Episode 1: Norwest Venture Partners’ Teri McFadden: Private Market Trends

Rodney (00:01

Teri, I'd like to welcome you to the Invested at Work Podcast. And I got to say I'm excited for today because every time I talk to you, Teri, I learn something new about the world of private equity. But for our listeners, can you share a little bit about your career background and how you got to Norwest Venture Partners and what you do today?

Teri (00:22):

Happy to do that, and thank you for having me. I'm excited to have this discussion with you as well. So, I started my career in venture capital a long time ago, actually with the first bubble in 1999. I jumped into a talent partner role with a venture capital firm, and I've been doing basically that role ever since. And then I joined Norwest 15 years ago, actually during the downturn, that was fun, early 2009. And so, you could say I've been doing this role for venture capital and growth equity firms for a long time and have seen a lot of cycles, which makes it interesting when it comes to compensation.

Rodney (01:07):

I bet it does. So, you've worked with a lot of entrepreneurs, a lot of startup companies and their teams. I want to better understand the path for a startup today versus say, two, three, four, five years ago. How is it different?

Teri (01:25):

Well, I would say the exit horizons have definitely extended. Even if you go back a couple of decades, the historical norm was a four-year exit path, which is why equity typically has a four-year vest period. I would say over the last couple of decades, what has happened is to be a truly successful IPO-ready company, you're looking at 10-plus years before that exit happens. M&A can still happen earlier. I think it's still difficult for any company to find a meaningful exit within four years. So, again, that four-year vest period typically is up before there is any liquidity event. So, that's the biggest change. And I think that hasn't just necessarily happened in the last three to four years, but that's happened definitely over the last decade.

Rodney (02:24):

Why is that? What precipitated that change where the period got longer and longer to get to that liquidity event?

Teri (02:33):

That's a really good question, and I'm not sure I have a perfect answer. It's probably the perfect storm of one, companies have been raising more money to get to a meaningful exit, which means that to get to a meaningful liquidity event, they have to grow farther. So, it's no longer okay, to just be $100 million revenue company. Now, you have to be a $200 plus million revenue company. And these days, even EBITDA positive before you consider an IPO. You have to have higher growth rates, and so that's harder to maintain as you get larger as well. So, early days it's easy to grow 80%, 100%, but as you get later stage, even growing 40%, 50% can be a challenge. And so, when markets turn down, business slows down, that's harder to achieve, and that extends the window to exit, I guess I should say.

Rodney (03:36):

I want to continue on the theme of timing. I live in a region where every fall, people go apple picking. And I'm always wondering, when you get into the apple orchard, how do you know what's the right apple and that it's ready to be picked and it's going to be the best apple you've had? And so, I want to ask in a similar vein, how can a company know it's the right time for that initial public offering, that merger, that acquisition? What are some of the markers that will tell a company, "Okay, now is the time to do it"?

Teri (04:14):

Yeah, I think for some of our portfolio companies when it comes to acquisitions, they start getting offers, preemptive offers, right? And that's usually a sign that there's some interest in their product and in their positioning. They're probably solving some pain in the market that others have holes to fill, and that's when they have to make the decision. Do we go the acquisition route? And if we've got one or two people interested, maybe we go and shop our company to see if we can get a higher price for it and get more interest, start some bidding wars, get some competitive interest.

(04:50):

And maybe there's so much interest in what we do that this is a standalone business, and we should just give it a couple more years and try to take it public as a standalone entity. So, I think there is inflection point for a lot of our businesses where they have to really do a gut check. Is this a business that can stand alone as a public company? Can we expand our products? Can we expand into maybe new verticals, expand internationally to make this a bigger long-term business? Or are we better suited to go inside a larger corporation and be a large business unit, for instance, inside of that company?

(05:34):

We have had some companies in the past, and some might argue maybe we sold them too early, but now they are the single biggest source of revenue for a very large Fortune 500 business. So, that path can also be interesting for some of our portfolio companies. In fact, several years ago we had one company that was in New York poised to ring the bell on a Monday. And Sunday night, they got an offer for an acquisition, I think it was around a billion or so. And it was an all-cash offer, and everybody did the math, right? "Do we go public, hope that we stay at our billion dollar valuation and we can all cash out over the next six months, or do we take the cash now?" And everybody chose to take the cash. And now, it's still a thriving business inside of this larger corporation.

