The Economy and Venture Capital

One of the most frequent questions I get these days is "What does the current economic downturn mean for you and venture capital?"  It's still early to fully know the answer, but here are some thoughts.

1.  Good companies will continue to get funded.  This has two levels: (1) Great companies, technologies and ideas still come about during tough economic times -- and the best will find funding.  Pain killers and problem solvers find capital.  And (2), some longer-term macro demand trends are real and will sustain through this downturn such as the continued move to clean technologies and Healthy Living.  These are two real, longer-term trends and are a focus of Clear Venture Partners.    For example, even in the downturn, natural/organic products are still growing much faster than traditional products, but perhaps at a slower clip than pre-downturn.

2.  Venture funds have money to deploy.  Over the past few years, many new venture capital funds have raised capital -- and that capital must get deployed.   In most cases, LPs (investors in venture funds) have not backed out of their commitments to funds.  There are often harsh penalties for doing so.  Therefore, funds that were raised and intended to invest in 15-20 companies, still need to find those companies.  Your best bet when raising capital is to find funds that have had their initial closing within the past two or three years; those are the ones with the most capital left to deploy.  There was an article last week in the Wall Street Journal called "Venture Capitalists Get Creative" that made it seem as if venture funds in general were pulling back, but that article focused on funds that were closer to the end of their 10-year life cycle (venture funds exist for 10 years -- with the possibility of a one-to-two year extension), then cease to exist.  What the WSJ article really said was that funds closer to the end of their 10-year cycles were pulling back on commitments to existing companies (let the losers die sooner), shoring up their winners (feed them) and save money for fund management fees (gotta feed their own children too).

3.  Earlier-stage companies, in general, will have a tougher time raising capital.  The credit squeeze has forced a lot of mid-stage and later-stage companies that typically went to debt markets for lines of credit and other forms of debt are finding a less-receptive market. This is forcing those companies to look for equity instead.  While this is great for venture capital in general (better, later-stage companies to fund at attractive valuations given the increased demand), it also squeezes out earlier-stage, higher-risk companies.  That said, my point #1 still applies:  Good companies will continue to find funding, but perhaps at tougher valuations.  Attitudes and expectations will accordingly adjust.  As I've heard from investors lately, "flat (valuations) is the new up."

4.  Raising new venture funds will also become more difficult.  Institutional LPs to venture funds typically set aside a percentage of their overall asset value to deploy in alternative (venture/private equity) asset class.  As their public equity portfolio is now worth 50-70% of what is was this time last year, the 10% they had set aside for alternatives may still be 10%, but it's 10% of a much smaller number.  To catch up, some LPs may actually skip a year or two on new investments.  Others will ratchet down.  It's ironic that this is likely short-sighted thinking.  This may perhaps be one of the best times to deploy private capital.  Demand is high, quality is high, valuations are low...  My partner and I plan to be in the market in 2009 to begin to raise Clear Venture Partners.  Hopefully some potential LPs might be reading this post and thinking the same things...

5.  Angels investors will close their wallets.  Angels are fickle and idiosyncratic.  And raising money from angels can be like herding cats.  Well, the fat cats aren't as big as they recently were and are likely to see many of their early-stage investments die off, or get severely crammed down, in 2008/9.  I think many will simply stop investing for the near-term.  Time for friends and family, credit card debt, what's left of home equity...to get startups through the early phases.

6.  Time to tighten the belt for all.  Given the above, companies that have capital need to figure out how to make it last longer.  Sales cycles will grow, revenue will not be what projections said six months ago, M&A markets have/will slow down in the near-term...so you need to make your cash last longer and work smarter.  Time to cut salaries and take out your own trash.  Startups need to make sure they act and spend like startups.

While those are some quick thoughts from me, here are some thoughts from others:

Jason Mendelson has a good post called How Does the Market Craziness Affect Venture Capitalists and Startups?   There is also an excellent presentation from Sequoia Capital which attempts to put some historical perspective on the current situation.