Venture Capitalists Facing an Identity Crisis
Published in Upside Magazine in 2002
Market Corrections and Pressures to Scale Up Force Reassessment of Priorities
by John F. Ince
Six years ago, when Alan Austin was Managing Director and Chief Operating Officer at Silicon Valley linchpin law firm, Wilson, Sonsoni, he wanted to get away for a ski weekend at Squaw Valley. Get away he did. In fact he got stranded for two days in blizzard like conditions. Recalls, Austin, who now serves at General Partner and Chief Operating Officer of Accel Partners, “It was one of those mid-December days with raw conditions. It was snowing on 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 realizing it. I skied off the backside 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. I wound up being stranded there for two days and snowed 40 inches. At the end of that time, it cleared a little, 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 went, but, like Austin, they ended up on the wrong side of the mountain. Is it a stretch to compare the recent markets for startup funding to the blizzard that Austin encountered? Not many think so. In March of this year, the slide of the NASDAQ achieved the dubious distinction of being most precipitous decline, in terms of percentage, of a major stock market, 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 reexamine 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: venture capital is undergoing a quiet and profound transformation. Not that long ago 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, who typically allocate 5% of their portfolios to these so called, “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 when smaller firms and angel investor groups are included, some estimate that there are well over 1000 VC firms operating today.
The amount of capital under management by VCs increased from $2.9 billion in 1980 to $29.5 billion in 1989 to $135.3 billion at the end of 1999. According to Mark Heesen, President of the Natural Venture Capital Association, “I’ve seen dramatic changes in a very short period of time. In 1995 the venture capital industry invested $5 billion. In the year 2000, we were a $103 billion industry. The industry changed from a group of individuals who 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 35% from 3,967 in 1999 to 5,380 in 2000. Although venture capital investments did slow a bit in Q4 2000 to $19.6 billion, down from $28.3 in Q3, the amount of capital under management increased to $134.5 billion.
Institutionalization of Venture Capital Firms
With this transformation, VCs are moving, sometimes reluctantly, towards institutionalization. The growth in size of VC firms has meant the adoption sophisticated management and accounting systems and along with that comes 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 is a stretch to call this a VC identity crisis? You decide. 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 VC firms to raise new funds in the coming years.
Crosspoint Partners, raised eyebrows this January with their decision to cancel a one billion dollar fund with commitments from bluechip institutional investors like Harvard University and the Rockefeller Foundation. Of course, the Crosspoint decision is not irrevocable. Like most of the top tier VC firms, they have a waiting list of investors that they can tap at any time, so, in essence, it amounts to more of a postponement. But Crosspoint’s decision has added fuel to an ongoing discussion that goes to the very character of the VC. Crosspoint’s General Partner, Seth Neiman declined to discuss their postponement of their recent fund in the recent Upside interview. But six months after their decision, rumors continue to circulate.
Crosspoint’s decision can be interpreted on two levels: professional and personal. On a professional level, the speculation is that Crosspoint simply didn’t feel they could achieve returns to satisfy investors, and communicated this to their limited partners in an effort to preserve their reputation. This is what is so unsettling to others in the VC community who are no longer seeing the same quality of deal flow they saw a year ago. Crosspoint’s decision is loaded with implications for institutional investors, especially because Crosspoint has such credibility. If the LPs buy into Crosspoint’s logic and start asking hard questions of their other funds, what does that mean about the ability of VC funds of unproven ability to raise funds 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 VC who wished to remain anonymous, speculated that the decision of Crosspoint’s founding partner, John Mumford not to 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 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 issue of time commitments of general partners is an especially vexing one for the industry. According to Mark Heesen, President of the Natural Venture Capital Association. “Because the industry has grown so dramatically in such a short time, the number of professional venture capitalists has not kept up with this incredible amount of money flowing into the industry. Professional venture capitalists today are more stretched than they ever have been.”
Says Seth Neiman of Crosspoint, “To work as hard as venture capitalists do, it’s going to take a lot of different motivations. I simply wouldn’t work as hard as venture capitalists do, simply for the money.” Speaking of the money, by postponing their $1 billion fund each of Crosspoint’s six partners were walking way from upwards of $3-4 million apiece per year in management fees ($1 billion times a 2-2.5% 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 Crosspoint already has almost $500 million in their existing fund, yet to be invested. But a more cynical theory sees the move as a self-serving, marketing ploy designed to differentiate themselves 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 has stirred 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 towards consolidation that characterized, commercial banking, investment banking, law and accounting are lurking ahead for VCs. Although venture capital may not be subject to the same economies to scale of investment banking, it is not immune to the market pressure to grow, especially in the critical area of deal flow. Says, Manny Fernandez, former President and CEO of Gartner and now a General Partner with SI Ventures and Chairman of Gartner,, “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 when many of the best entrepreneurs are waiting 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. Says Ronnie Skloss of Brobeck, Phleger & Harrison LLP, “We probably won’t see outright consolidation of firms in venture capital, but we’re likely to see 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, who have no immediate problems raising additional capital. Says Dennis Roberts, who brings 35 years of experience as an investment banker, commercial banker and more recently as head The McLean Group, “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 analyze 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 in a firm with only $25 or $50 million under management.”
