I’m now in the process of completely updating this post for 2010. I already have great new material…BUT I would really like to hear if there are any questions or requests for the updated version while I’m at it. Please comment here.
The third quarter of 2009 represents a new low in the on-going analysis of VC fund raising. Below is the chart; numbers on right are in MILLIONS of dollars.
In Q3 of this year, only 17 funds raised capital compared to 27 in Q2 and 50 different funds in Q1. The total amount raised was $1.5 billion down from $1.96 billion in Q2, bringing the total for the year to $7.5 billion. In short, that means we hit a level that “represents the smallest number of venture funds raising money in a single quarter since the third quarter of 1994 when 17 funds were also raised and the lowest level of dollars committed since the first quarter of 2003 when $938 million was raised.”
Now, the biggest question is how much the (apparently, at least at the time of this writing) rebounding economy will positively affect Q4 fund raising. The IPO market window is open for especially healthy companies and M&A activity has picked up. This doesn’t mean that valuations in either case are back to normal levels and therefore a “wait and see” attitude toward this asset class is very possible. This sort of stuff is no fun unless someone goes out on a limb…so here we go: I predict that Q4 will come in right at $2.0 billion and, therefore, the total funds raised by venture capitalists in 2009 will come in just under $10b.
To restate: the cost of capital will remain high for start-ups; and these three trends are still valid:
- To the LPs, the venture capital asset class is going to largely show negative returns based on the commonly used 10-year rolling average calculation
- Any exit via IPOs or M&A will be at fundamentally lower levels…consistency and predictability is highly unlikely
- while probably improved, significant liquidity concerns remain in the limited partner world of university endowments and public pension funds
According to the NVCA press release:
“Anecdotally we are hearing that fund raising activity is accelerating as more firms that were waiting for economic recovery are beginning to formally seek commitments,” said Mark Heesen, president of the NVCA. “The reality, however, is that many limited partners are still determining their long term strategies in wake of the past year’s financial crisis and that slows the process down considerably. We expect commitment levels to remain modest for the remainder of 2009 with gradual increases beginning in 2010.”
in my last post on this topic, I suggested that Q2 was the “tell tale” quarter for the year…and the numbers are in.
the NVCA has just released the Q2 numbers and they’re pretty bleak:
Just 25 venture capital funds raised $1.7 billion in the second quarter of 2009, according to Thomson Reuters and the National Venture Capital Association (NVCA). This level represents the smallest number of venture funds raising money in a single quarter since the third quarter of 1996 (21 funds) and the lowest level of dollars committed since the first quarter of 2003 when $938.1 million was raised.
Total so far this year is right at $6 billion. If we stay at this level, my suggestion that 2009 could be a $10b or less year is still possible.
The key take-away from my perspective is that the cost of capital will remain high and probably increase throughout the rest of this year, at least.
To re-state, I believe this is happening for three reasons:
- the asset class is going negative based on the commonly used 10-year rolling average return calculation
- there is effectively no exit market via IPOs or M&A…certainly nothing consistent and remotely predictable
- there remains a significant liquidity crisis in the limited partner world of university endowments and public pension funds
For startups with proven traction there is still money out there. For instance, Pandora just raised a massive $35 million round last week and we tracked $6.4 billion in venture money going into companies last quarter, a 25 percent drop from the year before but still a healthy rate of investment. VCs are getting more selective about where they put their cash, but when they do they are more likely to bet big.
…to which I say: when rounds of financing get big, now, in the absence of exits and the squeeze on the VC industry…well, that isn’t necessarily a good idea. And, as coincidence would have it, here’s an example of exactly that:
AdAge asks and answers: “What Sank (video start-ups) Veoh and Joost? Too Much Cash Too Soon”
There are many reasons why things went wrong: technical missteps, lack of premium content, tough terms from content owners such as CBS and Viacom, etc. But that’s not the whole story. Joost and Veoh had an even bigger problem, one that will likely claim dozens of other media and advertising startups that have been founded over the past three years: too much venture money, too soon.
…and that’s not meant to point any fingers; it takes two parties to do the VC tango: the company and the VC.
This Summer, I’m working with The Capital Factory and helping out a number of young companies here in Austin, Texas. The purpose of this spreadsheet is to show the effects and calculations for ownership dilution over the course of three rounds of investment for an example company. There is no rocket science here by any means; that said, the first time I had to figure this stuff out was a real pain in the butt…so hopefully this speeds the process for others.
For the sake of simplicity, we will assume there are 3 founders with arbitrary ownership percentages; we will also assume a total of two investors and 3 rounds of funding: seed, series A, and series B. Of course, these assumptions can be changed as necessary to make it match your actual situation if you want to plug in your numbers / facts.
