Five Years Too Late

April 18, 2009

Buy High, Sell… wait, what?

Filed under: Uncategorized — fiveyearstoolate @ 6:06 pm
Eric Wiesen

Eric Wiesen

I just read an article on Venturebeat entitled, “VCs are turning the screws with financing terms” (link here).

The piece talks about how the down economy means lower valuations, more due diligence and more downside protection for investors (in the form of larger liquidation preferences or stricter anti-dilution provisions). It’s a reasonably descriptive (if sensationally titled) piece that contains some good advice for entrepreneurs about how to negotiate effectively in an environment like this one, but upon reading it I’m essentially left asking, “Yeah, so?” as my primary response.

To wit, I searched and searched and couldn’t find the article from 2005 entitled, “Web 2.0 companies fleecing Series C investors with high valuation despite zero revenue“, or the one from 2007 – “Cleantech company raises $250M despite likely need for at least $500M more“. And that makes sense – in a high-flying market, companies get high valuations and don’t have to give investors much in the way of downside protection or other terms. In a go-go market, investors are often “takers of terms”, in that the demand (by the investment community) for a particular type of investment outstrips the supply of such companies. Think about the 2005-2007 financings done by Facebook, LinkedIn or Ning. Investors took whatever terms they could get to get into certain companies. As Econ 101 would tell you, the equilibrium price moves up under those conditions, and in the venture capital world, the equilibrium price also includes a number of associated deal characteristics besides valuation.

But it stands to near-obvious reason that in a down market, the opposite is true. The demand for many types of startups in this capital-constrained world is lower than the supply of such companies. And as a result, prices go down. This should surprise no one. Much has been written about the difficulties VC have had over the past year or two not only finding liquidity but raising funds. So as we’ve commented in the past, the velocity of capital has decreased and the number of transactions has gone down as well. This has fairly predictable and rational impact on the price and terms of those financings that take place in a climate like this.

Ultimately, you don’t see articles about greedy buyers of public company stocks “turning the screws” on the sellers of those stocks even though in many cases they are paying pennies on the dollar relative to where these companies traded in the Dow-14,000 days. Everyone understands that when the market is up, it’s up and when it’s down, it’s down. We don’t get angry when buyers of houses try to get the lowest price today, knowing that for the past 5 or 6 years they’ve had to really pay up. It’s the nature of markets to go through such cycles.

Now, all that being said, it is incumbent upon investors to avoid being rapacious, and it would miss an important nuance of the points above if I didn’t point this out. We at RRE have a very particular viewpoint about doing right by the companies in which we invest, and so we won’t ask for certain terms or structures even if the allocation of negotiating leverage might permit them. This is a long-term, reputation-based business, and investors build their reputation with every investment we make.

We believe strongly that building companies is a joint endeavor, with the large majority of the value created by the teams in whom we invest. Only by doing right by those teams can we productively deploy capital in a long-term, collaborative way. But the reality today cannot be ignored – this is a down cycle, the largest one most of us have seen. And just like people on our side of the table dealt with prices that often felt much too high when the cycle was at its zenith, founders and management teams have to navigate the nadir of the cycle in a way that’s dispassionate and acknowledges the rational nature of today’s dealmaking climate.

2 Comments »

  1. After Hurricane Andrew decimated Miami in 1992, people were selling bags of ice for $10. While temporary market forces allowed them to successfully do so, it was an insensitive and disgusting practice of price gouging.

    Right now our economy is in the reverse situation. Buyers have all the power. While temporary market forces may allow us to exploit sellers, it would be insensitive and ugly to do so. As consumers / investors, we are justified in seeking a good deal on a new sofa / startup, but we must make sure that we do not exploit the situation like the guy selling a bag of ice for $10 after Hurricane Andrew.

    Comment by Andres Moran — April 23, 2009 @ 10:00 am

  2. “so we won’t ask for certain terms or structures even if the allocation of negotiating leverage might permit them”. I would be interested to know what are the terms or structures you don’t ask for and why those in particular?

    Comment by Wallen's — May 3, 2009 @ 5:35 am


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