HV III Annual Report - 2016 - Google Docsfiles.constantcontact.com/97ae720b001/15261d1f... · Houston Ventures III 5 2016 Annual Report The Fund’s investment period ends November

Houston Ventures III Annual Report December 31, 2016

To Our Limited Partners: Houston Ventures III, L.P. and Houston Ventures III (Institutional), L.P., collectively (the “Fund” or “HV III”), invests growth-stage equity in technology companies addressing operational challenges in the Energy industry. Specifically, we target market-validated technology solutions that enable process improvements for industry participants. By identifying industry pain points where the effective application of technology can drive the largest returns to end users, Houston Ventures strives to build companies with sustainable revenue streams and healthy margins. The portfolio contains four direct investments in companies offering technology-enabled products and services to the upstream oil and gas sector. We have worked with each management team to establish performance measures for guiding strategic thinking and execution of their business models to achieve maximum shareholder value upon exit.

Company Security

Date of Initial

Investment Invested

Estimated Fair

Value % of Portfolio Fund Ownership

NuPhysicia Preferred Stock Mar-12 $1,367,201 $581,963 2.4% 7.0%

LiquidFrameworks Preferred Stock Sep-12 $5,000,001 $14,860,877 60.4% 31.2%

Geoforce Preferred Stock Aug-13 $4,436,350 $4,792,593 19.5% 10.4%

Oseberg Preferred Stock Dec-15 $4,000,000 $4,040,000 16.4% 21.1%

Other Carried Interest 1 $314,649 1.3%

$14,803,552 $24,590,082 100.0%

1 Carried Interest in Houston Ventures III Co-Invest, L.P.

As always, we look forward to your feedback and appreciate your support.

Best regards,

Chip Davis Jim Newell Fred Lummis

Houston Ventures III 1 2016 Annual Report

Since inception, we have called approximately $20.3 million of capital or 75% of total Fund

commitments. Investors have made five cash contributions and, on a weighted basis, have been

invested for three years. As of December 31, 2016, called capital has been utilized as follows:

$14.8 million (72.9%) for portfolio company investments, $4.6 (22.7%) for Fund start-up and

operating expenses, and $0.9 million (4.4%) cash on hand. No distributions have been made to

date.

The Fund’s portfolio positions are at various

stages of investment maturity and are

collectively valued at $24.6 million or 1.21x net

cash contributions.

Venture capital funds typically exhibit substantial

negative net internal rates of return early in

their lives. These negative returns

mathematically decline as capital is deployed

and management fees comprise an increasingly

smaller percentage of capital called. Accounting

policies regarding the carrying values of

investments can also handicap early year

returns. The industry has a term for this

pattern of returns, the “J-curve”. Annual returns

plotted in a time-series will start at zero, turn

negative in the early years, then grow positively

as investments appreciate in the latter years of

a fund’s life. 2016 marked the fifth “full year” of

Fund operations. To the right is a plot of the

Houston Ventures J-curve from inception

through December 31, 2016.

At December 31, 2016, a Fund limited partner

with capital commitments of $100 thousand

would have made capital contributions of $75 thousand, resulting in an equity value of $89.7

thousand as depicted in the graph below. We forecast HV III’s performance to continue to

improve during 2017 as the recent downturn in upstream oil and gas moves further behind us.

The carrying value of the Fund’s portfolio investments rose $4.7 million (23.6%) in total during

2016.


The Fund invests in technologies that improve processes in the Energy industry. Our strategy is

to assume a limited number of investment positions, and then to assist entrepreneurs in

developing sales, product development, and other operational tactics we believe will best

position them to achieve revenue growth and operating efficiencies with a scalable economic

model.

The relatively high cyclicality of the

oil and gas industry creates

significant challenges for operators

and service companies, who

struggle to efficiently scale their

operations to meet current

demand. In this context, we

search for technologies that

address processes with the

following characteristics (see blue

circles in the image):

The oil and gas industry very

closely fits the attributes above

where many mission critical

workflows include different

business functions passing around

spreadsheets (“loosely structured”) under volatile market conditions (“business rules change

frequently”) that are frequently changing what people have to do next (“highly variable”).