Rodney (06:28):

Yeah, I can understand taking that cash. You come to me with a billion dollars. Yeah, twist my arm a little.

Teri (06:36):

It made many people happy, I will say.

Rodney (06:38):

I bet. I bet they skipped home that night. I bet they did.

Teri (06:44):

They didn't get to ring the bell, but they were still able to toast champagne.

Rodney (06:48):

Exactly, exactly. When thinking about making that move to the initial public offering, what have you seen companies overlook that they should have thought about when going on that path?

Teri (07:05):

I think there's a couple of things. One is market conditions, and I think that's why we haven't seen a lot of companies go public right now. So, if you go public, can you sustain that initial IPO price and then grow it further? And some of our businesses, again, they think they have the product offerings to expand, but they're not yet proven. So, we have some portfolio companies right now that are taking the opportunity of these closed markets, if you will, to build out their platforms, to build more products, to expand internationally, to maybe move into new verticals that they haven't yet explored.

(07:48):

So, I think if they have the cash in the bank as a private company to go do that, if they're not yet profitable, that is a better way to go, so that when they go public, they can show continued growth and continued expansion into some of these new areas. I think some companies use IPOs as a method of getting capital. If they're not profitable and they need to get more cash in the bank, it's a way to get capital. Those companies maybe struggle a little bit more post-IPO because they haven't yet figured out the levers for growth that they need to show continued to increase in their stock price.

Rodney (08:27):

It seems like you've seen it all from those companies.

Teri (08:32):

I don't know if I've seen it all. I still get surprised, but I have seen a lot.

Rodney (08:36):

Yes, yes. Now, want to pivot to the employee. So, I'm an employee at a startup, looking towards that initial public offering and I want to know what's going on. So, what should companies do to keep their employees informed along the way and educate them what it will entail for that initial public offering?

Teri (09:01):

Yeah. First, I want to say, not every company goes public. So, I think it starts with communicating with your employees day one about the risk level and what the potential reward is. So, a lot of our portfolio companies actually utilize a spreadsheet, which shows an employee's number of options, what the strike price of those options is, basically what the employee has to pay in order to own those options. And then, what the potential upside of those options is in four years when you're fully vested at various exit thresholds. And typically, very early stages, the strike price and the preferred price, which is what investors pay and is generally a higher price than the strike price, in the early days, those actually can be fairly close together. And then, there's kind of a bell curve for employees.

(09:59):

So, as companies grow and new investors come in and pay a higher price for the equity when they invest, the preferred price goes up, and usually the 409A price lags a little bit further behind, so there's a bigger gap. So, you can show someone, basically your strike price is, call it $1 today, the preferred price is $5. So, today your shares are worth $4. Again, this is all on paper and in theory. And so, the spreadsheet will show today at this strike price, this is what your equity is valued. If we exit, again four years from now when you're fully vested at, call it 500 million, and I'm pulling these numbers out of the air by the way, and let's say at 500 million exit, the shares are now worth $10. Then your dollar strike price and $10 preferred, now your shares are worth $9.

(10:59):

And then, if you exit at a billion and it becomes a $20 per share price, then your shares are worth even more, $19. And so, if you show someone kind of what their potential upside is, I think that shows the value potential of staying with the company over the next four years, or again, to reach that billion dollar threshold, it's probably more like eight to 10 years. That's, I think, a meaningful way to communicate to employees. And the other really important part, and we always have this column on any spreadsheet that we recommend for our portfolio companies to utilize the risk is that it's worth nothing. There is that risk. It's not a guarantee. So, we always have that column at the end as well.

Rodney (11:54):

Who's doing the educating? Are they just giving the employees, "Here's your spreadsheet. Take a look. Read it over"? Is it the HR leader? And have you ever seen a situation where an HR leader kind of forgot to do some of the steps along the way?

Teri (12:12):

Yeah, very good question. Yes, generally, the HR leader, where there is an HR leader. For a very early stage company, sometimes they don't have an HR leader, so it's whoever is hiring. And not all managers have been equipped. So, we find that in the early days, sometimes employees aren't educated very well. And so, when we finally do get an HR leader in place, we set up programs to educate even the managers who are doing the hiring, so they're equipped to explain it to their employees as well. I'd like to say with all of our portfolio companies, they're all well-educated and they know how to communicate to new hires, but I don't think that's always the case.

