Third Quarter VC fundraising level falls to new low

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.

VC Fund Raising for 3Q 2009

VC Fund Raising for 3Q 2009

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:

  1. 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
  2. Any exit via IPOs or M&A will be at fundamentally lower levels…consistency and predictability is highly unlikely
  3. 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.”

Venture Capital in 2009 – an update for Q2

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 VC Fund Raising by Quarter

Total VC Fund Raising by Quarter

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:

  1. the asset class is going negative based on the commonly used 10-year rolling average return calculation
  2. there is effectively no exit market via IPOs or M&A…certainly nothing consistent and remotely predictable
  3. there remains a significant liquidity crisis in the limited partner world of university endowments and public pension funds

TechCrunch says:

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.

Barbell Issue #1: Viable Exits Moving Forward

To briefly re-state the “Barbell problem:” Early stage start-ups are starting to be sorted into two ends of a barbell with no middle ground:  one that has light capital requirements (software, web applications, SaaS apps) and one that has larger capital requirements (hardware, semiconductors, etc.).  There is no opportunity for start-ups in the middle or in the “capital intensive” end of the barbell in today’s market.   Non-capital intensive companies need to be run lean and mean until they have achieved some scale; capital intensive companies have little choice when it comes to starting and scaling:  they use other people’s money and therefore have larger outcome requirements; they must be certain to hit financeable milestones with current funding.

Jeff Bussgang over at peHUB writes about VC “right sizing” but describes a really interesting set of data points from JPM regarding business/revenue criteria where IPO is a theoretically possible exit:

I attended a breakfast last week where JP Morgan’s vice chairman, David Topper, gave his review of the macroeconomic picture, including the IPO market. Although he was too polite to say it outright, his data clearly showed will be irrelevant to VCs for the foreseeable future. He laid out the four criteria that are required for an IPO candidate:

  1. IPO size of $200 million (implying a market capitalization north of $700 million). Without this level of float, there isn’t enough liquidity in the stock to attrack investors.
  2. Profitable, established business (i.e., not “approaching profitable” but proven profitable over many quarters if not years).
  3. Minimal leverage.

Of these three, #1 is the real killer for venture-backed start-ups. When I was an executive at Open Market and did our IPO in 1996, we executed an $80 million IPO – at the time, that was considered mid-sized. In today’s environment, where Google is trading at a 6-8x EBITDA multiple and typical revenue multiples are 2-3x, an IPO candidate would need to be throwing off $100 million in cash flow and/or generating north of $200-300 million in revenue while still growing fast. These are incredible numbers for venture-backed start-ups less than 10 years old.

Of course, the point here is that businesses meeting these criteria are exceedingly rare; more rare to be venture backed; and more rare still in this macro-economic climate.  There is a public market window open right now — who knows for how long — and we’ll see a couple of companies beyond Rosetta Stone ($200m revenue run rate today; ~$27m EBITDA with good growth; = ~$40m market cap) try to get out in the next few months. They each are able to play in the “outcome ball park” described by Jeff.  If the IPO market maintains such criteria (seems likely), the current M&A market is focused on distressed assets (only question is how long is this true), then the only other outcome possibility is getting to profitability (and perhaps considering dividends earlier than typical) and staying there.

In a barbell-related note, Fred Wilson concludes that the most dramatic decrease in VC investment is happening on the West coast compared to the North East (Boston & NYC). Nonetheless, the notion of the funding level dropping, capital costs (to start-ups) increasing and capital efficiency remains a requirement:

There is money out there for good ideas, particularly ones that are capital efficient and located somewhere other than Silicon Valley.

Venture Capital Update for Q1 2009

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:

VC fund raising through Q1-2009

VC fund raising through Q1-2009

The barbell problem for start-ups

One quick note related to the discussion of life-style versus high-growth businesses. Today’s venture capital environment plus the infrastructure available to start-up companies will start to create a “barbell” problem/situation for start-ups.

The current environment will sort start-ups into 2 categories

The current environment will sort start-ups into 2 categories

Historically (before October of 2008), companies with solid business plans and good teams were funded largely based on amorphous subjective capital requirements for operations and scaling the business over a well-defined period of time with well-defined goals within that period (break-even, financeable milestones). Start-ups, not wanting to re-enter the funding cycle again too soon, would gun for as large a round as possible while balancing valuation / dilution concerns. VCs, having raised large funds with a limited number of partners + hours in the day to put those funds to work (among other supply chain issues), would generally prefer larger deals that enabled the firm to capture a larger percentage of ownership. I believe this “traditional” model is already changing.