Despite the generally high level of technical sophistication in the oil and gas sector, this pattern

of ineffective collaboration persists across corporate processes, field processes, and between

supply chain partners.

Advances in cloud architecture and related software design techniques have substantially reduced

the cost and time required to create technologies to solve complex business problems. The

reduction in capital requirements to build these technologies, combined with advances in software

architecture, have also made technologies less burdensome to sell and buy, all adding up to

decreased friction for all parties involved in the adoption of new enterprise software.


Prior to 2010, we invested in horizontal market technology plays. Product development historically required significant investment prior to commercial readiness, and committing to a single industry vertical meant voluntarily limiting a company’s market opportunity relative to its go-to market cost (something that venture funds do not like). The evolution of “cloud” economics altered the risk profile of industry specialization for funds such as ours, and caused a shift in our views on market optionality. Buyers generally want to believe enterprise solutions understand their business in the same way that a job candidate has relevant employment experience. It is the relevant experience of current solutions that make them attractive to potential buyers, thus accelerating adoption. The chart above tracks the historical price to sales ratios of vertically focused software companies against those of horizontal “high-growth” (>20%) software companies. It reveals that for the first time, vertically focused public software companies are trading at a premium to horizontal “high growth” software companies despite lower short-term growth estimates.


The Fund’s portfolio companies provide the Energy industry with technologies that are meant to make operations more scalable and mitigate the effects of cyclicality. Since 2000, the rate of fluctuation in oil and gas drilling exceeded that of automobile manufacturing (a common reference point of “cyclicality”) by more than 300 percent (based on trailing two-year averages). Furthermore, instances of oil & gas drilling fluctuations exceeding those of automobile manufacture occurred at a rate of 13 to 4. During the period late 2014 through 2016, the oil and gas supply chain experienced a severe contraction which had a mixed influence on portfolio company operating results. By categorizing each portfolio company according to its fundamental service offering, we can see how different categories correlate to changes in industry conditions and how the industry prioritizes itself around those conditions (see chart below). Using our portfolio results as a proxy for measuring those priorities, “Income Statement Optimization” (by means of “Revenue Management” and “Market Intelligence”) is the highest priority, “Balance Sheet Optimization” (by means of “Asset Management”) is second, and “Crew Welfare Enhancement” is a distant third. Using Q3-2014 as a baseline, the average spot price for West Texas Intermediate crude declined by fifty-one percent through Q4-2016. To the positive, LiquidFrameworks and Oseberg (stub period since initial investment) experienced revenue increases of 46% and 7%, respectively. To the negative, Geoforce and NuPhysicia experienced revenue declines of 22% and 46%, respectively. Geoforce’s revenue decline was attributable, in part, to product defect issues (as previously reported) which makes correlation to industry cycles less discernable. NuPhysicia’s target market was offshore drilling which was the hardest hit (comparing US land to offshore drilling) and has yet to reveal any meaningful recovery. In the cases of revenue decline, the senior position of our preferred stock securities played a positive role in mitigating the negative effects of operating declines on respective investment values. Despite the varying operating results across the portfolio, the Fund increased in value during 2016 by 23.6%. In other words, HV III’s portfolio concentration in “Income Statement Optimization” rendered the aggregate portfolio a “net winner” during a period of severe industry contraction. As stated above, we expect HV III’s performance to continue to improve during 2017 as the downturn in oil and gas moves further behind us.


The Fund’s investment period ends November 4, 2017. As of December 31, 2016, HV III has

uncalled cash of $6.74 million for follow-on investments in existing portfolio companies,

potential investment in one new portfolio company, and operating expenses.


NuPhysicia, based in Houston, Texas, provides advanced medical

services. Founded in 2007 as a spinout of the hallmark telemedicine

programs of the University of Texas Medical Branch.

