Why Venture Firms Tighten the Purse Strings in a Down Market

Anyone who has raised money during a down cycle like this one has noticed two significant changes in the fundraising climate.

1. Valuations come down
2. VCs make fewer investments

The first is probably fairly straightforward even to those entrepreneurs who don’t like it. When we’re in boom times (like the late 90s, 2005-6 for Web 2.0 or today for Cleantech), deals get bid up and investors pay high prices to get into great and even not-so-great deals. The inverse is also true – in tough times, the leverage shifts and investors hold the upper hand, often getting better terms and lower prices for good companies. That’s just the operation of what is, at the end of the day, a capital market.

The second of these is probably counterintuitive to some and deserves some attention. There is reasonably good evidence that firms are best-served by investing when prices are low and there is less competition for deals. It’s classic contrarianism. Well, aside from the basic truth that most people aren’t contrarians (by the definition of the word), there is another force at play here: When things are good, VC funds invest their funds as quickly as they can and go out and raise another (typically larger) fund. When things slow down, however, venture funds also slow their pace.

Why? Because it’s harder to raise that next fund. Venture funds are hit by an indirect consequence of problematic public markets.

Here’s how it works: Let’s say that you are an institutional investor (like a pension fund) with a $1 billion fund. Part of your fund is invested in venture capital funds. Your allocation to venture capital and private equity is set at 20% (for example). Now further imagine that the other 90% of your portfolio (equities, fixed income, real estate, etc…) goes down by 20%.

So prior to the market going down, you were invested like this:

Equities/Bonds/Real Estate             $900 million 90%
Private Equity/Venture Capital        $100 million 10%

Now, however, you are invested like this:

Equities/Bonds/Real Estate             $720 million 87.5%
Private Equity/Venture Capital        $100 million 12.5%

You are now over-allocated to PE/VC. The problem is that your public-market investments are “marked to market”, meaning that their value changes as the market provides a signal as to a new price. With a publicly-traded security, those signals are provided every business day via price quotations. Venture capital investments, by contrast, are marked to the most recent valuation, and that typically only comes with a new round of financing. There is a significant delay in the marking-to-market of these investments. They will eventually be marked down in this kind of environment, but it takes longer.

The way that most institutional investors respond to this situation is simple and devastating – they stop investing in new funds until their allocation returns to plan. Sure, if a top-tier VC fund comes calling, they’ll find allocation for them, but newer funds raising their first or second fund, funds that haven’t performed particularly well, and other less well-known investors will have a hard time raising capital.

In addition, there is a reduction in the velocity of money that flows through a portion of the Limited Partner base for venture funds. Many wealthy individuals, family foundations and other potential investors in funds use the distributions they receive from successful exits to fund their participation in new funds. In an environment where there are fewer and smaller exits, these investors’ money is locked up in their existing funds, and hence unavailable for new funds. To compound the problem, many of these individuals are technology founders and CEOs who make substantial money from big technology exits, typically IPOs or large acquisitions by public companies. When these types of transactions aren’t taking place, these individuals aren’t potential players as VCs look to raise new funds.

All of this combines to compel venture firms to be more patient and slower-paced with funds, because the bar is set higher for us as well, and we want to make sure that in a climate where fewer venture funds are getting funded, we’ve done only the very best deals that fit closest to our firm’s capabilities.

We know you need the money more than ever in times like this. It’s not personal.

Is Green the New Black?

By far the largest trend in technology venture capital over the last two years has been the extraordinary shift in attention from traditional areas of focus like security, telecom and semiconductors into the area known as “cleantech” or “greentech”. This has resulted from both the decline in some traditional sectors as well as from increasing awareness that there are real problems to be solved around energy consumption and production, and that they are the types of problems that might be addressed by high-growth technology companies (and hence the purview of venture capital).

I think it’s safe to say that all VCs have at least noticed this transition, but there have been a number of different approaches to the new opportunities proposed by cleantech. To borrow analogy from poker, here are a few ways firms have chosen to play the clean technology hand:

1.    “All in” – Some firms have essentially pushed in all (or virtually all) of their resources, betting that cleantech will replace traditional IT sectors. These firms have either repurposed their existing IT investors to focus on cleantech subsectors or they have hired additional personnel: materials scientists, chemists and others with energy sector expertise. Some of have raised new funds specifically to address cleantech while others invest out of their primary funds.

2.    “Fold” – Other firms take the view that their value-add as investors would be compromised by an out-of-scope shift of focus to the energy sector given the disparity in underlying technologies (biofuels, thin-films, photovoltaics, etc…), and so they continue to look for opportunities in sectors where the investment team has expertise and contacts in traditional IT areas.

3.     “Smooth call” – The third approach is to view the energy sector as a vertical market that is partially addressable by information technologies. This view holds that the economic, business and environmental problems being solved by cleantech companies are too large for investors to ignore, but that certain areas of clean technology are not a fit for the relatively small funds raised by venture capitalists. The play here is to map these new opportunities to the current VC evaluation process – size of problem, quality of team and appropriateness of technical solution to that problem. The additional layer here is the evaluation of technologies outside of software, networking, semi-conductors, etc… that have comprised IT investing for the last few decades.

