Riders on the Storm

Dan Primack of PEHUB posted on what seems to be a growing trend amongst Venture firms; raising 'Annex funds'. In the post, he cited prestigious firms such as Kleiner, Mohr Davidow, Tallwood and First Round Capital all going down this route.

Venture firms usually seek to raise annex funds when the world changes mid-fund, causing a change in their investment thesis or in execution strategy. Such changes most often are symptoms of a firm finding, for whatever reason, they have insufficient capital to carry out their stated initial mission.

In today's market, it would be reasonable to assume that VC's (and the list is surely much broader than these organizations) are faced with a dual market reality of portfolio investments taking a longer period of time to be self-supporting and finding a paucity of like minded firms sufficiently interested in leading follow-on rounds. This double whammy means that prudent firms ought to provision reserves, to support their portfolio, at much higher rates than budgeted. An Annex alternative would be to either reduce the breadth/depth of new investments (e.g. strategy change), or deeply triage existing investments (perhaps prematurely). These actions 'create' more reserves for surviving portfolio investments.

We were last confronted with firms raising Annex funds when the internet only bubble burst. Unfortunately, I don't think many of these funds did well for their LP's. Though, that was before many of these experienced managers garnered experience riding the storm.

Venture backed exit statistics

One of the major publications that follow the venture market, PEhub, recently published their recap of '08. As expected, the numbers were not pretty with:

M&A deal value was down 54% to $23B, representing 325 venture-backed transactions (down 29%).

The median consideration amount was down nearly 50% to $45mm; something to think about when these acquired firms raised a median $22.6mm

Seven IPO's generated a scant $551mm in liquidity.

Significantly, it took a median 6.5 years for a Company to reach liquidity via M&A and 8.3 years for an IPO.

No doubt these numbers were skewed by the financial downturn but I also sense something more significant that portends short-term bad news, and longer-term good news is happening, at least in the software and internet sector.

First the bad news.

Many of the investments in consumer facing applications that are dependent upon advertising dollars to support their businesses will be in for far tougher times than anticipated. The combination of a steep downturn in CPC and PPC rates, coupled with rising inventories will leave their backers with an unenviable choice of putting more capital to work in troubled companies (hoping for a short-term market rebound), or withdrawing support and allocating funds towards new investments or supporting the firms with positive momentum. While this Darwinian process is expected, and encouraged, in the venture business, it's happening earlier in the company life cycle than anticipated.

Investments in companies selling to the SMB's and Enterprise arenas are also seeing slower revenue momentum than anticipated, but all indications are that business spending is not as impacted as much as advertising budgets. The issue in this arena is crafting a value proposition that is so compelling that it overcomes the steepening conservatism seen in the early days of a recession.

The bigger market issue, in my mind, is that the dearth of IPO's has left the software and internet arenas with a large imbalance between the number of sellers (large increase) and the count of willing and able buyers (steady decrease). As a consequence, unless there is a rapid pruning of investments, I expect the 'time to liquidity' metrics to worsen over the next few years as many companies, lacking the growth story for a positive IPO, and having raised too much capital to show a positive liquidity event (but respectable businesses who have reached a critical mass to be self-sustaining), continue on their private path.

The good news is that these numbers do not reflect the intense move towards capital efficiency that many entrepreneurs, and their venture backers, have been preaching over the past 3 years. Harnessing instant information from the internet to optimize sales and marketing, and running their businesses based on 'just in time' infrastructure creates situations where less capital translates into better businesses that are equipped to pass these efficiencies onto their customers. Thereby, creating greater opportunities for all stakeholders.

Venture firms, which were formed in the past 5 years, seem to have the DNA to focus on these trends. In the NY area, we see firms such as First Round Capital and Union Square Ventures to be two examples of firms that vigorously practice the capital efficiency mantra; while focusing on high growth market opportunities. It is still premature to label these firms as institutions with the foresight of Kleiner or Accel; but their investing and portfolio maintenance styles bear watching.

Lux et veritas- Light and truth

Yale University announced yesterday that the value of its liquid securities within its endowment dropped 13% during Q3 + October. More meaningful, the overall endowment, that includes 'Alternatives' such as Venture Capital investments, LBO's and Real Estate dropped by 25%. As the market continued to punish investors, and the Alternative category tends to report write-downs later than public valuations are reported, the news for the full year, will surely be worse.

It's clear that the primary source of funding for venture firms; endowments, family offices (hello Mr. Madoff), and pension plans are under tremendous pressure to meet current obligations. The TRUTH is that the private equity community, (including the fund of funds) will see a rapid trickle down effect from these mark-downs that will include sales to secondary funds who will continue funding LP obligations (best case), defaults of current obligations (worst case), and a shut-down of funding new groups (certainty).

Companies are only as healthy as their customers. The customers for venture funds are their LP's that entrust their precious capital to firms in an effort to mitigate risk and seek healthy returns. If the customers (LP's) are not healthy, there is less funding, and a contraction of fund sizes, coupled with the gross number of firms who receive capital.

Unlike real estate and the LBO world, in the venture business, this may ultimately be good news as the thirst for capital, from a per company perspective, from early to mid-stage companies, appears to be diminishing as the recipients of their capital harness capital efficiency garnered from just in time infrastructure (Amazon's EC2), just in time sales, and just in time development.

Similar to the secular alignment during '01-'03, when many funds reduced their size and raised smaller successor funds, we may be at the verge of a similar, but horizontal shift throughout the industry. The TRUTH is that this painful ecosystem environment may align the business models of mainstream venture with the trend for capital demand by its constituency. If so, all this pain will give us a healthier ecosystem.

A return to 'little game' venture, coupled with the entrepreneurial spirit of self-exploitation by building equity through working insane hours at below market rates, is what brought us MSFT, AMAZON, Ebay, LINUX, ORACLE, DELL, etc. The foundation of the venture industry has been paradigm shifts started by small disparate groups of entrepreneurs, and initially supported by no or little capital, often disparaged by large organizations and too small for large venture to properly deploy capital 'efficiently' for their business model (notable exception is Kleiner Perkins).

I believe the Grateful Dead said it well; 'Once in a while you get shown the light in the strangest of places; if you look at it right'