Rodney (12:56):

For the past four years, Morgan Stanley at Work has conducted a survey that we call the State of the Workplace Financial Benefits Survey. And in this year's survey, what we did, we asked employees at privately-held companies about the prospect and their thoughts about the prospect of a future liquidity event, like an IPO or a tender offer. And we asked them, "How important is that to you?" And 62% said, "Yes, it's either very important or somewhat important to me that that will be taking place." I see your smile. That's not a surprise. But then, we also, for each year's survey, we also survey HR leaders. So, HR leaders at privately-held companies, it was more like over eight in 10, almost nine in 10 said, "Yes, it's important in the next 12 to 24 months that that liquidity event happens." I was intrigued by the difference between the HR leaders and the employees, where it's like over a 20 percentage point difference. Any thoughts about that difference? And then, I have a follow-up question.

Teri (14:12):

Yeah, it's interesting because I think in every corporation, every company startup or large, you have the noisy employees. And so, the noisy employees, which maybe are the ones who have been there four or five years, they're fully vested and they're like, "So, when's this going to happen?" They're probably in the HR leader's office every day, "When's this going to happen? When's this going to happen?" And maybe some of the later employees rather who've only been there two years and are only 50% vested, they're not as focused on it. They're thinking, "I still have another two years before I'm fully vested." It's not an imminent need for them. And so, I think HR leaders hear it from the noisy employees and that's why it becomes more important to them. And they're worried about losing some of those employees if they choose to move on.

Rodney (15:04):

When dealing with employees at a privately-held company, the motivations to join privately-held company, of course, is a liquidity event. But there are probably other motivations. What are some other motivations you've heard from employees at companies as to why they chose to join the startup world or even the entrepreneurs who go from startup to startup?

Teri (15:26):

Yeah, I think the biggest reason I hear is they want to be able to make an impact. So, if they've been at a really large corporation, they feel like a cog in the wheel, and they don't feel like they're making a big impact with what they do. And so, that's probably the biggest reason. I was talking to a sales executive the other day who's had a very successful career at some really large Fortune 200 technology companies, and she wants to join a startup.

(15:54):

And I said, "Okay, you realize the risk and you realize the compensation will be less, right? We can't pay you in RSUs every year what you've been making at this company." And she said, "It's not about the money anymore, it's about making an impact. Feeling like what I'm doing is significant to the company." And I think that's probably the biggest reason I hear. And for founders, truly, it is all about making an impact. They want to create something that changes, if not the world, changes something in the industry that they've been working in. They see a need and they want to go fix it. They have a solution and that's what motivates them.

Rodney (16:38):

And a startup there is that risk that the liquidity event might not happen or might be much further in the future than anticipated. What are some alternative solutions that companies can employ to make sure that employees remain engaged and motivated?

Teri (16:57):

I think there are a couple of levers that I see our portfolio companies utilize. One is retention equity. So, when employees are almost fully vested or fully vested, we see our portfolio companies give them an additional tranche of equity with another four-year vest ahead of them. This is for the top performers. Not everybody gets it. It's not like in a public company where you get refresh grants every year. Most of our portfolio companies wait until employees are about 75% vested, so three of four years vested. And then, the grants aren't huge. They aren't the same as an initial hire grant.

(17:40):

The benchmark we actually use is 25% of what a new hire would get for that role. So, they're getting additional equity. It's generally at a higher strike price than their original grant. So, their original grant is still what will make them the most money upon a liquidity event, because in general, the strike price is lower, and it's a bigger grant, so they'll have more numbers of shares and that initial new hire grant. But it gives them a little forward vesting, a little reward. I look at it a little bit like a bonus. So, just like you would get a cash bonus at the end of the year, you get an equity bonus for being a well-regarded, high-performing employee.

Rodney (18:28):

And what's the best way to make sure that that refresh grant, that retention grant is effective for your employees? Is there any best practices that you share with your portfolio companies?

Teri (18:42):

Well, again, a couple of things, which is a really expensive retention grant program can be highly dilutive to the pool. So, you want to make sure that you're utilizing it in an effective way that is going to motivate employees and motivate the employees that you think are essential to stay in the seat for another four years. So, it's rewarding your top performers that you want to keep in the seat. But again, communicating to those employees that the value that they will continue to create is in that new hire grant. So, with that new hire grant, again, in my scenario, if your strike price is $1 and today the shares are worth $5, if you stay another four years, the goal is that that $5 preferred price becomes $10, $20 in some sort of meaningful exit. So, you continue to create value in that new hire grant.

