VCs Respond to The Venture Capital Crisis

Posted on July 3, 2008
Filed Under VC Insanity |

Earlier this week, the “crisis” that has hit the world of venture capital. Last quarter, not a single VC-backed company went public.

Mergers and acquisitions activity is also down. According to a Dow Jones VentureSource report, last quarter saw the “slowest pace of merger deals involving venture-backed companies in at least a decade.”

The National Venture Capital Association (NVCA) is obviously concerned and as most American industry associations do when times get tough, is putting the government on alert. In , NVCA president Mark Heesen stated, “We need to put regulators, legislators, presidential candidates, and the private sector on notice that this situation represents a serious problem that will have long reaching economic implications if not addressed.”

Cry me a river.

According to the NVCA, 77% of VCs cite “skittish investors” as the reason for the IPO drought, 64% cite the “credit crunch/mortgage crisis” and 57% blame Sarbanes-Oxley regulation.

While these are certainly contributors to the current VC “crisis,” I have argued that the VC world’s problems have a lot more to do with their investments and bloat.

What I have found most interesting is the thoughts VCs have posted about the “crisis.”

Todd Dagres of Spark Capital called the NVCA data “artificial.” In an email he reportedly stated:

Facebook and several other privates could have gone public but chose not to. The issue is overall liquidity. If a private company sells to a public company — it’s similar to going public with less risk.

Dagres fails to distinguish between being able to go public and going public successfully and I think it’d be hard to argue that companies like Facebook would be warmly welcomed by Wall Street because while they have sufficient revenues to go public, they haven’t been able to turn profits and their long-term sustainability is highly-questionable.

As it stands now, some Facebook shareholders trying to dump their shares at a discount to recently-reported valuations apparently aren’t having much luck, giving some indication as to how hungry wealthy individuals and institutions are for Facebook’s stock (not hungry at all).

Of course, it’s worth pointing out that Dagres’ firm, Spark Capital, has invested in a number of Web 2.0 flavors of the month, most notably Twitter. Twitter’s last round valued the company at somewhere just under $100 million despite the fact that the company has no business model and its problems “staying up” increasingly evoke memories of Friendster.

Bill Gurley of Benchmark Capital blames regulation:

This passionate desire to be public is completely gone in Silicon Valley. For reasons you could easily list – Sarbanes Oxley; 12b1 trading rules; shareholder litigation; option pricing scandals; personal liability on 10-Q filing signatures – it is simply not much fun being a public executive.

He notes that the Benchmark portfolio has 15 companies with more than $50 million in revenues that are still private and laments the fact that “most of these companies would ALREADY BE public” had it been 1995 (or pre-bubble). He complains that “no one wants to manage a public company” today.

He also goes on to dismiss Paul Kedrosky’s argument that “there is nothing that the industry is producing that investors want,” stating:

Having had several conversations with mutual fund managers in the last three months, I personally disagree with this perspective. Many funds are starved for growth and appreciation. Many of the leading large capitalization technology companies have seen flat stock prices for as many as seven or eight years. Without a robust IPO market, these investors are not able to balance this lack of growth in their current portfolios. Moreover, the investors themselves lack the exposure to the new trends and disruptions. At a recent Wall Street conference, several investors were visibly upset that the venture community was not bringing more companies public. I feel very strongly there is no a “demand problem” when it comes to IPOs.

First, I would note that running a public company was never supposed to be “fun.” While regulations may be tougher, I personally don’t see them as being an insurmountable barrier to companies with solid financials and management.

In my opinion, Gurley’s statements reflect an attitude of “entitlement” that plagues venture capital. The truth is that just because a company hits a certain revenue milestone doesn’t mean that it’s an ideal candidate for an IPO. VCs should get used to the idea that just because certain milestones gave companies the ability to go public in the past doesn’t necessarily mean that those milestones will give companies the ability to go public in the future.

Second, as it relates to the mutual fund managers Gurley speaks of: most mutual fund managers are as clueless as most VCs. The fees mutual fund managers charge investors are almost always impossible to justify given the true returns. It’s also worth noting that few mutual fund managers invest in their own funds, revealing just how confident most of them are in their own money-making savvy.

Given the unimpressive facts about mutual funds and the people who manage them, it’s not entirely surprising that mutual fund managers would desire the return of over-hyped IPOs that can mask the fact that they rarely outperform the market. Of course, mutual fund managers are unlikely to find decent returns when less-than-compelling companies go public but it’s the thought that counts, right?