Right now in early stage venture firms and start-ups, I believe there is a huge amount of “sorting” going on. The sorting categorizes all start-ups into two big buckets – or ends of a barbell – one that has light capital requirements (software, web applications, SaaS apps) and one that has larger capital requirements (hardware, semiconductors). There is no opportunity for start-ups in the middle right now because the barbell defines the acceptable outcome and ANY outcome is rare right now.  Non-capital intensive companies need to be run lean and mean until they have achieved some scale; capital intensive companies have little choice when it comes to starting and scaling:  they use other people’s money and therefore have larger outcome requirements; they must be certain to hit financeable milestones with current funding.

This market environment will be very challenging for companies that SHOULD be in one end of the barbell but have ended up in the other.  For example, start-ups that have raised too much capital relative to the state of their business and market will be challenged in this environment. Capital intensive start-ups that have yet to hit demonstrable scale or financeable milestones and need to raise more money will be challenged in this environment. The barbell problem is going to create a much more pragmatic environment with respect to which companies need which type of funding.

The Major-Indie Phenomenon: film, gaming & start-ups

In the not too distant past, the major film studios were on a big-star-big-budget path that targeted huge hits, big sequels and the mass-mass market.  Without going into the history of the independent (indie) film, this led to the advent of the “independent studio” that worked with much smaller budgets but also had the control and vision to create more interesting (and less mainstream) characters, stories, and movies in general.  Around the early 1990’s, Independent Film started to gain real commercial traction as actors and directors that were pining for more artful / character-based projects to display their talents and highlight their craft.  Realizing that there was a real (and valuable) market for more artful, less mainstream movies, the majors created or bought their way into the indie film market and today, most major studios have an “indie brand” that allows them to play in the indie space. It took a few clear success stories in the new, independent-film model to get them to pay attention to a different model than they were pursuing.

Hang in there; I promise I’m going somewhere with this….

It’s interesting that the above studio story could be applied almost exactly the same way to the gaming industry. In fact, the market for indie/casual games is probably at an all-time high today with the popularity of the iPhone, Nintendo DS, and web-based Flash games. The major studios in this market are folks like Electronic Arts, Nintendo, and Activision.  As the majors grew, they spent big bucks going after big hits with mass appeal…just like the majors in the film industry. The casual / indie game companies filled a void that the majors had a hard time focusing on because it didn’t fit their model. Of course, after a few success stories and a maturing market, the majors started to take notice and today all most major studios have a casual game strategy. Notice a trend forming here?

OK. So now I think there is a new version of this story just starting to play out.  Full disclosure: I’m working with the folks at CapitalFactory in Austin, Texas as a “mentor” for thier first go-round of the process . They’re similar to Y-Combinator and focused on helping start ups in a variety of ways, including early, limited funding outside the traditional Venture Captial system.

“Capital Factory is a seed stage mentoring program for startups that provides a small amount of seed capital and weekly mentoring sessions by entrepreneurs who have founded successful companies. Startup companies apply to participate in our 10 week summer program intended to get a startup pointed in the right direction with a clear path to profitability and growth. This year the program runs from May 22nd to August 7th. At the end of the program we’ll be hosting Demo Day and streaming it live over the Internet.”

Something interesting happened last week in this space:  Sequoia Capital, one of the best known Venture firms announced a $2m “investment” in Y-Combinator that will give them more capability to fund and help seed-stage start-up companies. You can get more information here, here, and here.  Y-Combinator funds about 40 companies per year and has launched or help launch over 100 companies to this point, including: Dropbox,  RedditInfogami, Kiko, Loopt, ClickFacts, TextPayMe, Snipshot, Inkling Markets, Flagr, Wufoo, YouOS, PollGround, LikeBetter, Thinkature, JamGlue, Shoutfit, Scribd, Weebly, Virtualmin, Buxfer, Octopart, Heysan, Justin.TV, OMGPOP, SocialMoth, Xobni, Zecter, Adpinion, and more.

What’s interesting is that early-stage start-up creation/funding/mentoring starts to map to the same major-indie phenomenon that we’ve seen in the film and gaming industries:

  1. In the presence of clear examples of success, major players in a mature market begin to notice real opportunity in a new (efficient, scalable) model within that industry
  2. The majors did not die off or get crippled because of the new model; their scale allow them adapt (build or buy) to the new model in their own way and timeframe
  3. The new-model folks found real, material success; further, new-model proponents & the new model itself was NOT crushed by participation from the majors (they co-exist)

Now the question becomes whether or not this trend contineus as macro-economic pressure makes early-early stage company dynamics less interesting to the major venture players. Time will tell but there is at least some history on the side of the trend.

