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.

What to Do When the Sky is Falling

We are less than ten years removed from a complete meltdown in the equities markets, and yet once again we collectively find ourselves in the midst of a frightening financial collapse. The last one, from 2000-2002, was directly centered on technology, and it still feels recent to many of us. Companies had raised too much money, avenues for monetization dried up, and there was a shakeout throughout the tech industry. This time around, financial services firms are at the root of the crisis, and for a while people in the technology world were optimistic that it wouldn’t affect us much. That would have been nice.

There is a tremendous amount to be said about why this happened, who’s to blame and what happens next. But for now, here are a few thoughts about how this is going to impact our portfolio and technology startups generally. What is happening this week (even considering the public market reaction to the new bailout proposals) will have some meaningful effects on stakeholders in the technology industry, both direct and indirect. Earlier this week, we commented on likely fallout on the security industry, but even firms that don’t sell directly to Wall Street will be indirectly affected. There are a few takeaways from this:

First, be aware that raising money is going to be harder. In times like this, investors raise the bar for potential investments. This happens not because investors are cruel, but because our calculus around growth and return has to change during an economic contraction. Whether you are selling to Wall Street, media, retail, small business or consumers, economic troubles like these probably slow your growth. If you are offering a free service that will later be monetized with subscriptions or advertising, it’s time to adjust your projections for uptake. All of this impacts our view of how much money you will need to reach break-even, the likely proof-points you will have achieved the next time you go out to raise money, and how much a likely acquirer will pay for your company. This analysis raises the bar and tends to contract valuations.

Second, and related to the above, if you can raise money, raise as much as you need. There have been people calling the bottom since before the real problems began. Expect this to go longer than you think, and adjust accordingly. Cut your burn. Hire great people who can do the work of two or three. Be careful, because if this goes on for two or three years like it did the last time, you don’t want to raise twelve months’ worth of cash now.

Third, and particularly relevant to New York, expect to see a bunch of interesting, if non-traditional talent entering the market. One thing we’ve known for a long time is that there is a lot of technical talent locked up in the big Wall Street firms. A lot of those people are going to be shaken lose. First Round Capital has a great little site put up that looks to capitalize on this. If you are looking for people, this could provide a great new source of talent, and could certainly go toward the frequent complaint that New York is a hard place to recruit.

As we advise our portfolio companies and look to make new investments, we’re thinking about all of the above. The fundamentals of technology businesses haven’t changed, but we expect sales cycles to elongate, pilots to drag on, user growth for anything paid to slow and churn to increase. The IPO markets are on hold, and we don’t know for how long. Public companies will be getting their own houses in order, and with depressed stock prices will pay less for the startups they acquire.

Good companies will continue to be successful, but we are going to be very careful about follow-on rounds for our companies and will be encouraging them to be as lean and judicious as possible. These cycles come and go. Make sure you are managing the turbulence as best you can.

Security Feels Risky

I have been wondering about security startups recently.  We made a bunch of great security investments in the late 1990’s and at the time our underlying premise was pretty solid:  Many other types of software could be pushed off in the purchasing cycle, but important security functionality and protection could not.  This is what I called the “hair on fire rule”.  While a fortune 500 company could look at the hottest accounting, marketing, collaboration or governance software and think it was pretty nifty, they weren’t compelled to buy it RIGHT NOW.  Why not?

Largely because entrenched software vendors like Oracle, SAP or Microsoft would freeze out the startups by promising to bundle those same features into the next release within 9 months (whether they really planned to or not).  From a corporate executive point of view, why take a risk by paying more to an unknown startup company when my existing vendor will just give it to me for free for just waiting a little while.  However, security was an exception.  If your company is being broken apart by viruses, phishing or spam, then your hair is on fire.  You have to do something right now, not just wait for the future promises of larger companies.  So, you buy from the startup firms.  The startups would then get traction, ramp to $30mm in revenues, file to go public, and probably get bought. Good deal all around.

These days, however, even when the security startups seem to get to about $25mm in revenues (which are the fortunate ones) they get stuck.  What is happening?

First of all, there is a problem with the customers (and that is more true today than even last week when this post was originally written). Wall Street firms are the classic early adopters for security software.  Who needed to be more security-conscious than Citi, Lehman, Goldman, Merrill, and Morgan?   They frequently accounted for the first bunch of revenues the startups were able to book.  So what do you think is happening to those contracts today?  The big financial services firms’ own hair is on fire about staying solvent (or figuring out what to do post-insolvency). They aren’t focused on buying new software, even important software like security. At best, they are engaging in the type of endless pilots that kill startups.  So, our theoretical security startup starts to see revenue growth stagnate or start to drop.  And those who have taken corporate finance (or who have ever been part of a valuation or M&A process) will know that growth rate drives valuation, and that flattening growth kills it.

Secondly, and more troubling insofar as it’s not tied to current events quite so much, there is a problem with the public markets. Even getting to $40mm in revenues no longer means you are close to a public offering.  The public markets’ appetite for enterprise software generally (and technology even more generally) is demonstrably lower today that it’s ever been in the past, perhaps out of recognition of some of the above problems with the space.

A really smart CEO came in to see me this week.  He had been a very successful entrepreneur back in the late 1990s.  He had just finished selling a tired security company for cents on the dollar and felt lucky to have been able to do that.  As we talked, we thought about what happened to the security industry, and he had an interesting take on the situation:

He said that there used to be three levels in the security software ecosystem.

•    Big Fish: These were big companies like Microsoft;
•    Middle Fish: These were public (but not monolithic) companies like PeopleSoft;
•    Startups: New players with innovative technology.

The rules of the game were pretty well established. The Big Fish looked around and bought companies with $100 million in revenue. The Middle Fish were around to buy the startups.  So there were multiple exit points for smaller fish.

What happened is that the middle fish were eventually purchased by the big fish and by big fish in tangential spaces (like Oracle).  So now all you have are big fish, and none of the startups can grow large enough to get their attention in a meaningful way.

So where we are today is an environment where there are a number of security companies with between $5mm and $35mm in revenues that just cannot get the scale to be noticed by the big fish and don’t have the high growth rates necessarily to raise big rounds of capital to buy their way into higher revenues.  I don’t fish much but it makes sense to me – Marlins don’t eat minnows (I don’t think).

The problem isn’t the business case for security software – the hair on fire necessity around security is still there. But problems with the customers, the public exit opportunity and the difficulty of getting to acquirable scale make us very cautious in this space today. For us to get really excited about security, we’d need to believe that the problem being solved is monumental, and that the path to high revenue is both visible and achievable without large inflows of capital. That’s a high bar.