Wednesday, February 27, 2008

How the credit crunch is hurting VC backed firms

A very serious risk has emerged for some venture backed companies as a result of the credit crunch gripping the markets. Today some small VC backed companies have found that their cash is no longer liquid and this is the worst kind of crisis to a young company.

This crisis is coming up as a result of investing in Auction Rate Securities (ARS) - marketed to the companies as being virtually equivalent to a money market account, but they are not.

Per the excerpt from Venture Wire today:
While perhaps the most optimistic VC of the panel, Perkins said VCs need to be aware of the "cracks of the economy" that might affect the industry, such as the failure of auction-rate securities. Several start-ups hold these obscure financial instruments, which many considered nearly as good as cash but are now illiquid after many bond auctions failed recently. Lawler said his firm surveyed his group of 60 portfolio companies and has so far identified 12 that have some amount of cash in auction-rate securities. "I've been in business 22 years and I've never seen anything like it."Who'd have thought that Triple-A rated short-term securities you'd invest in would be completely illiquid," he said. "That's an indication something is up... Normally when you think about credit, you don't think about it affecting classic venture investing, but here it is coming out of left field and it hurts."

News travels fast in the VC community, especially between investors and CEOs, so we were contacted by more than one of our investors to check that our cash was not at risk. One of my investors shared this excerpt from an internal communication to explain what's happening and how they are trying to help their company through it (names obscured for obvious reasons). I posted earlier that all venture money is not equal - this is an excellent example of where having good investors who step up and tap into long standing relationships to get you through a crisis can make all the difference.

"I wanted to make you aware of a situation I’ve encountered at one of my companies, XYZ. The co’ has its cash invested in auction rate securities (ARS). These are securities whose underlying assets are long term bonds but that come up for auction at regular intervals (7 days, 28 days, etc). Recently, many of these auctions have failed, meaning that no buyers are available to buy the securities, and underwriters did not step up to pick up the slack. When an auction fails, the holder of the security gets reset to another 7 day or 28 day term and continues to receive interest. It does not indicate a credit default. However, there is no liquidity for the holders of these bonds. Unfortunately, the auction rate securities vehicle was promoted to the CEO by their money manager at Comerica “as safe and liquid as money market”. This has been true for the 20 year history of this vehicle however, last week the auction market dried up and liquidity is stopped. "

"The bottom line for XYZ is that although everyone believes that the cash is safe, it is illiquid for an unknown period of time. XYZ has $5.1m invested in auction rate securities, particularly in preferred shares of closed-end mutual bond funds. The securities are AAA-rated preferred shares backed by 200% collateral from the mutual funds. There have been auction failures the last few days and it is unknown when liquidity will return to this market. [The company] has 3 weeks of cash available in a money market account that is liquid but will need more cash if the illiquidity in auction rate securities continues. The three investors (A, B and C) and CEO are pursuing loans at both SVB (their current debt holder) and Comerica (their money advisor) collateralized by the auction rate securities. However, I don’t know if we can accomplish this action. We’ll be monitoring this situation day by day. It doesn’t appear that this illiquidity will go on for long but no one can tell for how long. A secondary market is emerging for the auction rate securities, but at a discount. That discount could be as high as 10% off face value so using the secondary market would be a less attractive alternative. However, it could provide a worst case option of liquidity for the remaining $5m should the auctions continue to fail."

Cash is your lifeblood as a startup - my heart goes out to the CEO/CFO teams trying to deal with this illiquidity.


Anonymous said...

Is this any update on this situation? I have personal money invested in this vehicle and cannot get a straight answer from my broker at Merrill Lynch about the situation. Appears that more than one brokerage house is selling these as having the security of a money market.

Appreciate any updated info that you might have.

Penny Herscher said...

Yes - Capital Group has launched an advisory consultancy to help people through this. You can find information at

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