn’t mean risk management is unimportant. There are various tactics that managers can employ to optimize returns when bad outcomes are inevitable. These include recycling proceeds from earlier realized losses and maintaining sufficient dry powder to take on a more concentrated exposure in high-performing investments.

(Note: for more insights on the loss-return relationship, please read Venture Outcomes Are Even More Skewed Than You Think at Seth Levine’s VC Adventure, and Venture Capital Disrupts Itself: Breaking the Concentration Curse by Cambridge Associates.)


There can be no guarantee that any investment strategy employed by Industry Ventures will be successful. The investments described herein are presented to illustrate examples of the types of investments Industry Ventures may have bought or the types of transactions it may have entered into as of a particular date. They may not be representative of any current or future investments, and the performance of these investments is not necessarily indicative of the performance of all investments made by Industry Ventures. It should be specifically noted that not all transactions entered into by Industry Ventures will be profitable or will equal the performance of the investments described herein. No guarantee of investment performance is being provided and no inference to the contrary should be made. Past performance is not indicative of future results.

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