The Company’s patented solution uses technology to distribute physician services to multiple remote locations

and markets. The method combines physicians, paramedics, electronic medical records, pharmacy

management, wellness, and proprietary telemedicine systems into an integrated, turnkey solution. Current

customers include offshore energy companies, corporate employers, regional clinic networks, and the U.S.

military. Select summary data follows.

Company Security

Date of

Initial

Investment

Price

Per

Share Total

Fair Value

Per Share Total

Fully

Diluted

Ownership

NuPhysicia Series C-1 Mar-12 $2.68 $1,367,201 $1.14 $581,963 7.70%

Positives Negatives

Workplace Clinic Marketing – Sales and marketing processes are maturing for the Medicine at Work product generating qualified opportunities for the 2017 sales pipeline.

No New Subscription Bookings - Closed no new deals aside from one-time equipment sales.


Subscription Revenue

As the Fund’s portfolio companies mature, recurring revenue growth becomes the most important performance

metric positively correlated with equity value and a potential liquidity event. The chart below summarizes two

components of historical revenue performance for NuPhysicia: Annualized Recurring Revenue (“ARR”) tracked

on the left axis and Annualized Subscription Value (“ASV”) of new quarterly subscription bookings tracked on

the right axis.

Based on the Company’s revenue model and achievable profit margins, we calculate an ARR target for

NuPhysicia based on a hypothetical 3x ARR exit multiple, a five-year investment hold period, and a targeted

minimum gross IRR of 25%. The Company has achieved 18.6% of its exit ARR goal at roughly the end of the

Fund’s assumed investment hold period.

Commentary & Outlook

NuPhysicia is now focused solely on growing its Employee Health Care business line of workplace clinics. The

Company has sharpened its marketing message based on results from experimentation during the year. Clinics

are now offered at “no startup cost” for worksites with 200+ employees. The simplified employer pricing

model is per employee, per month, with no co-pays or insurance claims to consider. Lead generation for this

product is now focused on industry referrals from healthcare brokers who consult with self-employed

employers. At year-end, NuPhysicia had six clinics under contract, including one that opened in early January

2017. The 2017 plan calls for opening four new clinics to bring the total to ten by year-end, which would

elevate the Company to a more sustainable cash flow positive position.

Conclusion

Based on the established investment benchmarks, NuPhysicia is currently not on track to meet the Fund’s

minimum investment objectives.


LiquidFrameworks, based in Houston, Texas, provides field force

automation software to companies in the energy and industrial

service industries. Customers using the LiquidFrameworks product

suite report numerous benefits including increased cash flow, labor

reduction, improved invoice accuracy, and greater revenue capture. The Company’s flagship product, FieldFX,

allows users to manage contracts, quotes, equipment, jobs and field tickets along with customer-specific

electronic forms such as safety incidents, inspections, and other operational data reports. Select summary data

follows.

Company Security

Date of

Initial

Investment

Price

Per

Share Total

Fair Value

Per Share Total

Fully

Diluted

Ownership

LiquidFrameworks Series A Sep-12 $0.47 $5,000,001 $1.41 $14,860,877 31.1%

Positives Negatives

Sales – Record setting fourth quarter with over $1.9 million of closed subscription bookings. Exceeded sales plan for the year by more than 90%.

Upsells – Major upsells with several significant house accounts expanding their annual subscriptions by more than $300 thousand each.

Customer Attrition – Eight customer losses during the fourth quarter bringing the total for the year to eighteen.





components of historical revenue performance for LiquidFrameworks: Annualized Recurring Revenue (“ARR”)

tracked on the left axis and Annualized Subscription Value (“ASV”) of new quarterly subscription bookings

tracked on the right axis.


LiquidFrameworks based on a hypothetical 5x ARR exit multiple, a five-year investment hold period, and a

targeted minimum gross IRR of 25%. The Company has achieved 113% of its exit ARR goal with

approximately nine months remaining in the assumed investment hold period.