(19:42):

And I think it's important that the HR leaders, managers are equipped to communicate that value, and again, the employee's ability to increase the value of their equity. So, you want to make sure that all of your employees are motivated by helping to make the company more successful and increase the value of equity over time. So, while refresh grants are a nice-to-have, retention grants are a nice-to-have. They're not the wealth creation vehicle. The wealth creation vehicle, which an employee at that point, if they're fully vested, owns or has the ability to own if they haven't exercised their options yet, is going to continue to increase in value, and they are a part of that. They are a part of making that happen.

Rodney (20:36):

Creating that ownership culture and making sure to reinforce that.

Teri (20:39):

Yes, ownership culture. That's a great phrase. I love that.

Teri (25:23):

There is one more lever that we've seen employed at some of, again, our later stage companies that have interest for new investors coming in. We've seen some secondary transactions where, again, key employees who've been there a long time are seeing some liquidity in those secondary transactions. So, they may not sell all of their shares but some of their shares to get some liquidity. That is the other lever that we see some of our portfolio companies utilizing.

Rodney (26:06):

Have you seen that particular market, the secondary transaction market expand as it's been difficult to get to the liquidity event?

Teri (26:15):

I wouldn't say it's expanded. I would say it's still selective. It depends on the company, it depends on the stage, depends on the investor interest in making a secondary transaction happen. But I do think it is one tool that some of our portfolio companies have explored and actually utilized.

Rodney (26:39):

And was that a tool available say five, 10 years ago, or is it a relatively newer tool?

Teri (26:45):

Nope. I think it's always been something that we've seen. Again, it's not necessarily common, but it is something that we have definitely seen. We also see it... Yeah, it's generally our later stage companies where we see it.

 

Rodney (20:42):

Yeah. So, we talked about employees that are in seed. Let's talk about recruiting when you're at a private company. Being recruited, privately-held company, you see the concept, what they're working on, you're thinking, "Wow, this is great. I can make an impact. But also, boy, when this goes public, it's going to be fantastic," or, "When this gets acquired, this is going to be great financially." How should companies think about managing the expectations for potential employees that they're looking to as to what happens within an organization as they move towards that liquidity event or don't move towards it in a timely manner?

Teri (21:26):

Yeah. So, again, it depends on the stage. And so, I think the messaging is different depending on early stage versus later stage. And I think the motivations of employees to jump into something really early stage has to be a little bit different than the later stages as well. So, for really early stage, again, when somebody is looking to make an impact, that's when you have the ability to make an impact. Joining a company that's only 40 employees, you're going to, by nature of a smaller team, have a bigger impact.

(21:59):

Joining a company that's 400 employees, you still have an impact. It's still private, they're still upside in the equity, but it's a different stage and a different level of impact. And so, from a recruiting perspective, when you're thinking about compensation... The other thing that happens over time, as companies increase in revenue and the risk decreases, and with that, they've likely raised more money, two things happen. One, cash increases. So, base salaries, bonuses, that cash compensation component becomes more equivalent to a public company in our later stage private companies. But the equity component, the number of shares as a percentage of ownership goes down.

(22:49):

So, maybe in the early days, an executive would command 1% for their role joining an early stage company. Later stage when a new executive comes in to that VP role, it might only be .75%, right? It's as a percentage less ownership, but the cash probably has gone up. So, there's definitely a trade-off. And so, you'll see different types of employees, if you will, different types of executives, be motivated by different stages. Those who have the appetite for risk can afford to take a little less cash will go early, so they can have more equity and more upside. Those who maybe can't afford that kind of cash risk, if you will, will tend to go later stage or stick with public companies.

Rodney (23:46):

Based upon what you've seen so far year to date, what do you think are the expectations for private market equity for the next say six months, year, two years, going out that far? If I can be so bold and ask that question.

Teri (24:08):

If I had a crystal ball, Rodney.

Rodney (24:10):

If you had a crystal ball, your years of experience, I know things change, so no one's going to hold you to this, but what are some thoughts on some things that... Especially because of the current IPO environment that we're in.

