Where is the money?

A few years ago, when Alan Austin was managing partner at a Silicon Valley law firm, he wanted to get away for a ski weekend at Squaw Valley, California. And get away he did: he was stranded for two days in blizzard-like conditions.

Austin, now a general partner and chief operating officer at Accel Partners, recalls, ‘It was one of those mid-December days with raw conditions. It was snowing at the top of the mountain. My companions were tired, so they headed back. But I had something left in me, so I went out for one last run.

‘Well, it turned into a whiteout. That's like a blackout, but it was all white, and I couldn't see anything. I got disoriented and turned around 180 degrees. Without realising it, I skied off the back side of the ridge, out-of-bounds, into no-man's-land. I got more and more concerned. Nothing was making sense.

‘At some point, I decided that I wouldn't find my way out that night, and, if I didn't make a shelter, I would freeze to death. So I made a cave in the snow, and I wound up being stranded there for two days - it snowed 40 inches. At the end of that time, it cleared a little, and a National Guard helicopter spotted me, and I was taken to safety.'

Not unlike Austin, the venture capital industry has suddenly found itself in a place far removed from where it hoped it would be 18 months ago. Down the slopes the VCs slid, and, like Austin, they ended up on the wrong side of the mountain. Is it a stretch to compare the recent markets for start-up funding to the blizzard that Austin encountered?

Not really. In March of last year, the slide of the Nasdaq achieved the dubious distinction of being the most precipitous decline of a major stock market, in terms of percentage, since the stock-market crash in 1929.

Even entrepreneurs who feel they have a clear path to profitability have found themselves feeling disoriented in this forbidding investment climate. Market realities are accelerating trends and forcing many firms within the venture capital community to re-examine some of their most fundamental assumptions.

A profound transformation

How deep that thinking goes will, to a large extent, be a function of how long the storm continues. But this much is clear: the venture capital industry is undergoing a profound transformation. In the 1980s, venture capital was a quaint little boutique industry, often with a few lawyers and doctors putting in $10,000 or $20,000 apiece.

More recently, VC firms started courting university endowments, pension funds, insurance companies, and other institutional investors that typically allocate five per cent of their portfolios to alternative investments. According to Venture Economics, the number of venture capital firms increased from 95 in 1980 to 387 in 1989, to 620 in 1999. And, according to some estimates, when smaller firms and angel investor groups are included, there are well over 1,000 VC firms operating today.

The amount of capital under management by VCs increased from $2.9bn in 1980 to $29.5bn in 1989, to $134.5bn at the end of 1999. Mark Heesen, president of the National Venture Capital Association, says, ‘I've seen dramatic changes in a very short period of time. In 1995, the venture capital industry invested $5bn. In the year 2000, we were a $103bn industry. The industry changed from a group of individuals that invested primarily in Silicon Valley and the Boston area to an industry that invested in 47 states and the District of Columbia.'

The number of companies receiving venture capital increased by 36 per cent, from 3,967 in 1999 to 5,380 in 2000. Although venture capital investments did slow a bit in the fourth-quarter 2000, to $19.6bn - down from $28.3bn in the third quarter - the amount of capital under management increased to over $210bn.

Institutionalisation of venture capital firms

Venture capitalists are moving, sometimes reluctantly, toward institutionalisation. This has entailed the adoption of sophisticated management and accounting systems, and along with that come bureaucratic human-resource policies and reporting burdens.

Dovetail these trends with the recent market corrections, and it all adds up to a growing sense of VC disquiet. Is it a stretch to call this a VC identity crisis? Some of the industry's most influential players vociferously disagree. But, clearly, the industry's process of self-assessment has been intensified by financial uncertainty, especially with questions concerning the ability of the mid- and lower-tier venture capital firms to raise new funds in the coming years.

Last January, Crosspoint Venture Partners raised eyebrows with its decision to cancel a $1bn fund with commitments from blue-chip institutional investors like Harvard University and the Rockefeller Foundation. Of course, this decision isn't irrevocable.

Like most top-tier VC firms, Crosspoint has a waiting list of investors that it can tap at any time. In essence, it's a postponement. But Crosspoint's decision has added fuel to an ongoing discussion regarding the character of the VC. Seth Neiman, a managing partner at Crosspoint, declined to discuss the fund, but, six months after the firm's decision, the rumors continued to circulate.

On a professional level, some speculate that Crosspoint simply didn't feel it could achieve returns to satisfy investors, and it communicated this to its limited partners in an effort to preserve its reputation. This is unsettling to others in the VC community who are no longer seeing the same quality of deal flow they saw two years ago.

Crosspoint's decision is loaded with implications for institutional investors, especially given Crosspoint's credibility. If the limited partners buy into Crosspoint's logic and start asking hard questions of their other funds, what does that mean about the ability of unproven VC funds to raise capital down the road?

