Monday, December 15, 2008

When VCs become poor

I wonder if this downturn is what will finally sort the men from the boys in venture capital? We’ve had too many firms and too many VCs since the bubble but because of the long life of the funds the lower quality of the range has not gone away as fast as I would have expected. But maybe now is the time.

VC funds are an alternative asset class funded by investors like pension funds, hedge funds or high net worth individuals. The LPs commit their capital at the time the fund is raised but don’t have to provide it all at once. Then, as the capital is needed for the fund to make investments, the firm makes a capital call and the investor sends the next traunch.

Well what happens when the investor is a hedge fund that can’t make the call – or a wealthy individual whose net worth is way down and who doesn’t have sufficient liquidity to meet the call? Then not only is it really bad for the investor because they will typically lose their investment in the fund to date, but it is also really bad for the VC that needs the money to continue to invest. See here about the defaulting that's happening now.

In good markets and bad companies usually need several rounds of financing and continuing investment preserves the VC’s position. In a normal market as a good company grows its sales grow and when new money is needed its valuation has grown too. The valuation is set by a new investor, all investors usually come in pro rata, but if they don’t they are diluted but not wiped out.

In contrast, in a bad market, things don’t work as smoothly for the investors or the company. If the company needs more cash to continue in a bad market it may or may not be able to bring in a new investor easily because it has not made enough progress to raise the valuation. That means a lower valuation from the new investor – which can mean significant dilution for prior investors, the employees and founders – or a round around the table from the existing investors, or a sale. In the first two of these the existing investors will need to put up their share or face significant dilution.

But today we are seeing a whole new set of ugly events happening. Now some firms are “triaging” their portfolios, not unlike triage in an ER, and deciding which companies will live or die through the next year. And when companies need money we are seeing pay-to-play financings – this is when the round is set up so that anyone that comes in pro rata keeps their share but those that don’t are wiped out. Very painful for a VC who’s been investing in a company for a number of years.

I’ve been lucky to have some terrific investors in my two companies, long term strategic guys who know how to help a company, and given what I am seeing now I believe more than ever that all venture capital is not equal and I am very grateful for the support I have now in FirstRain. As one of my investors told me last week over dinner – 20 years ago there were 50 great VCs out of 500 (and I was definitely lucky to have one of the great ones in Gib Myers from Mayfield) – and the problem now is there are still 50 great VCs (albeit a younger crop) but now they are out of 15,000. I thought a shakeout would come earlier but with typical fund lengths being 10 years there’s still a ways to go. Good funds like Accel (who just raised $1B) will survive, but maybe this downturn and the cash crunch from the ultimate investors will cause a good shakeout back to a smaller, higher quality venture capital industry.

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