Will will also assume a $5m exit (liquidation) as might happen if the company were acquired. We’ll discuss it further but it’s important to say right up front that you’ll never make this amount of money from such an exit with such ownership. This is a theoretical MAXIMUM because it does not take taxes, legal fees, potential preferences, etc. into account.
In subsequent versions of this spreadsheet, we will consider how the “preferences” of preferred stock can affect the outcome. For now, this spreadsheet assumes everyone participates equally as if everyone owned common stock. When a company starts, the founders use some means to determine initial ownership: who’s idea it was, amount of personal capital invested, drawing straws, etc. The actual means used to determine initial ownership is immaterial to this analysis.
Many times, founders will not proactively allocate an option pool early in their company’s life. Whether you do it now or later, most investors will require the creation of an option pool BEFORE they make any investment because, simply, they do not want to be instantly diluted by pool creation immediately after investing. In the case of later rounds, it’s very common for investors to require an expansion of the pool up to 10%-15% ahead of their investment, depending on the situation.
In this example, we will create a 10% option pool at the point of founding. You can see that the Founding Stage total is made up of the three founders and the option pool = 100%
Here, our example company is taking a $20,000.00 seed-stage investment at a $400k pre-money valuation (value of the company before you take any money). It is not surprising, then, that the “post-money valuation” is the amount invested PLUS the pre-money valuation. This post-money valuation is exact value of your company immediately after completion of the financing and will be used to price stock options.
For each column / financing: pre-money valuation is on the left; below that is the amount raised; post-money valuation is on the right.
In the seed investment, you will be selling 4.76% of your company to Investor #1. This is simple math you can see in the spreadsheet cell. You can also say that everyone in the company will be diluting by 4.76%. You can see that Founder #1 “dilutes” from 37% ownership to 35.2% of the company, and so on.
Series A Investment
in the series A investment, our example company has done well enough to nearly double it’s pre-money valuation to $700k. The company has determined that it makes sense to raise $250k – usually that means a balance between necessary capital to reach the next set of financeable events and dilution to employees and investors.
This Series A investment represents a sale of 26.3% of the company to Investor #1 again – they must like what they’re seeing in our example company!
Note, however, that Founder #2 has decided to step up and invest $15k themselves. Such an investment is wholly predicated on the founder, the investors, and the current situation – there are no hard and fast rules to founders participating in subsequent financing although most investors would see it as a great show of enthusiasm and more “skin in the game” for the founder (both good).
For $15k, Founder #2 owns 17.7% of the company after Series A versus 16.1% if they had not made their series A investment: an increase in ownership of 1.6% instead of any dilution.
Investor #1 now owns 28.2% – and in this example – more than any individual founder. This is not an uncommon situation and over time and various fund raising, you should not be surprised to see this happen.
Series B Investment
This round is similar to Series A in terms of mechanics; here, valuation has more than doubled and the amount being raised is $850k. Employees have probably been hired; business model and go-to-market has probably been proven out. In a typical Series B, the money raised goes to scale up the mostly-proven business.
Founders are not investing in this round – and that is common as well. At this point, the price the founders paid for their stock (potentially zero) is significantly less than what Series B investors are paying; that coupled with the fact that the foudners will not materially change their ownership with small investments typically means that founders / early employees will not participate in late rounds of financing.
Dilution is 36.2% overall and investor #1 will typically have “pro rata” rights to invest an amount in a subsequent financing required to maintain their ownership percentage. In this case, Investor #1 must invest another $240k to maintain their 28% ownership in this company. Investor #2 leaves the Series B investment with 26% of the company that is now worth $2.35m.
Liquidation (acquisition) of the company
Ignoring all tendency to describe the relative rarity of such an event, “liquidation” doesn’t have to mean acquisition as we will see when we discuss term sheet structure; in our example, it does.
As we mentioned before, we’re going to assume a $5m exit (feel free to add some zeros when you’re alone). This represents another “doubling” of value from our series B investment. Note that it’s an entirely different conversation as to what is “good” versus “bad” from a returns perspective. For now, assume that it’s good enough to allow it to happen.
An Remember: you’ll never make this amount of money from such an exit with such ownership percentages becuase this spreadsheet does not YET taxes, legal fees and potential investor preferences into account.
In our next version we’ll start looking at the effects of long-term/short-term capital gains, some nominal fees, and investor preferences. This is where you’ll start to see how certain terms can materially affect the outcome of your company; we’ll also use that opportunity to define common term sheet terms.
I’ve said in the recent past that I believe there is trouble in the supply chain of venture capital and that 2009 might be a significantly down year for fund raising with a potential total raise of $10 billion. The National Venture Capital Association just released numbers today that confirm the trend but suggest my $10B 2009 target may be a bit too low. That said, I’m not adjusting the target yet. The reason this subject is important is because it affects the cost of capital for start-ups and the “ways and means” of how they get started in the first place.