So the days of the boutique VC firm may be numbered as the industry places a growing premium on the speed through which they can move dollars through the pipeline. Firms like San Francisco-based, Round1 are seeking to bring efficiencies to the private capital markets by using the Internet to automate workflow and increased information transparency. But even Round1’s CEO, Jamie Cohan acknowledges, “There are established behaviors to overcome for an industry where personal relationship have played such an important role. But those same behaviors create limitations. We believe it is inevitable that private capital markets will see the same level of standardization and information access that you see in the public markets.” Not everybody agrees with that prognosis. According to Bob Kagle, General Partner at Benchmark, “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 VC involvement with their portfolio companies? And it 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?
Entrepreneurs Feeling the Pinch
And this disquiet has filtered down to the entrepreneurial community. Many entrepreneurs now find themselves in situations like Alan Austin, trying to live by their wits, building a financial cave in the snow, hoping that National Guard helicopter with a few sympathetic VCs in it will spot them below. Many entrepreneurs have turned their business plans around 180 degrees from what they had when they set out to seek capital. According to Bob Kagle, General Partner at Benchmark, “Companies raised an enormous amount of money prior to proving themselves as a 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.”
A Shakeout Ahead for Smaller VCs
Make no mistake about it, not only for entrepreneurs, but also many of the newer and smaller VCs this is a game of survival. Through a random sampling of VCs, a consensus emerges that of the estimated 1000-1500 VCs in existence today, as many as half will not be around in a few years. In the history of investment banking or commercial banking is any gage, these projected attrition rates are probably inflated, but with exit strategies through IPOs all but blocked off, the portfolio pipelines of VCs are getting clogged.
For the moment, exit activity through mergers and acquisitions remains robust, but if the market slide continues much longer, even this avenue will become increasing littered with debris of dotbombs, and less viable. The precipitous decline in the market value of firms like Cisco, Microsoft, Lucent and others who have traditionally been active in the M&A market further aggravates the VCs dilemma. Until a liquidity event occurs, the VC’s capital investment is captive in the coffers of the portfolio company and subject to 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 their sales and marketing effort. Even after a liquidity event, with today’s depressed stock prices, VCs are reluctant to move stocks in their portfolios through either sales on public exchanges or M & A activity. Says Jeffrey Grody, Partner with Day, Berry & Howard LLP and a specialist in M & A activity, “Although M & A activity is still strong, that really may not be what VCs want. Sometimes, it doesn’t enable them to achieve maximum return.”
VC Taking a Tough Line on Valuations
Recognizing that their reputation with their institutional investors is on the line, most VCs are taking a tough line 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, especially in followup rounds of financing. But VCs defend their stance, pointing out that the market is the ultimate determinant of values and that valuations in earlier rounds were clearly inflated. Says, Jeff Grody, “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 upwards of 50-60% of their investment funds are now going to prop up existing portfolio companies. Says Howard Schwartz, CEO and Founder of ShareSpan Wireless, “Valuations of companies are divided by four or five from where they were last year.” Woe be those entrepreneurs who have neither a cash hoard or customer base with the sort of bluechip 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 VCs. 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 VCs firms. They need to know that when you need to go for the next round of financing, that other firms VCs will be there.” Says Schwartz, “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 thirty days and your deal will still be there.” One of ShareSpan’s investors and board members, Arnold Kroll, Senior Advisor from Burnham Securities offered 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 realize that they have little leverage in the negotiation process. Says Gary Hemphill, CEO of VHB technologies, “There 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 bargain chips you might have have, in the negotiation process.”
Vivek Wadhwa, chief executive of Relativity Technologies in Cary, NC is more blunt. He says, “”Companies absolutely are 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 $2 million working capital loan and $3 million line of credit instead.
Hoping for Divine Intervention
So, like Alan Austin, out there at Squaw Valley in his 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. He knew that if the took a wrong step and fell into the stream, he was history. So should he stay put and wait for a rescue or venture out? Should VCs be investing their time in raising new funds, when their reputation might be tarnished by bringing their investors lower returns? Should VCs be pumping more capital into companies to keep them afloat, when nobody knows for sure when the market will bottom out? Are they throwing good money after bad? Says Manny with SI Ventures and Chairman of Gartner, “Our position is that if financing 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 walk.”
It was only after Austin was rescued, that he had time to reflect on the deeper meaning of what happened to him. Says Austin, “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 their going through as a spiritual experience, they also wouldn’t mind a little divine intervention.