What VCs actually do in a down market

So, last time I said that seed deals on really disruptive risky technology that can be game changing when the market recovers should go for early stage VCs ... Well, some are rubbing their hands together--either in excitement over predatory deals they can do to struggling entrepreneurs (or at cramming down their hated VC rivals), or in apprehension over how they will raise the next fund. Sadly, most have their hands in their pockets, or are sitting on them pretty firmly, reluctant to put them into their pockets for fear of having to take cash out.

We are seeing financings fall apart in literally the 11½ hour, when all the existing investors have transferred money, and the new lead lobs in a last minute call to say sorry our partners have decided we aren’t doing these type of deals anymore. This begs the question, "so what type of deals are you doing then?" Simple, they are doing C-round deals at A round prices--VCs trying to do later stage deals--I think that’s an OK strategy but there are already a lot of late stage firms out there who are better at that than early stage VCs are, so suddenly you end up with a competitive environment (albeit a weak one) and your bargain deals aren’t that much of a bargain anymore.

VCs are largely in decision paralysis, they triaged their portfolios, forgeting the companies that are likely to fail and reserving as much cash as they can for those they think can still win even in this market. If you are portfolio CEO don’t worry most of them went through this exercise back in Sept (but they do it monthly or at least quarterly too). Now they are wondering just how bad it will be--they certainly aren’t excited to fund chip deals, or medical devices. Anything that is going to need $50M+ and then mezzanine financing is out for now. (Personally I think this is actually a good place to invest if it’s the right deal). Anything consumer is largely out--and thank God no more social networking or internet dating deals (at least for a while)--sorry Web 2.0 guys but you had a great run. Cleantech is still OK, but no panacea--there is a lot of hype that still has to clear the system before anyone will make real money in that area, and the lack of later stage financing will kill many of those deals.

Syndication is back in, even in A rounds many VCs are wanting to get two and even three firms around the table so there is enough dry powder to carry the company through. The behaviors of VCs is often driven by their Limited Partners' behavior, and many LPs are telling their General Partners “don’t put us in a position to say no to you.” In other words don’t call any more capital for a while until we can sort out this mess--so no deals. Other LPs are saying, "why is your fund so big when you are not doing any deals--give us our money back." Many VCs are increasing their reserves for existing portfolio companies both to extend their ability to support the companies and to keep the money away from their LPs. The worst case scenario is the VC who is almost at the end of their investment period--they need to reserve more cash but have little chance of raising a new fund until they get some exits, and the IPO window is firmly closed.

The LP perspective on this is, "don’t complain to me about the IPO window, where are my returns?" This is not an unfair ask, actually, as VCs we always expect our CEOs to take personal responsibility for everything, so why shouldn’t we hold ourselves accountable to the same standard? Also, Venture is supposed to be key to any portfolio in order to “flatten out the beta.” Well there sure is a lot of beta to flatten right now ;-)

What VCs should be doing in a down market

This is a two-parter, since its always instructive to compare the ideal with the actual ...

Every company I’ve ever started was done in a recession--you know all the reasons: people are available, your competitors are pulling back giving you a great chance to be ahead of them when the market turns positive again, etc. etc. It's very hard to go to market when there isn’t one--and in this environment customers are scared of the future and are delaying buying decisions. Time to market has become irrelevant--so called first mover advantage (please don’t ever use this in a pitch) never was relevant. So if your company is early, and developing something really revolutionary that may take one or two years to create then ideally VCs should be really interested in this, provided the burn rate is manageable and it doesn’t require a massive infrastructure investment.

When the market inhales,large companies cut R&D projects and really high quality people get bored and become available to start or join new tech startups. VCs need to find these teams and embrace them because they create the next round of Googles and Ciscos. Be under no illusion it's harder today to get funded than ever before, because these great teams are out there and if you are competing with deep domain experts you will likely come up short. Also, VCs are human too (well, almost) and are just as scared and uncertain as everyone else, so making the funding decision will take longer and longer, and each time the market takes another big hit they will be reminded just how tightly closed the IPO exit window is, and that they have to have another round of explanations with their LPs as to why the money should stay in the fund. At the same time, their LPs are hammering on their management fee, and wanting to know why they are paying it if the partners are not investing.

I think there are two basic choices in this market, other than the non-choice of do nothing and sit on the money until things get better. VCs first triage their portfolios to see which investments can and should survive, circle the wagons around the portfolio and make sure they have a low enough burn and enough runway to make it. Then they can either go out in a predatory way and force their way into deals they would otherwise be unable to enter, leveraging the fear factor. There is a natural bias towards later stage deals--i.e., doing series B & C deals at A-round pricing--remember many of these firms need to have an exit soon, and given that public markets are closed the only option for many is to be able to sell a later-stage company to demonstrate a return to LPs who have seen nothing but losses for the past year. The problem with this path is it does not leverage the natural skills of a VC--there is a lot less value to add to a later stage company and it looks more like a banking deal. Also there are a lot of bankers and other VCs also looking for that type of deal ;-)

The other path is to forget revenue and look for highly disruptive plays that may take two years to develop their product but when they do it can really cause order of magnitude changes in the business model. These are extremely risky, and often more like science projects than businesses but they also offer venture scale returns--10 to 100x and it only takes one good one to make an entire fund (one of the Google VCs experienced exactly this win in a portfolio that was otherwise abysmal--and who says we are so smart...)

It’s a shame to waste a good crisis, in good times companies are struggling to meet orders and focus all their efforts on supporting manufacturing and keeping the engine running. They have no time for revolution. In times like this they need aspirin for the pain, not steroids for performance--it is a time for revolution. And a little revolution now and then is usually a good thing ;-)

Next time: What VCs are actually doing in this market (this one might take a while...)