The Great VC Ice Age is Thawing (for now)

Mark Suster, a venture capitalist at GRP Partners, recently started a series of articles talking about the thawing of the "VC Ice Age". Mark gave us permission to report his article here.

When venture capitalists scale back investing activities it can be very swift and leave many companies that are in the process of fund raising hung out to dry. Just ask anybody who was trying to close funding the fateful week of September 11, 2001 or even March 2000. I would argue that the shut-down of September 2008 was equally severe yet there are signs that this “VC Ice Age” has begun to thaw.

But any entrepreneurs raising capital should keep in mind that this opening of the markets could possibly be temporary. They should heed the age old advice that raising slightly more money while you can is always better than trying to optimize future valuations. This should not be confused with raising too much money as many companies did in 2006-08.

The rest of this post series deals with the reasons why VC froze up in the first place, why investments have heated up recently and why the future of VC funding at the current pace is not certain.

Why did the VC markets freeze so quickly?

Market downturn – We all know that investors move in herds. Should VC’s really be impacted by public market valuations when the money that they’re investing today should be for returns in 7-10 years? Short answer – yes. Three reasons:
1. There is a relative valuation between the price a VC pays and their expectations of what it will exit for in an IPO or trade sale. Also, it’s harder to pay a $30 million pre-money value on an unproved company when you see public companies with $100 million in sales trading for less than $20 million.
2. Huge downturns have a real impact on the revenue line of start-ups and therefore the pressure on valuations. They also make M&A activity more difficult and with lower outcomes. In the first scenario it threatens the viability of some companies investors had hoped to sell and in the latter case it affects returns.
3. The most obvious reason downturns affect investors is psychology. Whether you like it or not, VC investors are impacted by investment psychology and get scared when markets are in a free fall. The best MBA class I took was an investment strategy class. The professor plotted data and showed us statistically that most people buy stocks when they are booming (e.g. overvalued) and sell when the fall precipitously. VC’s are not immune to this phenomenon. Despite my cynicism of MBA’s, this class was very valuable to me. It helped me avoid chasing deals (and a house) in 2007/08 and it led to GRP’s fastest pace of investment in many years in the first three quarters of 2009 at a time when many others weren’t investing.

2. High burn-rates fueled by over investment – One of the most damning things that happened to the start-up markets in 97-00 and 05-08 was the overfunding of technology companies. This came in part due to the huge influx of money into VC but also because hedge funds and private equity shops with no VC experience wanted part of the action. As we all know the VC industry is now set to contract dramatically as profiled in this seminal Paul Kedrosky presentation predicting a 50% contraction.

The high burn rates were OK in investors’ minds when they figured they could just raise another round at a huge valuation and find a bigger sucker to fund the future large cash burn. Bu when you start to worry that the world is ending (as it seemed it was in late 2008 / early 2009) you tend to get worried about large burn rates. Enter the famous Sequoia “RIP Good Times” presentation and Ron Conway’s publicly leaked emails calling for big slashes in burn rates. While this really was a lagging indicator, I like to think of it as one bookend in the current VC cycle because both Sequoia and Conway are now ironically driving the increased pace that signifies the thaw (I’ll cover this later).

3. The triage problem – What many entrepreneurs didn’t fully understand was the triage problem that faced investors. As a personal story, I sat on the board of one company with a very unhealthy burn rate relative to revenue or expected growth. I argued for literally a year to slash burn. The other investors around the table didn’t agree nor did the “independent” board members who were willing to turn a blind eye to capital inefficiency since they didn’t have any economic interests that would be diluted by continued fund raising to support a capitally inefficient management team. I can’t tell you how many weekends, evenings, early-morning board calls and hours of frustration I poured into this shitty situation. (disclosure: I am thankfully no longer on this board)

While the company continues to perform well it has come at a cost. But they were the lucky company because there was an investor that believed in the high-growth scenario and was willing to continue funding at any cost.

I only had one board with this problem. GRP had a small dose of foresight (we were very bearish in 2007 – ask anyone who presented to us) and a smidgen of luck (we closed our new fund Dec 2007) that we did very few investments during the 05-08 bubble. So we have almost no triage problem.

But imagine a VC that did 12 deals per year in 2006, 2007 & 2008. Of their 36 deals you can bet that they had at least 22 “issues” on their hands. I’m not saying all their companies were bad but I guarantee you they spent an inordinate amount of their time on “triage” meaning trying to determine which companies to shut down, which to do “internal rounds” of financing and which were strong enough to try to raise external capital. No doubt they spent countless hours arguing for reduced burn rates sometimes with founders, sometimes with investors. If they wanted to fund a company but other investors didn’t then they got involved in protracted negotiations over issues such as “pay-to-play” provisions.

It is no wonder why they had less time for new deals.

1. The pricing problem – So an investor put $5 million at a $10 million pre-money valuation in a company with a great beta product but no real customers. The company was therefore priced at $15 million post-money and the VC (s) own 1/3^rd. The deal was done in late 2007. The company had a huge burn rate but investors and management brought that under control by late 2008. The company couldn’t get a new customer between September 08 – March 09 even if it gave away products for free but they took their time to recast their strategy and build a better product. Now they have $1 million in the bank, a $200k burn-rate and they’re ready to raise some dough. Can a deal get done?

It’s surprisingly difficult. The problem with the bubble is that too many companies were overpriced and didn’t grow into their valuation so new investors have a choice between investing in a totally new company at a $5 million valuation or this mythical company above at $15 million pre.

Sure, investors and management are signaling that they’ll take a realistic valuation (“they know that times have changed”) but many new investors are reluctant. First, they don’t want to have the cat-and-mouse discussions about valuation. Second, they know that if they do get to invest at $5 million pre the management team is going to get washed out ownership wise given the previous round. So it’s easier to just pass.

Put crudely, if you know you’ve got your own internal overpriced shit to clean up why do you want somebody else’s mess? I’ve heard that line many, many times in the past year. But when you invested in a high-priced deal you own the problem and it sucks up your time.

2. Fund raising – We all know that the VC industry is contracting. It’s a game of musical chairs. A good piece covering the contracting VC market is by Bill Gurley So partners at many firms are racing around to the limited number of pension funds, endowments, insurance companies, family offices, etc. and trying to raise their next fund. If you thought getting a start-up funded in the past year was hard try raising a VC fund! Yet partners in funds don’t give up easily so they have taken to the road to “pre market” their funds (for some reason VCs are never really fund raising. They pre-market their fund raising until one day they announce a first closing).

3. Partnership resets – Finally, the issue that nobody seems to discuss – partnership resets. I don’t have any real data here other than anecdotal. VC’s fund their salaries and operations through management fees, which typically equal 2% per year. These fees also tend to decline in % terms in the later years of the fund where the investor is no longer doing new deals. So if you’re in year 8 of a 10-year fund and fund raising hasn’t gone so well, it’s no surprise that some partners will leave.

What has been more of an impact is that several funds still in years 3-5 (e.g. active) are out raising their next fund and realizing that the fund size will be smaller. In the Darwinian world that is VC it means that either partners will make less money per partner or that some partners (and staff) will have to go. I put my money on the latter. A certain amount of infighting is clearly going on and would make for a great book about this era if some enterprising journalist would write it. Any which way you slice it this is more time spent on internal politics and less time funding.

So with triage, fund raising and internal VC politics it is no wonder it was hard to even get a meeting with a partner between September 08 – April 09. Doing a deal as a VC in this period was the equivalent of putting your head above the parapet – it might get shot.

Those days are largely behind us (for now). To find out how we came out of that era please read my next post, The Big Thaw, Why VC is Moving Again.