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Where’s the Money? A Survey of Massachusetts Venture Capital Funds

Andrew Updegrove 

It’s no secret that venture capital is much harder to find than it was a year ago. And it should be no surprise, either. With the drubbing taken by many funds that invested heavily in Internet based startups, and the disappearance of the market for initial public offerings (IPOs), the industry received a one/two punch. The first blow was negative returns on an industry wide basis for the first time in most peoples’ memory. The second was the indefinite unavailability of the liquidity option with the highest potential return on investment. The results for many funds were write offs and write downs for many of their investments, and dramatically reduced prospects for showing early returns for surviving companies. Added to this has been the need to carry financially those companies which had not reached breakeven, and long, hands-on hours trying to shore up the same companies. Hardly a pretty picture, or one conducive to the enthusiastic review of new business plans.

Although some funds that had invested at the beginning of the Internet craze were able to liquidate enough positions to more than offset later losses, others came to the party too late, and were left standing when the music stopped. Briefly, these funds had shown stellar paper profits after many of their portfolio companies went public at historically unheard of valuations. But the bubble burst before they were permitted by the underwriters to sell their stock (i.e., the so-called “lockup period” had not expired), or after the lockup had run out, but before they were able to bleed their large holdings into the market without further depressing share prices.

Paradoxically, there is more uninvested money in venture capital fund coffers and limited partner commitments today than there has been at almost any time in the history of venture capital investing. Despite the recent defenestration of many hot startups, venture firm after venture firm in Massachusetts has announced the closing of new funds in the last 12 months – most of them in the $500 million to $1.2 billion range. But during the same period, the rate of US venture capital investing dropped abruptly by 50% early in 2001, and from that diminished amount, by 50% again, just as abruptly during last summer.

With all this uninvested capital, why is venture capital so tight and valuations so low? What’s the true picture in New England today? With over 200 venture capital funds invested in our clients, a large number of which we had introduced to our clients, we decided to visit with some of the VCs that we’ve known for many years to find out first hand who’s investing and who’s not, and why. Over the past three months, we’ve met face to face with the senior managers of over 35 funds that invest in early and middle stage deals to find out how they are looking at today’s changed world. Most firms we visited are regarded as being the top funds in the business, although we sampled some smaller and less well-known funds as well. Here is what we learned.

Welcome to the Past. First, it’s important to remember that the world of the last few years was an aberrational, bubble world. Anyone that entered the investing game on either side of the equation during this period needs to realize that bubble economics no longer work, and that a return to fundamental market realities is not a bad thing for the overall health of the marketplace. For example, an investor can’t get his target return on investment in a startup with a pre-money valuation of $100 million unless that company goes public fairly quickly with a $1 billion market cap. Except during the height of the Internet frenzy, IPO valuations of that magnitude had never been seen before, and won’t be seen again until the memory of the last irrational investment craze has grown dim. Now that historic market dynamics have more or less been restored, valuations must return to traditional territory in order for venture capital funds to remain economically viable.

From this perspective, “down rounds” – in which an investor gets a bigger chunk of the company for each investment dollar than in the previous round – are inevitable. The more realistic question for an emerging company to ask when it looks at a new term sheet should be whether the down round is at a historically appropriate level. What was a good valuation in 1997 should be considered a good valuation now, given that the valuations during the bubble years were unsustainable. The other issue of concern to a startup is whether the investors are requiring the renegotiation of the valuation and terms of previous rounds as part of the price of survival funding.

Some funds are indeed renegotiating prior rounds and requiring painfully low valuations, below historical levels. In some cases, management (and non-participating prior investors) are seeing their holdings become essentially valueless. Only key existing employees and new hires will receive options sufficient to make continued participation worthwhile. In other cases, funds are agreeing to valuations that are reasonably consistent with those which might have been offered before valuations went briefly skyward. While even this latter case may be discouraging to the founders of a company that hit the valuation jackpot in a 2000 round, that disappointment should be tempered by the knowledge that they are being no less successful in the valuation game than were their peers throughout all but the few, most recent, years of venture capital fund raising. And, if they have escaped a retroactive adjustment, they still retain a significantly larger portion of their companies than did their predecessors at the same point in their developmental cycle.

Let’s All Slow Down. The current investing status of the funds that we met with can be divided into three main categories: those that are unable or unwilling to resume investing in new companies, those that have returned to a slower, more historically typical investing style, and those that are maintaining a brisk pace, taking advantage of the current high supply, low demand situation. Each strategy is worth understanding.

Those who are sitting on the sidelines are doing so for several reasons. Some have only enough money left to meet the needs of their existing portfolio companies (and some don’t even have enough for that purpose). But some might best be described as shell shocked.

For a time, a fund’s avoiding making new investments could be explained by a reasonable preoccupation with shoring up existing companies. But with time, most companies which are not viable on a long-term basis should either seek a buyer, or simply face reality and give up the struggle. If a company does have potential, then it should be supported at a rate which will increase the chance of success for investor and entrepreneur alike. Some funds are not only not making new investments, but are simply putting most or all of their existing portfolio companies on a bare maintenance budget, requiring each company to dramatically downsize to survive for at least 12 months on a budget which in many cases may effectively freeze their ability to execute. In some cases, this may well be appropriate. In others, it may be hard to justify.

