There’s a new analysis from the Kauffman Foundation that captures the situation that venture capital firms find themselves in today. It’s very informative and worth your time to read.
The usual observation is that venture capital is in trouble because of excessive and disadvantageous regulations, especially Sarbanes-Oxley, and the fact that the IPO market has dried up leaving them with no viable exits.
When you look at the total amount of money committed to venture capital hovering around $250 billion since 2000, versus the performance of venture capital hovering around zero since 2004, Kauffman concludes that this level of venture capital money is not sustainable because the market they are focused on is shrinking. It is this over commitment of venture capital money by limited partners that has led to its collapse.
Likewise, the pace of venture capital investments is currently hovering around $30 billion per year, which is 2 to 3 fold the pace of opportunities. This is arguable in that there are lots of new opportunities in biotech and cleantech that could justify this difference. Nevertheless, venture capital performance doesn’t support this pace.
According to Kauffman, the likely outcome is that limited partners will decrease the amount they invest in this asset class. This certainly is a trend we have been seeing for the last several months, mainly driven by the downturn of the economy which has caused them to reconsider their venture investments. This action will cause an appropriate adjustment to the overall amount of venture capital in play and the pace of investment, the result of which will be a realignment of valuations and ultimately improved performance.
Kauffman believes the adjustment could be to $12 billion per year driving a reduction in committed capital to around $100 billion.
Meanwhile, venture capital firms are responding to this challenge by finding new ways of doing business in an entirely different business environment of lower investments required, lower valuations and lower returns. We have seen new forms of syndication, new alliances, and new business models all of which are responding to the downturn of the venture capital market.
I am often asked by people from all over the United States if I know any angel investors that might be interested in their company. I then ask them about their business and their readiness for angels. Unfortunately, the vast majority of them are not ready to approach angels. Their question is easy to answer, but the advice they need before they attempt it is pretty extensive.
There is a lot of work that needs to be done before you approach angels. Angel investors are reasonably sophisticated in their investment habits. You will need to be able to answer a lot of simple questions. If you mess up the answers, you will not get another chance to see them again. I have called this opportunity similar to using a one shot rifle. If you miss, you lose any chance for another shot. Take a look at some of my blog articles on this like this one on How to Find Angel Investors. Read also this article from entrepreneur.com.
Before you ask about angel investors, be prepared by:
Once you have prepared yourself, make the contact with the angel investor. Now you can answer their questions. They will soon realize that you have done your homework. With this positive reaction, you can then carry on a discussion about your business and get a commitment to a meeting to formally present it. This is the way to do it. If you come across as unprepared, unfamiliar with the process, naive about how angels operate or don’t really understand your business, you will never get to first base.
All said and done, when raising money, the most critical hurdle the entrepreneur has to leap over is gaining the confidence of the investors. You can have the most attractive market, with the most innovative and competitive product or service, but if the investors do not believe that you can execute your business plan, they will walk. Read more about this perspective at Startable.com.
With respect to the management of the company, including the CEO and the other main players, investors just simply have to believe that you have the right team. This is often a very delicate judgment they make, sometimes with clear facts and sometimes on gut feel. The management team has to “click” with the investors, or it’s over. Here are some of the things they are looking for:
Entrepreneurs have to be very diligent in pulling together the best management team possible. It’s the most important set of decisions they make. Make sure you are getting the kind of people that can take you substantially down the path to success and have the skills that are needed to get there. Investors pay a lot of attention to entrepreneurs that have made them money, or at least have made money for other investors. Nothing speaks stronger than past success. Keep that in mind and try to assemble a team that has proven they can get the job done.
The National Venture Capital Association just reported that the number of venture capital principles has declined by 15 percent since the end of 2007. These are the folks that do the due diligence on investment opportunities and make the investment decisions within venture capital firms. The number of venture capital firms has dropped by 13 percent. Take a look at the WSJ article that gives the full details.
Some of the best of the best are heading out the door. Large firms like Sequoia Capital and Bessemer Venture Partners, along with smaller firms like Atlas Venture, Advanced Technology Ventures and VantagePoint Venture Partners, have lost partner level people. This is all a natural outcome of the decline of the venture capital market, and is why we are seeing new business models emerging.
