Setting the Record Straight

Stuart Ellman

I admit it. We at RRE Ventures are terrible at public relations. We tend to want our investments to speak for themselves. So, this is what I hear all of the time, “Yes, RRE… you guys do later stage enterprise and financial services deals, right?”

Wrong. Here is the real answer. The quote above was true in 1997. Not now. We have evolved, much like the rest of the venture industry. We have figured out what we do well, and where there is opportunity. Here is a snapshot of what RRE does in 2008:

Roughly half of our deals are in the New York Metro area. When we started RRE, this wasn’t true, but as NYC has grown as an ecosystem for technology startups, we have allocated an increasing amount of our time, energy and capital to companies here. We love doing NY deals for a bunch of reasons. The environment is getting better and better, we know the entrepreneurs, we get an early look at great companies, and awesome entrepreneurs are starting businesses here. The downturn on Wall Street will only bring more smart people to startups in NYC.

Roughly half of the deals in our latest fund are early stage investments. Why? Mostly because we can. We have a reputation with entrepreneurs for being good startup investors and a firm that’s genuinely interested in the type of company building early stage investments require.  Also, because there are only a handful of VC firms in NYC that will make early-stage investments, we get a look at the very good deals. We have incubated two companies per year in our downstairs conference room during each of the past few years. Sure, there will be higher failure rates with seed investments, but we are often backing CEOs that we have backed before, getting in at lower prices, and having a significant influence on how the companies are built.

Here are the industries that we focus on:
• Consumer and Digital Media
• Mobility
• Green Technology
• Software and Services
• Financial Technology
• Infrastructure

The proof is in the pudding. Here are the early stage and NY deals we have done in the past two years.
• Drop.io
• Storm Exchange
• RecycleBank
• GoMobo
• M-Via
• Peek
• Payfone
• Skygrid
• Stealth Company #1
• Stealth Company #2
• On-Deck Capital
• Betaworks
• Tendril
• Certeon

So yes, we agree that the venture market has gotten tough all of a sudden. But we are still doing deals. The bar is set very high and our valuation expectations have been lowered but we are closing two deals this week. And we like them a lot. And moving forward, we’ll continue to invest in the same mix of early and growth stage deals we’ve been doing for the past few years. We’ll spend a lot of time looking at deals here at home, but will continue to be active in Silicon Valley, Seattle, Boulder and other geographies as well.

In sum, sure – if you’ve got a great B2B company, we’d love to see it. But if you’ve got a great early-stage B2C or B2B2C company, we do those as well. A big reason why we started Five Years Too Late was to take the opportunity to let people know what we do here at RRE. We’re interested in a variety of sectors across a range of stages, and across the information technology spectrum. Late-stage enterprise and financial services deals have been very good to us, but there are a lot of opportunities in a lot of other areas today, and we’re looking at all of it.

Oy Vey, says Stuart’s Mother

I got a call recently from my mother. She read in the New York Times that all the hedge funds and LBO funds are in real trouble and she wanted to know if RRE was OK.  Since most Jewish mothers like to worry all the time, she wanted to know if she could ratchet up the worrying about me.  While I hate to deprive her of the opportunity, the truth is that if a venture capital firm invested wisely, it’s likely in pretty good shape.  Let’s look at the current state of running a VC firm right now.

How does the Credit Crunch Affect the Venture World?

In a recent post we wrote about the current and near-term climate for fund-raising becoming more difficult because of mark to market issues and asset allocation.  So, let’s take for granted that the bar is raised for new investments and even supporting existing portfolio companies. Two critical (and related) points:

First and foremost, venture-backed companies have essentially no leverage.  With very few exceptions, the only bank lines these companies employ are tied simply to a balance equal to the amount of the loan in cash at the bank.  That is not leverage; it’s working capital management.  Given this lack of leverage, that bank lines are now essentially unavailable doesn’t interfere with these companies’ operations. These companies’ capital structure is (for the most part) 100% equity, 0% debt. Those companies that employ “venture debt” are few, and generally have a very heavily equity-oriented capital structure.

The second piece is that VC funds themselves are also 100% equity. Others have covered the basic structure of venture capital funds, but the short version is that we don’t use leverage. Hedge funds, private equity/LBO funds and some mutual funds raise money from investors (equity) and then borrow more money to juice their returns. VC funds don’t. We raise equity capital from our Limited Partners, and then make equity investments in companies. Those companies, as mentioned above, are also all-equity.

So the fact that the debt/credit markets are a complete disaster affects us only indirectly.

So What’s the Problem?

The real frustration for VCs is the lack of exits.  In the 1990’s, once you grew a company to $40 million in revenues, you could get one of tech investment banking firms to take you public, like Hambrecht & Quist (now part of Chase), Robertson Stephens (gone), Montgomery, or Alex Brown (now part of Deutsche Bank).   Then, after the bubble burst, the bar got raised.  In the post-bubble world, you grew a company to $100 million in revenues and then you could get Goldman, Morgan, or CSFB to take you public.  Once you filed for an IPO, or even got ready to, that also put you in play to be acquired.  Now, there is no current IPO market.  Which leads to the frustration.

RRE has a number of companies that had zero revenues when we invested and which are now doing $100 million or more in revenues and growing very quickly.  These companies have achieved what they needed to achieve, become market leaders, yet they cannot go public or exit under the assumptions that employees or founders assumed when they began.

So what do you do?  Sit tight, be patient, and continue to grow the company.  It’s as if somebody told you that your goal was to jump five feet in the air.  After a few years of practice, you build up the ability to jump five feet, and then they change the height to six feet.   It won’t kill you, it is just annoying.

What Next?

As the economy slows, there is no doubt that it has an effect on consumer spending.  Does this hurt all companies?  Some companies, certainly.  Other companies it should help.  Those companies that allow people to do things more cheaply or make money from activities should grow even faster.

RecycleBank will pay you for recycling.  Tendril will save you money on electricity costs.  Peek will give you cheaper mobile email service.  These companies should thrive in a down economy.  I am working on a seed deal that entails free items for consumers.   What could be better for those who have been downsized?  In addition, companies that make capital available when banks dry up such as PrimeRevenue or On Deck Capital should be huge benefactors.  There are lots of opportunities out there for startup companies.  We at RRE intend to take full advantage of them.

Mom, don’t worry about me.  We didn’t overpay for overpriced deals with no revenue.  We didn’t commit ourselves to cleantech deals that need $500mm of CapEx to get to scale.   We did mostly smart deals at good prices and continue to hold their feet to the fire to keep the costs down in these hard economic times.  And no, I will not stop buying these stupid sports cars.  And yes, I can still afford to take you and Dad out to dinner in New Jersey.