Why put a portfolio on ice? Again, the reasons vary. Some investors are new to the game. In 1999 and 2000, investing was comparatively easy – one could follow the latest fad, pick one of a number of available companies with a similar business model, and hope that the underwriters would take them public while the sector remained hot. Today, there is essentially no IPO market, and there are very few sectors with an enthusiastic, broad based following. Hence, it’s hard enough for a veteran to know what to bet on, let alone someone new to long term investing in high-risk situations. As a result, there are both experienced as well as new investors who are reacting to current market conditions by keeping investing to a bare minimum.

Fortunately for entrepreneurs, this is a fairly small group of funds. Some will slowly come back to the table, while some funds have already announced that they will make no new investments, or even disband.

Those who are returning to a traditional investment pace expect to make anywhere from four to about eight new investments in 2002. While this pace may seem paltry in the context of the bubble years, when some funds made thirty or more investments in a twelve month period, this reduced level of investment is in fact likely to lead to a healthier long term market for startups and venture capital investors alike, since each portfolio company will be able to receive far more attention and assistance from its investment partners. During the Internet craze, some general partners in venture capital firms took board seats on more than a dozen companies, or assigned junior, unseasoned staff to represent them and assist the management of emerging companies. Both sides suffered as a result.

Although four to eight investments per fund may seem to suggest that venture capital will remain hard to find, the good news is that the number of new companies receiving funding in 2002 should compare favorably with early stage investing figures for the mid 1990s, given the expanded number of venture capital funds which exist today which still have money available to invest.

The real issue for emerging companies is that today’s investment decisions are being made on a far more selective, patient basis than was the case 18 months ago, as indeed they should be. In 1999 and early 2000, a startling number of startups were financed on the basis of a handful of PowerPoint slides. Today, a carefully prepared business plan and a solid business model are required. However, the degree of selectivity in the profile which most funds are employing to vet new investments will leave many well-prepared and potentially successful companies unfunded. Most venture capital investors are requiring both a significantly experienced management team and a product based on strong, proprietary technology, and will reject many business sectors out of hand. While some seed stage investors will still invest in an incomplete team, the other requirements still remain.

Look for some pickup in the pace of investing in this category, but not before the fall of 2002.

Finally, there are the plungers, who have decided that this is a great market to be in. Regrettably (for emerging companies), this group is small – about the same size as those who are sitting on the fence. Those that are in this category frequently drive very hard bargains, including as regards existing investors who are unwilling, or unable, to participate in the new round. Those existing investors who do not “pay to play” may lose most (or all) of their preferred investment terms, and be dramatically diluted. Those that are investing at a rapid pace now are likely to continue to do so for most of the year.

Yesterday’s Strategy may not Work Today. Most investors are remaining true to their traditional focus, but some are adapting to current market conditions. Some of these more Darwinian funds are early stage funds that are taking advantage of current market conditions to make some of their investments in more mature companies at rock bottom valuations. The result is less risk for the same investment, particularly where business models and products have been validated by meaningful revenues. Others that have moved up the investment ladder are early stage investors who plunged heavily into seed stage Internet companies in 2000, with predictably dire results.

But now that growing emerging companies at the speed of light is out of fashion, some of the very large funds are in something of a predicament – most startups can’t absorb $25 to $50 million per investor during their pre-public existence and spend it productively. Some of these mega funds have decided to solve part of the problem by looking at buy out or spinout situations, again with the added benefit of lower perceived risk. Interestingly, few, if any, have adapted by planning to make smaller investments in more companies.

The Money’s in the Wrong Fund. Perhaps the most frustrating fact for entrepreneurs who are trying to raise money is that those funds which have the most money are sometimes the least active in investing it. For a cash-starved portfolio company of a venture capital firm which has just raised a billion dollar fund, this is doubly frustrating. The problem is that the older fund which is already invested in that portfolio company may be low on cash, while the terms of the new fund usually bar investment in the portfolio companies of the prior fund. The reason for such a term is to prevent a fund with new investors from being used to shore up the faltering investments of a prior fund. As a result, while there may be a billion dollars available for new investments, the existing company may be put on a bare maintenance diet. And the fund managers may still be too preoccupied with the problems of the old fund to find time to begin investing the funds of the new.

You Won’t Take My Company, and I Won’t Take Yours. Unfortunately for companies which have already received one or more rounds of investment, the great majority of venture capital firms are still making most of their new investments in their existing portfolio companies and into companies which have not previously had venture capital investors. There does not appear to be any imminent shift in the offing to this position.

The reasons are several, and each tends to compound with the other. First, with the IPO window shut indefinitely, venture capital funds are reserving more money to support existing portfolio companies than previously – as much as two dollars (if they still have enough to do so ) for every dollar invested in a first round, as compared to a more traditional one-to-one ratio. Second, there is a general suspicion among many venture capital investors that most already funded companies represent shaky situations that are best avoided for now, at least. Finally, many of the funds which are investing would prefer to be the dominant investor in a new investment, which is not as likely to happen where they simply join a round with existing investors.