Fred Wilson of Union Square Ventures is another VC citing Sarbanes-Oxley and other regulations as a prime culprit in the VC “crisis.” He states:

Sarbanes-Oxley and other post bubble, post Enron regulations have certainly made it harder to be a public company here in the US. I know every time I sign a 10K or 10Q, my hand shakes a little. Honestly, it takes a very big opportunity to make me want to be a significant shareholder or a director of a public company. The risks and hassles are just so big.

Not surprisingly, Wilson has voiced his support for “secondary markets” where shareholders in currently-illiquid startups would be able to sell stock to “sophisticated” investors without all of the “hassles” that the SEC has created:

The idea behind both of these new emerging (and currently illiquid) markets is to provide a place for private equity investors to trade securities with each other. The companies remain private, do not have to file with the SEC, and do not trade daily like public stocks do. When an entrepreneur or investor wants liquidity on a position they own, they come to these private markets, offer their position or part of their position for sale, and a trade is made.

Wilson argues:

The company/web service creation process needs some kind of end game. The entrepreneurs who spend years and risking a ton need a way to get paid for that effort. And those of us who finance their efforts need to get some return on our investment.

Again, an attitude of entitlement is apparent.

Note to Wilson: nowhere is it written that entrepreneurs deserve to get paid for their efforts. And nowhere is it written that those investors who finance entrepreneurs deserve to earn a return.

Making money is not easy. If it was, everybody would be wealthy. If you want big returns, you usually have to take bigger risks. And if dealing with challenges and jumping through hoops is too much of a “hassle” to earn a big payday, perhaps you’re in the wrong business.

In my opinion, secondary markets for stock in private VC-backed companies would create little more than sham marketplaces where startup employees and VCs would be able to more easily find - often “sophisticated investors,” like hedge funds, many of which are losing their shirts as we speak because they overleveraged themselves and made stupid investment decisions.

While there is certainly a lot to discuss and debate, I really don’t think the VC “crisis” needs to be overcomplicated.

The bottom line, as I see it, is quite simple: there is far too much VC money and far too much of it has been invested in startups whose value and long-term prospects have been overestimated.

As Paul Kedrosky :

  • Sarbanes-Oxley hasn’t helped, admittedly, but that is not the core issue. Among other things, the industry hasn’t been able to find enough companies about which Wall Street can get excited.
  • Venture capital still has too much money under management.
  • Average fund size remains too large. Adjusted for inflation, and based on pre-bubble 1994 figures, the median VC fund size in 2008 would be $100m, not the current $200m figure.

Personally, I find the “venture capital asset class” to be less-than-appealing and while I don’t expect money to stop flowing into VC funds overnight, I think it’s worth taking a step back and putting venture capital in context with the world we currently live in.

To a large extent, I agree with the following:

We should expect prices for our most basic of needs, food and energy, to continue to rise until the supply and demand equations are back into balance. And it looks to me like that will be achieved mainly by demand destruction, which could take years to play out. This bear is going nowhere.

Meanwhile, energy and commodities, including agricultural commodity ETFs, are doing very well this year even as the rest of the market goes south. Along with traditional safe havens like gold and silver, bonds, T-bills and the like, they’re really the only place to be right now.

From this perspective, the question goes from “Why is there an IPO drought for VC-backed startups?” to “Why should anyone care much about VC-backed startups in the first place?”

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7 Responses to “VCs Respond to The Venture Capital Crisis”

  1. insider on July 3rd, 2008 4:18 pm

    you might also consider the effects VC’s MASSIVE management fees have on the VC asset class

    remember they collect 2% (or more!) PER ANNUM of the total *committed* capital. (so: a $200 million fund yields fees $4 million/year for 7-10 years, or $28 million at minimum!)

    given the durations of typical VC funds (7 years plus) thats a whopping 14% of a funds capital, off the top. meaning only $0.86 of every dollar raised actually gets invested

    moreover VCs make portfolio companies pay for legal costs of fundraising — a cost which VC fund management fees should pay. further lining VCs pockets with fee dollars, and further eroding how much of every dollar raised actually gets invested — gets to go to work trying to create return

    any case, in addition to glut of dollars and an embrassment of me-too copycat investments, add in the horrendous drain created by management fees and its no surprise the VC asset class is a dog

    fund LPs enjoyed huge returns from hedge funds and LBO funds for many years until last year — masking the huge void where vc returns were supposed to be. but now that the wind has gone out of those sails, it wouldnt be surprising to see asset allocations shift away from vc

    also, just likie mutual fund managers, vc partners at most cough up 2% of their funds capital - a mere pittance, and financable entirely thru the management fees, so they never actually put much or any of their own dough at risk

  2. Drama 2.0 on July 4th, 2008 11:08 am

    insider: thanks for your comment.