For most of its recent history, venture capital deals have been structured with the requirement for a big payout upon exit, based on an initial public offering (IPO) or acquisition. IPO’s have nearly dried up to nothing and acquisitions have suffered a tremendous decline over the last year or more. As a result, venture firms are left holding onto investments that have no viable way to achieve liquidity in order to pocket their returns.
On top of this, with the rapid economic downturn at the start of the Obama administration, the institutions that fund venture capital have had to back away from this asset class. These institutions have lost up to 40 percent of their value, with some recovery recently, but have been in the mode of selling off their venture investments. Some have even had to withdraw their capital commitments to some venture firms. This has also put the brakes on venture firms that need to raise more money.
If a venture firm has recently raised a fund, they may have a chance to get through this economic downturn, assuming it recovers sometime next year. To survive, many are simply protecting the best companies in their portfolios, and are making few if any new company investments.
If a venture firm is nearly out of money, they are going to have a heck of a time raising a new fund in this market, and are faced with simply going out of business.
Despite what you read, this is not a natural evolution of the venture capital market. This is a forced outcome as a result of the economic downturn that has now nearly destroyed the venture capital business. This all goes back to the fundamental causes of the bank failures that was driven by mismanagement, government meddling and oversight failures.
Venture capital firms are finally making corrections in their valuations in response to the downturn in the economy late last year. Read about the details in the WSJ, but this decline in valuations represents an adjustment to the value they place on their portfolios and to any company they are considering for new investments.
The sharpest decline is occurring with later stage companies whose valuations declined about 43%, dropping from a median of $56.1 million in the fourth quarter to $32 million in the first quarter, all of which is pretty comparable to the decline in public markets last year. The median for the third quarter was $64 million. Likewise, their limited partners have felt the squeeze as well in that their portfolio values have dropped a similar amount.
Second round companies had a similar drop from $16.1million in the fourth quarter to $10 million in the first. But, first round companies faired well by rising from $6.6 million in the fourth quarter to $7 million in the first, but usually show less volatility to changes in the public markets.
In the first quarter, 57% of all venture rounds were done by the current investors, giving them the chance to tamp down the pain of the write-down thus protecting the fund’s performance. New investors would be much more likely to want a more aggressive reduction in valuations.
Entrepreneurs of start-ups that are going for their first venture round should expect valuations that track consistently from the last two quarters. Unfortunately, this is a bad time to have to go out to raise later stage VC money. The company will probably be faced with a down round where the company’s value is less than what it was at the time of the last round, and it’s all due to the economy. The hard thing to swallow is that even if the company performed well and met all its milestones, it still will get punished with a lower valuation.
If you need the money though, you have to do it. This is where tightening the belt and conserving cash pays off.
Entrepreneurs need to take care to choose angel investors that are going to add value to their business in addition to the cash infusion. Believe it or not, there are some bad choices of angels. The trick is to avoid the angels that might cause you some problems in the future.
Just because they can write you a check, doesn’t make them your best choice for a business partner. Entrepreneurs need to take a deeper look into the background of potential angel investors and find out who they really are. Here’s what you need to avoid:
The angels you want bring considerable business value and are the kinds of people with whom you want to have a long term relationship with. The value comes in various forms:
As you search for angel investors, look for the ones with the wings that can really take you to where you need to go. By all means, make sure you have your attorney create the investment documents. That way, you know they are right.
Last week I wrote about angel investors becoming super angels and replacing the role of the venture capital firms in investing in early stage companies. Well, venture capitalists are not standing still. With institutions backing away from venture investing and the IPO market drying up, venture capital firms are rethinking their strategies. Take a look at what Tim Draper is doing to reposition his firm. However this comes out, this is all good news for entrepreneurs who need to raise early money.
Draper is corralling money from other private equity firms and high net worth individuals to create what he calls an exchange for trading shares in early stage companies.
In addition to being an informational network for investors and companies, the exchange provides a facility for matching investors with companies and a platform for actually buying and selling company shares. It’s a private stock market, giving investors the opportunity to invest in high potential companies and getting some early liquidity in lieu of an IPO.
Although this is not a new idea, it is the first time that an exchange has been pulled together for venture capital.
