Five Years Too Late

September 29, 2008

Oy Vey, says Stuart’s Mother

I got a call recently from my mother. She read in the New York Times that all the hedge funds and LBO funds are in real trouble and she wanted to know if RRE was OK.  Since most Jewish mothers like to worry all the time, she wanted to know if she could ratchet up the worrying about me.  While I hate to deprive her of the opportunity, the truth is that if a venture capital firm invested wisely, it’s likely in pretty good shape.  Let’s look at the current state of running a VC firm right now.

How does the Credit Crunch Affect the Venture World?

In a recent post we wrote about the current and near-term climate for fund-raising becoming more difficult because of mark to market issues and asset allocation.  So, let’s take for granted that the bar is raised for new investments and even supporting existing portfolio companies. Two critical (and related) points:

First and foremost, venture-backed companies have essentially no leverage.  With very few exceptions, the only bank lines these companies employ are tied simply to a balance equal to the amount of the loan in cash at the bank.  That is not leverage; it’s working capital management.  Given this lack of leverage, that bank lines are now essentially unavailable doesn’t interfere with these companies’ operations. These companies’ capital structure is (for the most part) 100% equity, 0% debt. Those companies that employ “venture debt” are few, and generally have a very heavily equity-oriented capital structure.

The second piece is that VC funds themselves are also 100% equity. Others have covered the basic structure of venture capital funds, but the short version is that we don’t use leverage. Hedge funds, private equity/LBO funds and some mutual funds raise money from investors (equity) and then borrow more money to juice their returns. VC funds don’t. We raise equity capital from our Limited Partners, and then make equity investments in companies. Those companies, as mentioned above, are also all-equity.

So the fact that the debt/credit markets are a complete disaster affects us only indirectly.

So What’s the Problem?

The real frustration for VCs is the lack of exits.  In the 1990’s, once you grew a company to $40 million in revenues, you could get one of tech investment banking firms to take you public, like Hambrecht & Quist (now part of Chase), Robertson Stephens (gone), Montgomery, or Alex Brown (now part of Deutsche Bank).   Then, after the bubble burst, the bar got raised.  In the post-bubble world, you grew a company to $100 million in revenues and then you could get Goldman, Morgan, or CSFB to take you public.  Once you filed for an IPO, or even got ready to, that also put you in play to be acquired.  Now, there is no current IPO market.  Which leads to the frustration.

RRE has a number of companies that had zero revenues when we invested and which are now doing $100 million or more in revenues and growing very quickly.  These companies have achieved what they needed to achieve, become market leaders, yet they cannot go public or exit under the assumptions that employees or founders assumed when they began.

So what do you do?  Sit tight, be patient, and continue to grow the company.  It’s as if somebody told you that your goal was to jump five feet in the air.  After a few years of practice, you build up the ability to jump five feet, and then they change the height to six feet.   It won’t kill you, it is just annoying.

What Next?

As the economy slows, there is no doubt that it has an effect on consumer spending.  Does this hurt all companies?  Some companies, certainly.  Other companies it should help.  Those companies that allow people to do things more cheaply or make money from activities should grow even faster.

RecycleBank will pay you for recycling.  Tendril will save you money on electricity costs.  Peek will give you cheaper mobile email service.  These companies should thrive in a down economy.  I am working on a seed deal that entails free items for consumers.   What could be better for those who have been downsized?  In addition, companies that make capital available when banks dry up such as PrimeRevenue or On Deck Capital should be huge benefactors.  There are lots of opportunities out there for startup companies.  We at RRE intend to take full advantage of them.

Mom, don’t worry about me.  We didn’t overpay for overpriced deals with no revenue.  We didn’t commit ourselves to cleantech deals that need $500mm of CapEx to get to scale.   We did mostly smart deals at good prices and continue to hold their feet to the fire to keep the costs down in these hard economic times.  And no, I will not stop buying these stupid sports cars.  And yes, I can still afford to take you and Dad out to dinner in New Jersey.

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9 Comments »

  1. Great post and very entertaining :-) The sports cars really will be the death of you ;-)

    Comment by Sanjay Mathur — September 30, 2008 @ 2:06 am

  2. Stuart is soooo dreamy!

    Comment by Mark U — October 3, 2008 @ 6:45 pm

  3. [...] not the same argument as “VC is dead”, which we’ve addressed a couple of times in this space, but another common theme emerging out of the discussion around startups and [...]

    Pingback by Bootstrap ‘n Flip? « Five Years Too late — January 23, 2009 @ 2:17 pm

  4. [...] 2) There are a lot of really solid companies sitting in venture portfolios waiting for the right moment to go public. Stuart Ellman of RRE wrote last fall that: [...]

    Pingback by Finance Geek » The End Of The IPO Drought Is Coming — May 5, 2009 @ 8:07 am

  5. [...] 2) There are a lot of really solid companies sitting in venture portfolios waiting for the right moment to go public. Stuart Ellman of RRE wrote last fall that: [...]

    Pingback by TheTradingReport » Blog Archive » The End Of The IPO Drought Is Coming — May 5, 2009 @ 10:54 am

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    Comment by Kelvin52 — October 13, 2009 @ 3:31 am

  7. While I would agree that the pendulum had swung too far in the direction of big banks and big deals, I believe there is ample opportunity for it to swing back in the other direction. Smaller investment banks like Needham (my firm), WM Blair, RW Baird, Jeffries and others have survived where H&Q and Robertson have failed and these smaller banks continue to court the smaller asset managers (of whom there are many) who can still move the needle by investing in smaller deals. Ultimately, in an economy that is growing at 1 or 2%, small companies that are growing at 20% will be highly valued and will drive the returns of these equity funds. What it will take it a couple of management teams and leading VCs who select a team of smaller banks to lead their IPO, rather than defaulting to the bulge bracket banks preaching from the bible of scale, such as was the case in the 1980′s when firms like H&Q got their start. Yes, a company has to be a bit bigger today to cover the sins of Sarbanes Oxley, but not nearly as big as the bulge bracket firms would like to have you believe.

    Comment by JReilly — October 14, 2009 @ 7:22 pm

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    Comment by Daddy37 — October 22, 2009 @ 3:41 am

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    Comment by JXL12 — October 23, 2009 @ 3:20 am


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