The net result is that most dollars that are going into existing venture funded companies are coming from their historical investors, and on terms which are quite stiff, and usually to support dramatically reduced budgets. This is likely to continue to be the case well into 2002.

Farewell to Corporate Venture Capital. The predictability of this result is almost comical. Every time venture capital returns increase, a large number of corporations decide to try their hand at investing. And every time that the stock market pulls back from supporting emerging company equity offerings, most of these same corporations abandon their often tentative investing efforts, usually after sustaining a net loss on their portfolio. In fact, it would not be inappropriate to observe that a dramatic increase in corporate venture capital investment is a reliable leading indicator of an imminent and dramatic downturn in the emerging company investment market.

This time around, the drop off has been even more precipitous than usual, with even some long-term corporate investors dramatically curtailing their investing. More corporations will certainly follow in this retreat, and those that stay in the game will be much more likely to invest only in companies in which they expect to become actively involved as business partners, and not just investors. In other words, those companies that have been providing capital primarily as a means to access technology or products, rather than for capital returns, will be most likely to stay the course.

Conclusions. The two themes which were most evident in our conversations were a return to basics, and a heightened sense of uncertainty and caution. For the most part, a return to fundamentals is both inevitable and necessary – without it, funds will not be able to produce satisfactory returns, and the supply of venture capital would eventually dwindle. Those with long memories will remember a time when the largest source of funding for venture capital funds for the last 20 years (pension plans) invested little or nothing in high risk investments. If negative returns were to become common, these necessarily conservative investors would need to scale back their future commitments.

In our view, while uncertainty is understandable, the sense of caution may be less supportable, no matter how understandable on a human level. No one knows whether the IPO market will return in 10 months or 10 years, and high risk returns after all are the reward for taking high risks. During the boom years, venture capital has become, perhaps, more risk averse, and it may take time for the industry to get its full courage back.

But long-term investing ultimately needs to move on regardless of market conditions, and fund after fund will need to return to the business of investing, or face simply giving the money back at the expiration of the fund’s term. Since venture capitalists need to turn a profit to collect their “carry” (typically 20% of fund profits – a potentially enormous reward), this is not an attractive prospect. Nevertheless, heightened caution will certainly have a continuing effect through at least the end of 2002.

The result will be a market in which the figures seem to belie the facts, and the availability of venture capital will continue to seem very tight even if the gross dollars invested in fact are respectable. One reason is that the requirements to be funded will be both more rigid, and more sector specific. Another is that there will be many “first funds” which were formed during the bubble years that haven’t been successful enough to raise a second fund. Given that a typical fund term is ten years, there will be many funds in existence for quite a while that will be incapable of making new investments. This will bolster the impression that “the VCs aren’t investing”.

Another lasting effect will be the continuance of more traditional “burn rates” for emerging companies. In 1999 and early 2000, many startups were urged by their investors to follow the Amazon.com “grow fast” model, and burgeon to 100 employees within a year of incorporation, resulting in monthly budgets of up to $2 million. Although the mega funds will still be looking to invest large amounts in each portfolio company, they will be more conservative in how that money is spent. Also, a larger proportion of the seed and first stage investing will be done by the smaller funds which continue to be formed to bridge the so-called “capital gap” between what angels can provide and what the larger VC funds look to invest.

The result of the reduction in growth expectations will be that startup companies will be able to move (at least on a comparative basis) more slowly and thoughtfully, and with a greater opportunity to thoroughly investigate their market and adapt initial product plans accordingly. The benefit will be that by the time a startup is ready to launch a product or service into the marketplace, there will be a greater likelihood that its target customers will actually be interested in signing a purchase order.

In the end, the emerging company financing marketplace will return to a more stable, more economically rational, more historically consistent model. 2002 will be a painful transition year to a new equilibrium for most existing and new companies, but it is hard to imagine that this transition will not be well along by year’s end. It will be a painful year for some funds as well, as some additional funds may decide that they cannot productively invest the entire amount of capital committed to them by their investors. Investors in venture capital funds typically provide their money in three successive “capital calls”, and some funds have announced to their investors that they will reduce remaining capital calls, thereby downsizing the originally announced size of the fund. In a few cases, the investors have mandated this result on their own initiative. Most funds, however, will take down the entire amount of the originally committed capital, and this money will need to get moving again.

The bottom line for companies seeking investment is that they need to be much more knowledgeable about the realities of the marketplace, and brutally honest in their evaluation of the likelihood of attaining financing. Venture investing has always been a formulaic exercise – if the VC stays inside the model and has a good eye for potential value, then she should end up with enough winners to offset the losers. In 2002, that model will be applied more conservatively than at any time in the last ten years. Any company that doesn’t meet the criteria of strong management, proprietary technology, a very large target marketplace, and the potential for fast growth, would be well advised to pursue a strategy which is not dependent on venture capital. Luckily, for some companies, this will still be an option.