Then there are the personal issues facing VCs, who are often stretched thin, sitting on the boards of 12-15 portfolio companies. One industry venture capitalist, who wished to remain anonymous, speculated that founding partner John Mumford's decision to not be a part of the next Crosspoint fund had an important psychological impact on the other partners.
Given Mumford's decision to walk away from the stressful VC lifestyle, they also wondered just how much of a commitment they wanted to make, especially looking ahead at the possibility of several years of tough markets. The time commitments, or lack thereof, that general partners are able to make are especially vexing. Heesen says, ‘Because the industry has grown so dramatically in such a short time, the number of professional venture capitalists has not kept up with the incredible amount of money flowing into the industry. Professional venture capitalists today are stretched [more thinly] than they ever have been.'

Crosspoint's Neiman says, ‘To work as hard as venture capitalists do, it's going to take a lot of different motivations. I wouldn't work as hard as venture capitalists do simply for the money.' When Crosspoint postponed its $1bn fund, each of its six partners was walking away from upward of $3m to $4m apiece, per year, in management fees ($1bn times a 2 per cent to 2.5 per cent management fee, divided by six partners, less the expenses of running another fund).

Another more charitable theory sees Crosspoint's move as a mature and responsible decision, given the current market realities and the fact that Crosspoint already has almost $500m in its existing fund, yet to be invested.

But a more cynical theory sees the move as a self-serving marketing ploy designed to differentiate Crosspoint from the greedy pack of other VC firms. Those of this persuasion wince a little at some of Crosspoint's public statements that take the rest of the industry to task over the issue of management fees. Whatever the interpretation of events, it is clear that Crosspoint stirred up controversy by attempting to seize the high moral ground.

Pressures to scale up

The Crosspoint controversy also raises deeper issues about where the industry is headed. Some of the industry's most influential players are wondering if the same trends toward consolidation that characterised commercial banking, investment banking, law, and accounting are lurking ahead for VCs.

Although venture capital may not be subject to the same economies of scale as investment banking, it is not immune to the market pressure to grow, especially in the critical area of deal flow.

Manny Fernandez, former president and CEO of Gartner and now a general partner with SI Ventures and chairman of Gartner, says, ‘Although, in the beginning, the value add of the VC is operational involvement, in the final analysis, the venture capital industry is all about deal flow.'

In an environment where many of the best entrepreneurs are waiting on the sidelines, it becomes increasingly difficult for smaller firms to sustain the quality of deal flow, and this suggests that the pressure will only increase for VC firms to scale up. Ronnie Skloss of Brobeck, Phleger & Harrison says, ‘We probably won't see the outright consolidation of firms in venture capital, but we're likely to see an increased raiding of talent by the VC firms that better weather the fallout from the downturn in the technology sector.'

This becomes an especially attractive option for the top-tier firms that have no immediate problems raising additional capital.

Dennis Roberts, who has 35 years of experience as an investment banker, commercial banker, and, more recently, chairman of The McLean Group, says, ‘The economics of venture capital argue for the same scalability that VCs want for their portfolio companies. If a fund is small, it can't hire enough good people to analyse and do deals. By the time a firm has paid office overhead, legal fees, support services, acquisition costs, and partner salaries, there's not a lot of money left over at the smaller firms for quality deal analysis. I, personally, wouldn't put my money into a firm with only $25m or $50m under management.'

As the industry places a growing premium on the speed of moving dollars through the pipeline, the days of the boutique VC firm may be numbered. Firms like San Francisco based Round1 sought to bring efficiencies to the private capital markets by using the Internet to automate work flow and increase information transparency.

But even Jamie Cohan, co-founder and chairman of the board at Round1, says, ‘There are established behaviours to overcome in an industry where personal relationships have played such an important role. But those same behaviours create limitations. We believe it is inevitable that private capital markets will see the same level of standardisation and information access that you see in the public markets.'

Not everybody agrees with that prognosis. Bob Kagle, a general partner at Benchmark, says, ‘I'm not sure that the venture capital business scales per se. The unit of production in our business is the general partner's time and availability to serve on the board of directors. There are only so many boards that one individual can effectively serve on.'

If the VCs give in to the market pressures to scale up, how might that change the character of the VCs' involvement with their portfolio companies? This also has potentially profound implications for the culture of an industry where intuitional hunches, networking, and the nurturing of personal relationships are key determinants of success.

Is this ultimately compatible with the sort of assembly-line mentality that comes with pressures to increase deal flow?

This disquiet has filtered down to the entrepreneurial community. Many entrepreneurs now find themselves in situations similar to Alan Austin's: trying to live by their wits, building a financial cave in the snow, and hoping that a National Guard helicopter carrying a few sympathetic VCs will rescue them.

Many entrepreneurs have turned their business plans around 180 degrees from what they had when they set out to seek capital. Kagle says, ‘Companies raised an enormous amount of money prior to proving themselves as viable businesses. What's happening now is we're reverting to the mean. You're seeing both entrepreneurs and venture capitalists return to fundamentals, and treat capital as a scarce resource.'

Shakeout ahead

Make no mistake about it: this is a game of survival, not only for entrepreneurs, but also for many of the newer and smaller VCs. Through a random sampling of venture capitalists, a consensus emerges that, of the estimated 1,000 to 1,500 VCs in existence today, as many as half won't be around in a few years.

