Non-Linear Growth

A glimpse around the next corner; mind the curves.

March 30, 2012 • 8:52 am 0

Introducing Digital Fortress

Today, my Partners and I at Meritage Funds announced that we’ve established a new platform in the data center colocation market. Headquartered in Seattle, WA, Digital Fortress operates nearly 50,000 square feet of data center colocation space, focused on delivering high-power density installations to enterprise customers. A  Meritage Funds blog post announcing the investment has much more on our thesis and goals for the investment.

Getting this transaction done was a long an arduous process. In earnest, we began evaluating the Pacific Northwest data center market in October 2010. What we found was a fragmented market that had great supply-demand characteristics. In addition, the market has great power-dynamics, meaning that power is cheap, stable and largely from renewable sources. It blows my mind every time I cite this statistic, but over 95% of the power in metro Seattle is from renewable sources, principally because of the huge hydroelectric energy production in eastern Washington state.

It was easy to see there was a great opportunity for data center operators in the PNW. But, finding an entry point into the market was a bear. Because the market is fragmented, there was no natural starting point. Rather than buying a platform, we would have to create one. In the end, we made that happen by completing the simultaneous acquisitions of two data center operators that happened to be located in the same building. In concept that sounds easy. From first hand experience, I can tell you it was really hard. There were an incredible number of moving parts here, including simultaneous negotiation, documentation and diligence processes on both acquisitions, a debt syndication, an equity syndication, and most importantly, the establishment of a new management team which has the chops to achieve our goals for the investment. In all, executing the transaction took the better part of ten months.

In the end, it was worth it. Overnight, Digital Fortress has become the leading independent colocation provider in its market. We’ve established a strong leadership team with the addition of Mark Hughes (former EVP of Operations at SunGard) as Executive Chairman and Tim Doherty (former CEO of Fortress Colocation) as Chief Corporate Development Officer. Already, the Company is executing its expansion plan with the announcement of a new facility in downtown Seattle. With our equity partners, Halyard Capital and Sweetwater Capital, we have dry powder to fund further organic and acquisition-based expansion plans.

If you believe that the hard things are the most rewarding, then our investment in Digital Fortress is sure to be a success.

For my friends in Seattle, please let me know how Digital Fortress can be a resource to you in your market.

Filed under: Growth Equity, Investment Selection, New Investments, , , , ,

September 1, 2011 • 9:59 am 0

One Surefire Way to Screw up Your Lifestyle Business

Some businesses are designed – maybe even destined – to be owner operated. Industry parlance often refers to these businesses as lifestyle businesses. Wikipedia has a nice definition. They are typically small, profitable, generate cash and enable their owner-operator to sustain a well-above average lifestyle. In some circumstances, they may even make their owner-operator filthy rich over time.

Some people may think that the term lifestyle business is an insult. I couldn’t disagree more. Being the owner-operator of a lifestyle business should be a source of pride; a badge of honor.

As a growth stage investor, I see quite a few lifestyle businesses in our deal log. This type of opportunity finds us because they often meet our high-level screening criteria. They have paying customers, generate meaningful revenue and produce EBITDA and cash every year. They “fit the profile”.

But when I meet with an entrepreneur who is running a lifestyle business, I’m not shy about asking a most important question. It usually goes something like this:

I understand you wish to raise capital to grow your business. But if I’m hearing you correctly, today you own and control nearly 100% of your company. This enables you to lead a balanced life, generate meaningful personal wealth and take great satisfaction from your work. Why would you want to screw all of that up by raising capital?

I mean it too. Raising capital comes with loss of control, changes in lifestyle (read work flexibility) and other issues. More importantly, lifestyle businesses tend to lack one key ingredient that institutional equity investors (particularly growth equity investors) need to generate returns; rapid scalability. Bringing in institutional capital creates an incredible amount of pressure to generate top-line growth. In the context of most lifestyle businesses, that kind of top-line growth is either not achievable or if it is, will so fundamentally alter the character of the business that it will be unrecognizable to the entrepreneur at the end of the process. In short, that pressure will probably do more damage than good from the owner-operators point of view.

So if you are an entrepreneur seeking capital from me and I say something like “You own a great lifestyle business; why on earth would you want to raise capital and screw it up?”, please know I’m coming from an honest place. I’m not insulting you.  I am, however, trying to get you to come to grips with the fact that raising capital may be a surefire way to screw up the good thing you have going.