LiquidFrameworks posted its best sales quarter in its history with $1.9 million of annualized subscription

bookings. That includes major upsells in three existing accounts plus a small new account with Chevron, the

Company’s first oil and gas operator customer. New subscription bookings for 2016 totaled $3.5 million, and

the product mix consisted of 75% field ticketing revenue and 25% derived from the other six FieldFX modules.

The Company is gaining significant traction outside of oilfield services in the areas of industrial and

environmental services. The Company reports a current winning percentage on competitive deals in excess of

90%.

The erosion of smaller accounts was a steady theme throughout 2016, as the extended oil and gas downturn

hit small service companies particularly hard. On the positive side, the Company’s focus on moving up market

resulted in significantly larger average account sizes. The average account size grew 35% year over year to

$138 thousand.

During 2017, the Company will look to scale the organization to capture additional market share in its core

oilfield, industrial, and environmental services markets. LiquidFrameworks has $4.4 million cash on hand,

which is sufficient to finance the 2017 growth plan. We believe the Company will be in a position to explore

exit opportunities during the second half of the year.

Conclusion

Based on the established investment benchmarks, LiquidFrameworks is currently on track to exceed the Fund’s

minimum investment objectives.


Geoforce, based in Coppell, Texas, develops and markets systems for automating management of oilfield service equipment. The Company uses a combination of proprietary and third party GPS (satellite and cellular) reporting devices combined with a web-based software platform to enable

customers to best utilize their oilfield equipment and maximize rental revenues. The Fund’s Series A investment in Geoforce financed the Company’s international expansion and several hires in key functional corporate roles. The Fund’s Series B investment financed the replacement of defective GPS devices and ongoing operations. Select summary data follows.

Company Security

Date of

Initial

Investment

Price

Per

Share Total

Fair Value

Per Share Total

Fully

Diluted

Ownership

Geoforce Series A, Warrants Aug-13 $21.50 $3,049,990 $22.93 $3,344,542 7.4%

Series B, Warrants Nov-15 $24.00 $1,386,360 $24.50 $1,448,052 3.0%

Positives Negatives

HAL & PXD Wins – Closed new deals with major North

American land accounts, Halliburton and Pioneer Natural

Resources.

Product - The Company’s reengineered proprietary tracking

units seem to be performing well and likely creating a

material competitive advantage.

Negative Active Device Growth – Total active devices

declined for the second straight quarter. Account churn

remains a major challenge hampering the Company’s

performance.

Cash – Negative operational performance created a liquidity

squeeze and a significant projected cash shortfall in the

2017 plan.





components of historical revenue performance for Geoforce: Annualized Recurring Revenue (“ARR”) tracked

on the left axis and Annualized Subscription Value (“ASV”) of new quarterly subscription bookings tracked on

the right axis.


Geoforce based on a hypothetical 5x ARR exit multiple, a five-year investment hold period, and a targeted

minimum gross IRR of 25%. The Company has achieved 60% of its exit ARR goal with approximately

eighteen months remaining in the assumed investment hold period.


Geoforce reported another poor quarter with negative net device growth, as a result of 6,282 device

cancellations for a gross quarterly churn rate of 8.3%. Total gross device churn for the 2016 year was 28.8%.

117 total accounts canceled during 2016, which represents a 22% customer churn for the year.

The Company booked $916 thousand of new subscriptions during the fourth quarter, its highest quarterly

bookings since 3Q2015. That includes key account wins with Halliburton (US Land) and Pioneer Natural

Resources (1,000+ vehicles). Demand from the US services market is rebounding, but the Company must

improve its service delivery to reduce churn and generate net business growth in 2017.

Subsequent to year-end, the Company secured $2 million of warrant financing to cover a projected 2017 cash

shortfall. The Fund did participate in the financing and full details will be included in the 2017 first quarter

report to the limited partners.