We here at RRE pursue this third approach, selectively deploying our capital toward “green IT” companies that are solving serious energy sector and environmental problems using technology and business model innovations in ways that we’ve valued since long before the cleantech movement began in earnest. Today we have several investments that can be described as “green” investments: Recyclebank, which is building an infrastructure to enable incentivized consumer recycling, Tendril, whose software powers smart meters that enable consumers to manage their energy use, and Ember, whose chips and suite of products enable the sensors and devices that will power the awareness and reduction of energy use by consumers and businesses. We have a couple of others in the hopper, too, but this isn’t the place to announce them.

In each case, we have invested in a business we understand (software, semiconductors and technology-enabled networks), but which seeks to solve a green problem. We are not the right investor for capital-intensive project finance, and are unlikely to get involved in those types of businesses. We probably couldn’t tell you which type of algae can convert waste into oxygen faster than another and don’t want to try. But just as the mainframe computer solved large problems for enterprises, and personal computers solved large problems for consumers and small business, and the way the internet solved problems for everyone, we think technology can effectively address a lot of the problems associated with energy use and efficiency. And we will continue to aggressively pursue great companies solving these critical problems. We think that venture-backed startups can be as important in the green sector as they have been in other IT areas, but we’ll be selective about which hands we’re willing to play.

Is Tech VC Dead?

The idea for this blog originally came out of the ongoing whispers that “VC is dead”, dramatic as that sounds. We’re now 7 or 8 years from the crash of the “dot-com” boom economy, depending on how you count. Those who follow trends in the tech economy and the venture capital industry know that these years have seen lower returns, longer hold times, a weak IPO market and consolidation within the ranks of the erstwhile acquirers for technology startups. So it makes sense to ask, rhetorically or otherwise – Is tech VC Dead?

The short answer is: no, we don’t think so (or we wouldn’t still be doing this).

The longer answer is: Dead compared to what? If by “Is Tech VC Dead” you really mean, “Are the returns and short hold times enjoyed by internet and software venture capital funds raised between 1993 to 1998 likely gone for the foreseeable future?” then the answer is … probably, but that’s a poor standard.

From 1995 to 2000 we saw an unprecedented era in venture capital. Companies merely needed wide distribution (Netscape) or simply an online delivery mechanism (Pets.com et al) to gain astonishing valuations in both the private and public markets. That ended, as all speculative excesses eventually do (five years too late for condos in Florida…), but a lot of venture investors did extremely well while the merry-go-round continued to spin. So if we’re going to compare returns, hold times and the influx of capital into technology investing to those heady days, we’re probably going to conclude that technology VC is no longer attractive or, if you prefer, dead.

And there are some real challenges today, particularly as regards valuation on exits. We have telecom investments that, as businesses, are doing extremely well. But the way that the market views these investments today relative to ten years ago is dramatically disparate. A company with $100M in revenue in the late 90s in the space would have been worth a couple of billion dollars (see the likes of Siena and Cerent back in those days), but today (given the multiples being assigned to the likely acquirers of these companies) such a business is worth maybe $300-400 million. At 3-4x trailing revenues, one has to ask why an investor would seek out this type of company today.

With enterprise software we see a similar dynamic. Many of the great VC funds were built on the success of enterprise software in the 1980s and 1990s, huge software packages that cost high six or seven figures, took 180 days or more to sell and came with a perpetual license business model. Many of these companies turned into enormous wins for VC funds back then, but today the model is quickly being abandoned as the willingness of firms to pay for such unwieldy software diminishes and the world moves to a Software-as-a-Service model. The problem there is that these business, at least so far, have proven difficult to build to scale. With the exception of Salesforce.com (a $6.6B business as of this writing), how many large companies have been built with SaaS?

And finally there’s the Web 2.0 sector, where so many have gone in the face of decline in sectors like those mentioned above. We think Web 2.0 is interesting, depending on how you define it, but we question some of the money that went into this sector chasing things that were shiny, but weren’t necessarily solving real problems. And many of the acquisitions that have come out of this space have been small – great multiples but small in actual dollar terms.

All that being said, if we step back and take a longer view, we start to think about what technology VC has always been about, what it’s for. For the last few decades, the lifetime of modern venture capital, our capital has been used to build out the leading edge of different evolutions of technology, from large computing to smaller, from semiconductors and devices to software and web services. And this is still what it’s for today.

The questions we’re asking ourselves a lot these days are:

• How much do we worry that information technology has been superceded by newer technology fields like cleantech or biotech?
• What do we make of the influx of capital from hedge funds, sovereign wealth funds, the increasing importance of angels, etc…?