    In theory I personally don’t have a problem with management fees provided that the people doing the managing are competent and make investors money.

    Just look at John Paulson of Paulson & Co. He personally made $3.7 billion last year. One of the hedge funds he manages returned nearly 600% because he bet that the credit markets were going to run into problems.

    Some of the hedge fund managers like Paulson now charge far more than the typical 2 and 20 but investors aren’t complaining because the returns justify the higher fees.

    Of course, there is always the risk that many of these high-flyers won’t be able to deliver such returns over the long haul (and there is certainly no shortage of incompetent hedge fund managers) but unlike their VC counterparts, top hedge fund managers are extremely knowledgeable and they have the flexibility to adjust their strategies based on their analyses of the markets.

    The real problem with venture capital is that it’s so limited and really only works under certain conditions. The fact that these conditions don’t exist most of the time is becoming readily apparent.

    Like you, I would not be surprised to see an eventual decline in the amounts investors allocate to VC funds.

  3. insider on July 4th, 2008 1:09 pm

    hi drama

    i think you compare apples to oranges

    hedge fund managers charge huge fees but the 2% is on *invested* capital — money put to work. VCs charge 2% of *committed* capital - money that for years is not even under management by the vc!

    also — hedge fund investors can redeem (withdraw) periodically, often every 90 days. they can and do vote with their feet. so hedge fund managers are paid for performance - money under management that can leave

    vc investors are stuck for 7-10 years.

    i agree big performance is worth paying big fees. and thats exactly why vc’s should radically shrink management fees (how about working off an operating budget, just like their portfolio companies?) while radically increasing carried interest — and so properly align their own incentives with their limited partners?

  4. Drama 2.0 on July 4th, 2008 1:49 pm

    insider: I don’t think I compared apples to oranges. I was simply making the point that no matter what type of fund you’re running, management fees have to make sense when compared to returns.

    I think we’d both agree - if VCs were earning great returns, their management fees would look a lot less problematic. 2% of committed capital and 20% of carry is really only “expensive” when you’re getting sub-par returns for the risk you’re incurring.

    Of course, I think we’d also both agree - the flaws in the VC model (too much money chasing too few startups, etc., etc., etc.) and the realities of the world we live in make it pretty damn difficult for VCs to earn the type of returns that justify their fees.

    As such, the venture capital asset class is, for practical purposes, less-than-appealing.

  5. antje wilsch on July 4th, 2008 5:28 pm

    why do you say too much money chasing too few start-ups? You mean too many of them fund a) clones b) what their friends (other VCs) are funding c) or?

    Most companies who seek funding from VCs don’t get it, like less than 1% of all who seek it. Obviously many of them don’t qualify at all, but there are many who might be worthy that don’t get funded b/c they don’t know the right people, don’t have the right board, not in a “hot” at the moment space, etc etc.

    So just curious about your comment.

  6. Drama 2.0 on July 4th, 2008 6:34 pm

    Antje: according to the NVCA, in 2007, 248 VC funds raised nearly $36 billion. In the first quarter of 2008, 57 VC funds raised $6.3 billion.

    I mean quite simply that VCs have raised far too much money. As Paul Kedrosky observed, if you adjusted pre-bubble fund sizes for inflation, an average VC fund in 2008 should have about $100 million instead of the current average of $200 million.

    Throw in the fact that there are too many VC funds and you have all the makings of a vastly overfunded “asset class.”

    A lot of the glut that you see in the form of stupid startups (and clones) being funded is a direct result of this. I’d also observe that outside of Web 2.0, this is resulting in a glut of cleantech startups whose technologies will never scale commercially.

    This is a problem of economics. VCs have to put the capital they raise to work and when you have a large fund, the economics dictate that you have to invest larger amounts (i.e. a firm with a $500 million fund reasonably can’t invest it in $500,000 chunks).

    When you have a valley full of VC firms each with lots of money, the picture becomes clear - you have a bunch of guys running around with suitcases full of C-notes and they can’t give them away fast enough.

    While it’s true that most startups that seek VC funding don’t get it, that does not detract from the fact that VCs are still putting too much money into too many startups.

    At the end of the day, there just aren’t enough good investments out there to support the amount of money that VC firms have raised and the number of VC firms that exist.

  7. Is Web 2.0 One Big Party? : The Drama 2.0 Show on August 1st, 2008 4:45 pm

    […] are missing in action, most stock options are worthless and/or illiquid and venture capitalists have realized that this time, there aren’t a whole lot of greater […]

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