Teri (24:26):

Yeah, so generally, what I will say is this year already looks better just from an M&A perspective. So, we're seeing a little more M&A interest in our own portfolio, so that's a positive sign. From an IPO perspective, fingers crossed 2025 has a window that opens. And some of our companies that thought maybe they could go public in 2023, and therefore, are more ready for that event. If the window opens in 2025, I think we might see some companies start to go public. Again, I don't have a crystal ball, but that would be my hope. How's that?

Rodney (25:10):

Yeah. No, that's a great. Like I said, I'm not going to hold you to that, but was just curious as to your perspective from where you sit within that world. Any-

Rodney (27:01):

Any of the trends or technologies that are changing the private market liquidity landscape?

Teri (27:43):

What I will say is the general market conditions definitely have an impact. And so, with public markets slowing down, I think that has had a ripple effect that then impacts our private businesses. So, not only have market valuations come down in general public and private, so new investments where you generally look at let's say a multiple of ARR or a multiple of EBITDA, if they happen to be an EBITDA-positive business, those have come down. And so, with that, I think valuations have come down, growth has come down, growth has slowed. So, you have kind of a double-whammy happening in our portfolio companies, which is valuations have come down and growth has slowed.

(28:46):

So, if they were targeting 80% growth two years ago, maybe now they're targeting 50% growth. And again, this is some of our later stage businesses. If you're an early stage company that's very early in revenue or still building your product, the current market conditions, ironically, have been less impactful to our really early stage businesses. And ironically from my perspective, they're less risky. So, when I have executives come to me and say, "Well, I'm considering risk when I make my next move," and I'm like, "Then go early." Because honestly, the tougher environment right now are the portfolio companies that have raised a lot of capital at really high valuations and their growth has slowed. And those are the ones that are going to be the most challenged.

(29:38):

And so, I think those are the ones where we see things like repricings happening because 409A valuations have come down. And so, basically, people's stock price is technically... Their stock is underwater because their stock was issued at let's say $2 a share when they joined, and now the 409A valuation has it at $1 a share. And so, in those scenarios, we see some of our portfolio companies pulling the lever to reprice everybody's options, so they're no longer underwater. And so, I just think that it's a tougher slog for some of our portfolio companies until the market turns around, until valuations start to go back up, until growth starts to increase. Those are the ones that are the most challenged right now.

Rodney (30:26):

See, I knew you had an answer to the trends. I knew that it was there.

Teri (30:30):

It was circular, it had nothing to do with technology, but definitely a trend.

Rodney (30:35):

Yeah, absolutely. And that's why I said trends or technology, but I knew that there were trends and once again-

Teri (30:43):

You keep me talking long enough, Rodney, you'll eventually get there.

Rodney (30:48):

And again, I learned something in all of that, like I usually do in our conversations. Teri, one final question for you. So, I know you've been doing this for a while and you are well-respected within the industry, and that's why I was so pleased that you were able to join us for this conversation today. But what makes you invested at work? What makes you get up every morning and say, "Yes, I want to go and do this"?

Teri (31:22):

Well, first, I'll say I actually love what I do. I love helping our founders create a long-term viable company from their vision. So, a lot of the companies that we invest in are a founder and a great idea. And I love helping those founders make that great idea into a long-term viable business. And whether that's ultimately an IPO company or a company that, again, gets acquired by a large corporation and then becomes a meaningful part of that corporation, seeing that growth, helping the founders through lots of challenges... By the way, it's not easy. Being a founder and creating a startup is not for the faint of heart. It is a tough slog, there are ups and downs, there are pivots, turns. You have to be nimble. Helping them navigate all of that and making it easier for them, that's what gets me up every day.

Rodney (32:26):

Excellent. And I'm sure there are a lot of founders out there who appreciate that you get up and get in there every single day. Teri, thank you for joining me today.

Teri (32:36):

Thank you for having me, Rodney. It was a pleasure.

 

Rodney:

Thanks for tuning in. I hope you join us for the next episode of Invested at Work. If you haven’t already, remember to subscribe—and share it with your friends and colleagues!

 

Be sure to visit us at MorganStanley.com/atwork for more insights on workplace financial benefits, and how Morgan Stanley at Work may be able to help you.

 

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Invested at Work is brought to you by Morgan Stanley at Work, produced by StudioPod Media, and hosted by me, Rodney Bolden. Our executive producers are Fiona Kelsey, Lisa Boyce, and TJ Bonaventura. Our engineer is Alejandro Ramirez. And our writer is Dan Pelberg.

 

 

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