Filed under: Growth Equity, Investment Selection, Lessons Learned, Raising Capital

February 7, 2011 • 1:29 pm 0

Growth – I Like Mine Non-Linear

My Partners and I at Meritage have always had an investment mandate with broad stage flexibility. We’ve often described our investment practice as “multi-stage”, ranging from early/venture through later stage opportunities. This is in contrast to our sector preferences which are tightly and highly refined. It should come as no surprise then that we’ve been doing some soul-searching about our stage preferences.

I this Meritage Blog post, we’ve announced a significant refinement to our stage orientation. Going forward, we intend to focus all of our energy on growth equity opportunities. Over the years, we’ve made many investments that meet the growth equity characteristics we outline in the post and we’ve had great success at that stage. We see this as not so much of a change, but as an important refinement to our stage preferences – one that is driven by many factors, but mostly by our read of the state of the private capital markets and where we can best deploy the capital, time, energy and knowledge of our team to generate attractive risk-adjusted returns for our investors.

With this refinement, I’ve also decided to change the name of this blog. Goodbye Non-Linear VC; hello Non-Linear Growth. Maybe this will be a catalyst to get me blogging regularly again; it has been much too long!

Filed under: Growth Equity, Investment Selection

November 12, 2010 • 5:41 pm 0

An Entrepreneur’s Growth Equity Conundrum: Should I sell stock or sell growth?

Two times in the past year, I’ve been close to making an investment in two separate micro-cap growth equity opportunities only to have the opportunity go sideways deep into the process. The two businesses share a lot in common; they are similar in size, profitability, and growth prospects. Both are capital-intensive; the first being asset intensive, the second being customer acquisition expense intensive. Both are examples of businesses where capital is a necessary, but insufficient, ingredient for growth; no capital, no growth.

We were excited about both investments. We offered a fair-valuation and structure in both cases; on market with other proposals the companies had received. In both cases management communicated that we were their preferred investor. In neither case did our proposal require investor control of the Board, but in neither case would management have had control either; each Board would be balanced between investors, founders, management and independent directors who could act as a swing vote. Pretty good landscape for a deal to come together, right?

I thought so too. But, in the end, both groups of entrepreneurs chose not to take our money or any institutional money for that matter. In the first case, the entrepreneurs wanted to prevent dilution and were protecting a prior, too-high price per share that had been set by high net worth individual investors and an unwieldy gridlocked board structure. They decided to raise a small insider round with their existing high-net worth investors at a price per share that is above market. In the second case, the entrepreneurs wanted to prevent dilution and a loss of control at the Board level. They decided to raise a much smaller round from friends and family; also at a valuation that is above market.

I’m a huge fan of entrepreneurs who bootstrap their business to success without institutional capital. I recognize that raising institutional capital is risky business – new investors, new board, etc. I encourage entrepreneurs to choose their investors wisely. But, unfortunately, capital-intensive businesses can’t be bootstrapped. Eventually, capital-intensive businesses must raise capital and grow or whither. There is no future as a sub-scale player in capital-intensive sectors. These are not lifestyle businesses; staying small is a recipe for slow failure. Eventually, the market passes these companies by as larger, better capitalized competitors crowd out the small guys.

Entrepreneurs in these situations face a difficult choice. They have two things they can sell; one obvious, one hidden and difficult to quantify.  What do I mean? It is obvious that if you raise capital, you are selling stock. Via the sale of stock the company gets capital and with that capital, the company funds growth initiatives creating the opportunity to grow and become more profitable. To simplify, such a company has sold stock and bought growth. By choosing not to raise capital or to raise less capital, the reverse is true; the company has essentially sold future growth potential by not selling (essentially buying) stock.

If the company has great growth prospects and management is confident in those growth prospects, it’s better to sell stock and buy the growth. In that case, management will get a smaller piece of a bigger pie and come out ahead in the end. If the growth prospects are uncertain or management does not have confidence in its growth projections, it may be better to “sell the growth potential” and keep more ownership. After all, if management is not confident in its growth prospects, why take the dilution from selling stock (and the associated loss of control) to capture growth that may not materialize.

I sympathize for entrepreneurs that face this choice. There is no right answer here; much if this should be left to personal preference. But make no mistake, in capital-intensive businesses, entrepreneurs that choose to raise insufficient capital may be unwittingly selling something of tremendous hidden value – the future growth prospects of the business. And although it is counterintuitive, I’d argue there are greater risks in under-capitalizing a capital intensive business than the risks inherent in an institutionally financed deal (lower ownership, less control). In any event, the old big piece-small pie, small piece-big pie conundrum is alive and well.

Filed under: Growth Equity

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