If the history of investment banking or commercial banking is any gauge, these projected attrition rates are probably inflated. But, with IPO exit strategies all but blocked off, the VC portfolio pipelines are getting clogged.

For the moment, exit activity through mergers and acquisitions remains robust, but, if the market slide continues, even this avenue will become increasingly littered with the debris of dot-bombs. The precipitous decline in the market value of firms like Cisco Systems (CSCO), Microsoft (MSFT), Lucent Technologies (LU), and others that have traditionally been active in the M&A market further aggravates the dilemma of the VCs.

Until a liquidity event occurs, a VC's capital investment is captive in the coffers of the portfolio company and subject to a whole host of unpredictable factors, including the viability of technology, the growth of the micro markets, the strength of the management team, and the effectiveness of the sales and marketing effort.

Even after a liquidity event, with today's depressed stock prices, venture capitalists are reluctant to move stocks in their portfolios through sales on public exchanges or M&A activity. Jeffrey G. Grody, a partner with Day, Berry & Howard and a specialist in M&A activity, says, ‘Although M&A activity is still strong, that may not be what VCs really want. Sometimes, it doesn't enable them to achieve maximum return."

Recognising that their reputation with institutional investors is on the line, most venture capitalists are taking a tough stance in negotiations. Some entrepreneurs feel that VCs are unreasonable, seeking to exploit the current market to extract deeper concessions from their portfolio companies, in terms of valuations and especially in follow-up rounds of financing.

But venture capitalists defend their position, pointing out that the market is the ultimate determinant of values, and that valuations in earlier rounds were clearly inflated. Grody says, ‘In tough times, the golden rule applies: those with the gold make the rules.'

Although such figures are difficult to verify, an Upside sampling suggests that upward of 50 per cent to 60 per cent of VC investment funds are now being used to prop up existing portfolio companies. ShareSpan Wireless' founder and CEO, Howard Schwartz, says, ‘Valuations of companies are divided by four or five from where they were two years ago.'

Woe to those entrepreneurs who have neither a cash hoard nor a customer base with the sort of blue-chip companies that will make skeptical VCs pause from their frenzy and take notice.

Few options for entrepreneurs

Although many talented entrepreneurs are on the sidelines waiting for market conditions to improve, others have little choice but to continue to make the rounds with venture capitalists.

According to Garry Hemphill, founder and CEO of VHB Technologies in Texas, ‘What we're seeing now is that VCs want a slam dunk. Now, they not only want you to be in beta testing with customer testimonials, but they're also looking to mitigate their risks through partnerships with other VC firms. They need to know that, when you go for the next round of financing, other firms' VCs will be there.'

Schwartz says, ‘VCs are asking a lot more questions. They're telling us to close the deals, book the revenues, and then come back. With this market, they know they can wait 30 days and your deal will still be there.'

Arnold Kroll, a senior adviser from Burnham Securities - one of ShareSpan's investors and board members - offers this admonishment to Schwartz: ‘Companies don't go out of business from dilution. They go out of business by not getting the money they need.' But most entrepreneurs accept the new market realities and realise that they have little leverage in the negotiation process.

Hemphill says, ‘There is plenty of bloodletting going on right now. They don't say no. Their game is to sit on the fence and wait. In the process, they're removing any bargaining chips you might have had in the negotiation process.'

Vivek Wadhwa, chief executive of Relativity Technologies in Cary, N.C., is more blunt. He says, ‘Companies are absolutely being raped by venture capitalists. The VCs wanted me to accept a lower valuation without even knowing what the valuation was, or how the company was doing. That is what pissed me off so much. Their attitude was that we should take a cut and suffer the anti-dilution consequences just because they were losing money on their other investments.'

Wadhwa's solution? He went out and secured a $2m working-capital loan and a $3m line of credit.

Hoping for divine intervention

So, like Alan Austin, out there in his Squaw Valley snow cave, both VCs and entrepreneurs are wondering if they are, in fact, doing the right things - without certain knowledge of how long the storm will continue. Austin remembers hearing the sound of rushing water in his vicinity during the whiteout. He knew that if he took a wrong step and fell into the stream, he was history, and he had to decide whether he should stay put and wait for rescue or venture out.

Similarly, should venture capitalists invest their time in raising new funds, when bringing their investors low returns might tarnish their own reputations? Should they be pumping more capital into companies to keep them afloat, when nobody really knows when the market will bottom out? Are they throwing good money after bad?
Fernandez says, ‘Our position is that, if financing will not last the company one year, and if the company is not profitable after that, we will not invest. You have to make tough decisions in this environment, and sometimes you just have to walk.'

After Austin was rescued, he reflected on the deeper meaning of what had happened to him. He says, ‘Only in retrospect did I come to appreciate the spiritual dimensions of the experience. I really felt there was divine assistance at work with me out there. I was only a casual churchgoer before the experience, but now I'm much more religious.'

While most VCs and entrepreneurs may not view what they're going through as a spiritual experience, they probably wouldn't mind a little divine intervention.

Copyright © 2002 Upside

John F Ince is a journalist with UMAC Inc.

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