Questions to ask in a Venture Capital pitch

Over the past 10 or so years, I’ve been directly involved in raising about $85m from venture investors across 4 different companies and 6 rounds of investment, not including public company or seed-stage stuff (that’s probably another $25m or so). I’ve also invested in 4 different start-ups in the past 2-3 years.

Pitching investors is part art and part science, in my opinion, and very relationship oriented.  After probably 300 different investor meetings over the past decade, I still find it challenging to switch from pitch/sell mode to asking questions of the VCs themselves.  Nonetheless, it’s never been more important to understand their business, the fund, and the attitude of the firm that you are going to partner with on your start-up.

With that in mind, here’s a half-dozen questions that I’d ask at the end of a pitch to any VC that you are interested in working with…along with a brief explanation as to why these questions are important:

How big is the fund that you’re currently investing out of?

This is simply calibrating how much “dry powder” the firm has on hand.  Big, new funds have different dynamics than small or older funds.  This is especially relevant after the NEXT question:

How much have you invested out of that fund so far? How many deals is that?

This will tell you what’s really left in the fund. There are issues with both “brand new” funds (such as the need to potentially made a new capital call) as well as with funds that are so old that they basically must be kept in reserve for companies the firm has previously invested in.   “How many deals” gives you a sense of how much capital they typically put to work per deal…which is a fine question to ask directly. This also gives you a sense of the firm’s over-all volume.  A very low volume means that your company really needs to line up with the firm’s core domain/interest or there is likely no deal to be had.

How many deals have you done this year so far? How many in 2008?

This is related to the previous question but starts to consider the firm’s behavior in the current environment…and this is where it starts to get interesting. I believe there is some significant inertia to overcome in getting financing deals done these days. If they’ve not done ANY deals so far in 2009, then one has to wonder what will it take to get them to do a deal?  It’s totally fair to ask them this question directly as well.

Have you made any capital calls to your limiteds yet this year?

And here’s where the smart/confident firms will realize that you’re asking the right question. This begins to show you understand the current macro-economic impact on the VC business and that you’re savvy enough to make sure you’re working with folks that have the support of their limiteds. This is also where they might start to get defensive if they don’t have as much support as they’d like.

If you have made capital calls, have any of your limiteds missed a capital call in the current fund?

This is really one of the most meaty questions you can ask. Try to get a clear “yes” or “no” sort of answer. To say “yes” is to admit that their fund (and maybe firm) is at some risk that this trend continues…and that will inject some (potentially large) amount of inertia into doing ANY new deals; to say “no” is to suggest the firm is in a better position than many of their peers.  Its also interesting to understand if they’d need to make a capital call in order to make this investment.

How long do you think it would take to close this round if we started today?  And would you anticipate any unique “conditions to closing” for this deal?

Closing typical rounds of financing takes time; and, in general, the larger the round, the longer it takes. Even in the best of times 60 days would be considered blazingly fast.  Today, honestly, 3-6 months isn’t surprising. There are many standard conditions to closing a round of financing, such as due diligence.  However, this question is trying to get at whether or not there are conditions that might make the financing more difficult than usual. For example, does the VC require another venture firm to participate in the round?  Does the VC require some significant new customer traction before being ready to fund?  Does the VC require the round to be of a particular size?

I’ll add more questions as I can think of them…but get answers to these and you’ll understand more than most.

UPDATE #1:  What other firms / individuals do you like investing with?

Perhaps the first thing to state is that a syndicate (the set of venture investors in a single round of investment) adds complexity to any round of financing AND the go-forward board and outcome dynamics for any company. This is true, in part, due to human nature and, in part, due to firm-specific behaviors of the partners themselves. Ff your company can avoid a the need/desire to syndicate and raise money from a single venture firm, it will reward you with significant elegance (financing terms, board structure, differences of opinion, etc.) in many cases.  Any sort of negative complexity will tend to arise when things are not going well within a company; the squeaky wheel gets the grease. When things are going well, its amazing how aligned everyone’s perspective and opinions can be.

All that said, finding out what other firms this VC likes to invest with in a syndicate is a great way to do two things: first, you find out who you should go talk to next.  And don’t forget to ask for an introduction to whoever comes up after asking this question.  Second, it is increasingly important to make sure you have a set of investors that get along and have history together. As the Venture industry goes through challenging times, venture firms will be forced to make hard decisions around their portfolio, funds, and strategy. Trying to ensure that you have a set of investors who have a good relationship and have worked together on other deals can de-risk the negative effects of diverging investor/firm agendas.