The exchange provides a service for entrepreneurs to raise money for their ventures, while at the same time offering investors a new way to get a return on their investment short of an IPO or acquisition.
This service doesn’t quite reach the pure start-up in that the company has to have at least $20M in revenue to enter the exchange. Nevertheless, this is a good thing for these companies in that they will have another viable opportunity for raising capital.
Launching in September, this will be a grand experiment worth following. Stay tuned as this evolves and see how other venture firms deal with this dilemma.
Here’s a slant on the angel investment world that you may not imagine. Those angel organizations that view this down economy as an opportunity to get some really good deals may be introducing a new model of angel investing that could replace the role venture capital firms play today. Read about this in Spenser Ante’s article in Business Week.
Here’s the idea and premise. Instead of raising huge amounts of money in venture funds, which many claim is a broken model because the IPO market is nearly dead, raise much smaller funds. Every wonder why you read so much about the health of IPO’s? VC’s need them to get the multiples they require to make their deals whole. The new premise is to raise smaller amounts of money and invest much smaller amounts in many start-ups looking for much smaller but more predictable exits.
The aggregate should be more positive exits but at much smaller values. The idea is that the overall returns will be greater than the very high risk opportunities that VC’s engage in today.
The issue may be that VC firms are just too big. They have to place so much money in any single deal that they are almost destined to fail because the exits will not be lucrative enough. It has nothing to do with the recession, but everything to do with a basically broken business model. Some VC’s are seeing the light and going back to their roots of investing in start-up companies with small amounts of money. The difference today is that many companies can be started with a whole lot less money than we were seeing in the late 90’s and early 2000’s.
Well, the proof of the pudding is not yet seen. An entirely new model of venture investing may be emerging; one where VC firms invest in a lot more deals at the start-up stage with a lot less money per deal. This is placing a lot more bets on much riskier opportunities. Stay tuned as this model emerges.
In its most recent Angel Group Confidence Report, the Angel Capital Association (ACA) reported that 2008 average angel group investments were down 9 percent from 2007. They did point out that many groups actually increased, seeking opportunities while valuations are depressed.
We are all familiar with the impact of the economic downturn. As institutions backed away from venture capital investments, angel investors also become much more cautious and selective. They too took a big hit in the markets. The reaction of angel groups has been to be much more selective about making investments in new companies. This has led to the decline in average angel investments. In addition, they circle the wagons and protect their portfolio companies. Knowing that their companies will need help as it became unlikely to be able to raise VC money, the angel groups have to carry more of the water.
It’s not all gloom and doom. Entrepreneurs that have a great business idea should not shy away from approaching angel groups. They should really get familiar with what valuation and terms to expect in this market before they approach them.
Angels will be looking for well thought out business models that will get substantial sales traction quickly. The less money needed the better. Many web based businesses have that characteristic. It is important to portray a realistic and near-term exit strategy; the shorter the better. The management team matters even more. Gather an outstanding group of people who have both the technical and business wisdom to grow the business.
Well, I am afraid it is going to be more of the same, and perhaps a little worse, in 2009. But, again, don’t let that stand in your way as entrepreneurs. Put a whole lot of discipline in your business planning and execute smartly. Nothing beats a company that knows how to get to market. Be one of them.
The market downturn has certainly put the damper on the view of risk by angels as well as VC’s. I keep reading that there is plenty of money out there, which is true, but the problem is that there is actually less money than last year. The personal wealth of angels and the portfolio value of foundations and institutions are considerably less by 30 to 40 percent. This puts a lot of pressure on their willingness to take on new investments.
As entrepreneurs go out with their investor stories, the lucky ones get to see term sheets that are unbelievable. See Ty McMahan’s article in the WSJ. The rest have to keep looking. The term sheets bring a new dose of current reality:
It has always been the case that entrepreneurs have to show that they have a mature understanding of the equity market. Entrepreneurs that have unrealistic expectations and are not willing to negotiate and compromise will fail to get any money. However, today’s equity situation is a shocker for even the most mature of entrepreneurs. We are in a deep buyer’s market and prices and terms are very much in favor of the investor. If you need the money, this is the way it’s going to be for quite awhile.
Before you approach investors, get an update of your understanding of the market and be prepared to deal with this new reality.