The Q1 2009 VC raise is $4.3 billion, up from $3.5 billion in Q4 of 2008. That’s better than I would have guessed but it’s still down significantly from the $6.4B and $7.1B in Q1 of 2007 and 2008, respectively. It’s looking like Q2 will be the real tell-tale quarter that either delivers total funding in the $10B range at the half-year mark or shows a precipitous drop. I still believe the latter will be the case because VC fund raising takes a considerable amount of time…sometimes as much as 6-9 months to complete. This means that the fund raising that closed in Q1 would have been in progress since mid-2008. Undoubtedly, the global economic situation scared some limiteds off over that time; that said, there was probably enough momentum to carry some of the deals with the bigger, top-tier firms through to closing the fund. TechCrunch has written about two of those top tier funds in their summary of this data.
One other important observation from the data has to do with the number of new and follow-on funds that were involved with rasing in Q1 2009: only THREE new funds and 37 follow-on funds. To be clear, the number of new funds raising capital is three times smaller than any other qarter over the past 2 years (there were 10 new funds in Q1 of 2008 and 11 in Q4 of 2008). VentureBeat has suggested that there is a growing list of “walking dead” VC firms…and I think we’ll start to understand how true that is based on Q2’s data.
Here’s the updated the bar-chart that graphs VC fund raising by quarter starting in Q1 of 2007 through Q1 of 2009:
One quick point of order: I am not a VC but I get the dynamics pretty well. And I have invested in a handful of early-stage companies over the past few years; some with VCs, some ahead of traditional venture capital.
If one considers the amount of total venture capital raised from 2006-2008, and then take a look at the last three quarters of 2008 in the context of the larger macro-economic environment, current liquidity issues in traditional limited partner institutions, and the generic venture business model, there are some interesting implications for the not too distant future. This is the first in a series of posts that takes a look at what’s going on in the supply chain of venture capital.
The NVCA reported that $35.5 billion was raised across 327 funds in 2007; $27.9 billion was raised across 253 funds in 2008. During the last three quarters of 2008, you can see a decline (red, dashed arrow) mid-year and then a very sharp drop as the economy started slide (to put it mildly) in Q4 of last year. During Q4 of 2008, the total amount raised was $3.3 billion compared to $11 billion in the same quarter the previous year.
With a bit of extrapolation, it’s not hard to imagine that 2009 could be a year in which $10 billion or less! is raised across the entire industry.
Here’s why I believe that number is about right:
First, I believe that traditional limited partners are experiencing a liquidity crisis. More on the data and what this means in a future post. But, in short, the businesses that fund the venture capitalists are short on cash for that purpose. Not only are the short on cash, but they’re over-subscribed in their commitments to venture capital funds.
Second, in many cases, these same institutions analyze their investment portfolio, per asset class, on 10-year rolling averages. Guess what year rolls off next year? 1999 is gone from the average and that was a pretty good year in many venture capital funds. In fact, with 1999 out of the 10-year analysis, it’s very possible that the over-all weighted returns go from positive to negative. Pretty obvious what happens if an asset class shifts from positive to negative when it comes to how investors choose to allocate any new funds they may have to put to work.
So what is the implication? I think that 2009 may look like a $10 billion year at most and 2010 will put up an even smaller number; perhaps only $3 – $5 billion in total. What this means for the industry is that there is a looming venture capital crisis the likes of which the industry has never seen. It’s going start becoming increasingly obvious and play out over the next 24 months. Many, many venture firms are going to go away. The cost of capital will go up.
UPDATE: April 18, 2009
There have been a number of recent articles on this topic from TechCrunch as well as VentureBeat. Even as far back as October, 2008, Business Week blog has reported on mounting tension from the VC world:
(Tom) Crotty hopes the atypical investment approach will insulate Battery (Ventures), but he nonetheless sees a reckoning coming—specifically toward the end of 2010. He points to 2000 as the “last really good year” for venture capital. Looking back, “the one-year, three-year, and five-year indexes are all going to be terrible,” Crotty says. “And once 1999 and 2000 fall off, the 10-year will be, too. It’s going to be painful.”
If the 10-year investment period hits at or below the S&P 500, portfolio managers are going to wonder why they’re investing in such a risky asset class. Crotty estimates that 20% to 30% of the money going into venture will go elsewhere, and that is going to be bad. A lot of firms will go under.
To re-state my concern from the original post: the VC-start-up supply chain will be disrupted for the asset class performance issues noted above AS WELL AS the general liquidity issues in limited partner land.