During 2017, new sales efforts will focus on growth opportunities within the Company’s “Big 3” accounts –

Swire, Schlumberger, and Petrobras. Geoforce is currently considering a significant new growth capital raise,

potentially in excess of $10 million, to capitalize on the strong current market appetite for deals in the

“Internet of Things” space.

Conclusion

Based on the established investment benchmarks, Geoforce is currently behind the requirements to meet the

Fund’s minimum investment objectives.


Oseberg, based in Oklahoma City, Oklahoma, provides customers in

the oil and gas industry with leading analytics software, rich datasets,

and industry expertise to inform decision-making. The Company

focuses primarily on extracting and presenting information contained

within a variety of regulatory filings that historically have only been

available in unstructured formats. The Company’s products include Atla, a SaaS product that provides access

to an ever-expanding database of actionable information and geospatial analytics, and Sol, a lighter weight

SaaS product that provides quick and up-to-date access to essential industry data points. Select summary

data follows.

Company Security

Date of

Initial

Investment

Price

Per

Share Total

Fair Value

Per Share Total

Fully Diluted

Ownership

Oseberg Series A Dec-15 $1.00 $4,000,000 $1.01 $4,040,000 21.0%

Positives Negatives

TX Sales – Closed three accounts for the new TX data set,

and one multi-state (OK & TX) deal during the quarter.

TX Product Development – New TX historical lease data set

is currently 81% complete and TX lease acquisition costs to

date have come in under budget.

Account Churn – Successfully renewed 15 out of 16

accounts, however net quarterly revenue churn was 8.8% in

the quarter, comprised of the one cancellation and three

subscription downgrades.



Recurring revenue growth is the single most important performance metric positively correlated with building portfolio company equity value in the Fund. The chart below summarizes two components of historical revenue performance: Annualized Recurring Revenue (“ARR”) tracked on the left axis and Annualized Subscription Value (“ASV”) of new quarterly subscription bookings tracked on the right axis.

Based on the Company’s revenue model and achievable profit margins, we calculate an ARR target for Oseberg based on a hypothetical 5x ARR exit multiple, a five-year investment hold period, and a targeted minimum gross IRR of 25%. The Company has achieved 25% of its exit ARR goal with over four years remaining in the assumed investment hold period.


Oseberg historically sells one-year subscriptions. The fourth quarter carries the heaviest renewal burden for the Company’s customer success team. All but one customer account successfully renewed during the quarter, however net quarterly revenue churn still hit 8.8 percent. For 2017, we would like to see net churn held under five percent quarterly. The Company’s small legacy accounts in Oklahoma are at a high risk of churning in any given year. However, the addition of new state data sets to the Oseberg product suite will give the Company’s sales team ammunition to upsell larger multi-state customers to offset those smaller account losses. Total ARR at year-end was $2.6 million, which represents seventeen percent year over year growth. The Oseberg sales team closed eight small new accounts with an average annual subscription value of $11 thousand. Three of these new accounts are Texas only subscriptions. Although the new data set is not yet 100% complete, the Company is aggressively pushing into the Texas product and already enjoying some success. In 2016, Oseberg invested a significant amount of capital towards extending the product set to include Texas. Many of the Company’s customers operate in both Oklahoma and Texas, which we believe will bode well for sales of the new Texas data set. Oseberg has begun to earnestly market in Texas. As exploration activity continues to rebound, especially in the Permian Basin, fundamentals look supportive of meaningful revenue growth in 2017. On the product side, Oseberg will continue development of its new Texas and New Mexico products. The company has a new vendor relationship in place with a specialized technology provider delivering data extraction services for lease files. As the partnership matures, more efficient processing of historical lease data should accelerate development timeline for new data sets.


Conclusion

It is too early to draw any conclusions about the performance of the Oseberg investment.


Houston Ventures III, L.P.

Financial Statements












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HV III Annual Report - 2016 - Google Docsfiles.constantcontact.com/97ae720b001/15261d1f... · Houston Ventures III 5 2016 Annual Report The Fund’s investment period ends November