How Deep is too Deep?

Stuart Ellman

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.

Self-sufficient is the New Sexy

Stuart Ellman

I was at a board meeting the other day and a portfolio company CEO surprised me. I was concerned that it was taking a little longer to sign up a key partner and therefore we would run short on cash. The CEO told me that he will never run out of cash. Not only has he run the company incredibly frugally, but he is only going to spend money when he is able to get that cash from revenues. In the short term, he will take on some consulting assignments that are relevant to his core business. Wow. This is music to my ears. This is a CEO that lived through the 2001 crash and knows what it is like to raise money during times like these. To VCs, this is incredibly appealing… even sexy.

Another CEO was telling a different story and not hearing what he wanted back from his investors. He has done a terrific job growing his company, the leader in a new and sexy space. He doubled his revenues last year and will double them again this year. His problem is that his company burns (and will continue to burn) a lot of money. He went out to market and assumed the environment would be easy given how great he is performing. But, as a very knowledgeable source said, many VCs are just out to hurt their friends right now. People only want to put new money in a deal at washout and vulture-like prices. I keep getting calls from other VCs to join them in deals at $0 pre-money valuations. Wow, I haven’t heard calls like that since 2001. So, this unhappy CEO is getting back indications of interest, but only at punitively low prices. As a result, he is looking to his existing investors to do the round. The problem is, existing investors do not have enough money to fully fund the company. Don’t forget, VCs also have time limits, percentage limits, and dollar limits on existing investments. That is not a happy boardroom. It is about as appealing as sitting in a middle seat on an airplane next to a smelly guy.

Right now, growth is not sexy if it’s accompanied by a high burn rate. To navigate through this climate, every CEO needs to perform a simple analysis: First, how much money is in the bank (not including debt)? How much runway does this give you at your current operational posture? And what are you going to do about it?

• First choice, get to cash flow positive on that money.
• Second choice, get the cash to last for two years..
• Third choice, see how much money you can gather from existing investors to get to cash flow positive.
• Last choice, go to outside investors to get the additional money. Yes, there may be exceptions to the rule, but it is not a pretty market for companies with a high burn right now, period.

If there is one thing etched into my memory from the last funding drought, it is that CEO’s always wished they had cut more deeply earlier. A company with 70 employees will think it is cutting to the bone if it goes down to 50 employees. “I just cant go any lower without killing the business.” That is true until they then cut to 35, and then to 25 employees. At 25 employees, the CEO always wishes he had done the hard cut earlier and saved the money and uncertainty. Yes, it is not fair to have to cut a company that has performed well. But, when markets change, you have to do it. Great CEOs have failed because they have not reacted appropriately to changes in the funding environment.

So, hear it from me, or hear it from the markets soon enough. Become self sufficient on the cash you have. Even at the expense of growth. Frugal is sexy again.