Now that the markets have tanked and pensions and endowments are selling off their private equity holdings to rebalance their portfolios, many people have gotten religion. VCs realize that the environment for raising new private equity funds is not great. If they are near the beginning of their new funds, as RRE happens to be, it is a very fortunate position because they have plenty of fresh cash to put into companies at attractive prices. If they are near the end of their most recent fund, it is not a pretty time. With little fresh capital to put in their existing companies, the first word out of their mouths is to cut costs at their existing portfolio companies. This makes sense, but only up to a point.
For some of our portfolio companies, especially web 2.0 companies that exist “in the cloud”, it’s realistic to burn very little money and grow virally. But, this model simply doesn’t work for companies in other sectors and with other cost structures. I sit on the board of a terrific company in an extremely attractive space. Given the current environment, some of their large contracts have been pushed out. With valuations down and the company on a path to burn through its cash, it seems obvious to cut the expenses and make the cash last as long as it can. This company will only remain the leader in its space if it continues to have engineers crank out the hardware and software that constitute its solution. It will only be a winner if it participates in most of the beta tests, trials and RFP‘s that most of its large customers are demanding. It needs to partner with many of the Fortune 500 companies and support these relationships. These things are not cheap. But we can only create value for the company if these things are done. The key is spending enough to remain on the “leading edge” without going overboard and hurting ourselves on the “bleeding edge”.
The takeaway here is that the board of directors (and each individual director) has to set aside the desires of their specific class of shares and do what is best for all shareholders. If, for example, my fund is out of fresh capital to put in a company but the company needs to spend money to retain or create value, I must vote to dilute myself in order to be doing my duty as a director. This is not obvious to all board members, but reflects that Director’s duty to the company. Directors must work to maximize value to all shareholders, unless the company is in distress and worth less than the amount of debt. Then, the duty of a board changes and the directors must work for the benefit of the debt holders. This is tough medicine, but we have all lived through this before in 2001-2003. Things will turn around but we must all do the right things now to let these companies survive and flourish in the future.