The first is a longer discussion, one that we’ll be thinking about substantially in this space. The short answer is – we think that biotechnology is a fascinating field that has relatively little relationship to what we do. Life sciences venture capital is a scientifically and capital-intensive business with binary outcomes that requires a totally different skillset and attitude toward company-building than IT investing.

On the cleantech side, we are much more interested, but more as IT investors who think the energy sector is a fascinating vertical. We have three investments that can be considered “green”: RecycleBank, Tendril and Ember (and a couple more in the hopper). In all three we leveraged what we are already good at – identifying strong technology entrepreneurs and helping them build great businesses. To us, the emergence of cleantech is an opportunity (of sorts) for IT investors, in that it is revealing a whole new galaxy of problems that need to be solved with innovative technologies.

As for the second – we think it’s something of a non-issue at this point. Angels have long been and continue to be an important part of the tech ecosystem. As VCs we rely on them to help entrepreneurs get businesses of the ground develop products and often devote their time (as well as their money) to getting some momentum going so that the company is ready for firms like RRE. As for hedge funds and others – there’s a lot more to this business than providing capital. Ultimately people come to RRE or to other VCs for our expertise in building companies, our access to partners and customers, and our judgment as much as for the dollars we put in.  Don’t mistake – we know financing is at the core of what we do, but the right VC can add a lot of value. We do as many repeat deals with the same entrepreneurs for a reason.

So is Tech VC dead? Ultimately the business is harder in 2008 than it was in 1998. But it was also harder in 1988 than it was in 1998. We are optimistic about today’s opportunities. We’re excited about clean energy, mobile, cloud computing, the business and consumer webs, digital media, and the continuing use of modern IT to change how business is done and life is led. These areas need innovation, and innovation comes from startups, often venture-backed. Are there questions around the decreasing cost of web startups, consolidation among large software companies and the appetite among LPs for venture capital investments? Sure. But the overall trend is up. And those are future posts anyway.

Five Years Too Late

Welcome to our blog, Five Years Too Late. What are we doing here?

In 2003 the venture capital industry started blogging, opening up the kimono just enough to give entrepreneurs and others insight into how this traditionally opaque industry works. VC blogs shared investors’ perspective on different sectors, how to pitch your business, trends in the economy, and what they look for in a founder.  In the five years since, dozens more VC bloggers have jumped into the fray, to the point now where there is even a consolidated RSS Feed that aggregates 84 different VC bloggers.

So why start a VC blog now, in 2008, and what are we looking to say with this one?

First off, we think that 2008 is pretty similar to 2003 in some important ways, and like that year represents a good opportunity to start some conversations. In 2003, we were collectively about 3 years into the “nuclear winter” that followed the excesses of the 1990s. The robust IPO market had disappeared, funding was harder to come by, and people dismissed the businesses that had been such darlings just a couple of years before. Today, as then, there is a drumbeat growing louder and louder telling us that technology, venture capital and the economy (particularly here in New York) is dead. That many of the companies the venture industry invested in these last five years (“Web 2.0”) were just another bubble, and that many of the companies being funded today (in Cleantech) are the next one.  We think at times like this it’s more important than ever to ensure that clear voices are heard. Plus, we disagree with a lot of that stuff, but think the discussion is one worth having.

Secondly, we think New York is really hitting its stride as a technology nexus. As a New York City venture capital fund these past fifteen years, we’ve watched the community here grow in fits and starts, and are genuinely excited about the companies being founded in our city. We are very focused on helping build out the ecosystem here, and will be spending time here talking about what we’re seeing as New York (“Silicon Alley” if you like that sort of thing) continues to develop as an entrepreneurial community.

This blog will have two voices. We work together as investors here at RRE Ventures, but have distinct voices and points of view. Most often we’ll write together and blend our thoughts (we’ll see how that goes…) but from time to time you’ll hear one or the other of us independently, as the mood strikes. Just by way of introduction:

Stuart Ellman: I co-founded RRE when I was 27.  That is probably too young but now I have 15 years experience and I am only 42.  I have been through all of the bubbles and busts, have invested and founded B2B, B2C, enterprise software, hardware, in the cloud, as a service, tools, software platforms, testing devices, incentive systems, wireless companies, semiconductors, mobile platforms, payment platforms, and some really cool clean tech companies. I have had really great years and some that seemed like a black cloud was following me.  I have never seen the venture industry as unsure of its future as now and the time just feels right to blog out my thoughts.

Eric Wiesen: I was an entrepreneur in college, then a Silicon Valley lawyer, and then an entrepreneur again after leaving the law but prior to moving to New York, getting my MBA and joining RRE Ventures. I am hugely optimistic about and excited by the possibilities of the web, mobile technology and distributed computing and media, but at the same time I’m something of a skeptic. You can find me at most NYC tech events, or follow me in the various webby ways available today (see my tumblr, follow me on twitter, or connect on LinkedIn).

Welcome to Five Years Too Late. We’ll be around, talking about tech, VC and New York. Happy to have you.