TheFunded.com Open Letter
Posted by The Founding Member on 2009-04-20
The NVCA orchestrated the release of abysmal venture investing numbers for Q1 2009 on Friday and Saturday evening, after most media outlets had closed. The rushed articles that appeared over the weekend were either data driven, sensational, or wrong, and the story may not gather any more news cycles, which is a shame. As the Founding Member of TheFunded.com, I avoid writing editorial on this site, but I feel that the poor caliber of reporting on the 62% drop in venture financing from Q1 08 to Q1 09 deserves a response.
To start with, there is nothing surprising about the slowdown, but nobody seems to explain why it happened. Let's start by looking at the "real" reasons for the near halt in venture investing during Q1 2009:
1. Venture capitalists were asked to stop investing. Major limited partners (LPs), or investors in funds, asked their private equity (PE) partners to slow down investing and reduce the number of capital calls (here). Various LPs had engaged in a popular strategy of accumulating debt, and they did not have the cash on hand to honor every investment commitment after both the equity and debt markets collapsed. The number of first time investments fell by 65% from Q1 08 to Q1 09, as venture firms stopped making capital calls in order to preserve relationships with the LPs.
2. New compliance rules tied up venture capitalists. In Q1 09, a large number of LPs asked their PE partners to comply with a mark-to-market accounting rule, FAS 157, which is better at valuing mature private companies with public market comparables than six month old startups (here). Venture capitalists were forced to go through both a time consuming exercise to value their portfolio and a process to figure out the FAS 157 reporting strategy, distracting partners from new investment opportunities.
3. Cash strapped portfolio companies needed saving. Only the best portfolio companies could raise money from new investors in Q1 2009. This forced venture capitalists to undergo another time consuming process of evaluating the fund's portfolio and identifying which companies to support going forward (here). Some cash strapped portfolio companies needed immediate support, and venture capitalists did a large volume of "inside rounds," where existing investors set the terms for new rounds into portfolio companies. Without external validation of a company valuation by a new investor, inside rounds require an internal review process that frequently results in dreaded "cram down rounds," complex penalty terms, lower valuations, and smaller investment amounts. The average deal size to shrink by 30% from Q1 08 to Q1 09.
Despite logical explanations for the slowdown in Q1 2009, there is a much more alarming trend in the data.
The number of new venture funds that were backed by limited partners fell by 81% between 2008 and 2009 (here). Venture capital positions by top limited partners (here) have been sold for pennies on the dollar (here). Venture capitalists have been complaining that traditional sources for venture financing, such as university endowments, have stopped supporting the asset class.
I believe that these are all early indicators that the overall asset class of "venture capital" is being abandoned by limited partners. The 10 year returns are being held up by the last companies from the dotcom era of 1999, but the returns for funds raised since then are poor (here). When you apply strict FAS 157 valuations on private companies with different venture firms reporting different valuations on the same company, the asset class returns go from bad to worse. There is a silver lining, however.
The three major causes for a slowdown in Q1 have passed. LPs have more liquidity with the rising value of public market equities, and most venture funds have addressed FAS 157 reporting processes and determined which portfolio companies to save. Q2 2009 investments will continue to be down, though higher than Q1, as venture capitalists take a step back and evaluate what investments to make in the new global economy, but new investments will start to surface towards the end of Q2 and in Q3 2009. Since new investments are smaller than later stage support, the amount invested in 2009 will be significantly smaller than any amount in the last 10 years, but the volume of deals will start to normalize by the end of the year.