Some background on “Too Early”

I really appreciated the comments on my post "Being too early" that talked about the difficulty in raising money to get a company up and running. After reading the comments several times and reflecting on recent entrepreneur meetings, I thought it would be useful to give some background on the current VC world.

Like me, most of my VC friends think we are already full into a recession. Worse, there appears to be greater risk of a period of stagflation (recession AND inflation) than we have seen for many years. This casts a pall over a venture world that is already gloomy from dealing with an exit-constrained environment (more on this below) – there's not much optimism to go around, a key ingredient to pulling the trigger on a new investment.

Although there has been some reduction in the size of venture funds post-bubble, the funds are still large. Sitting on a pile of committed capital (and getting paid fees to invest it) doesn't endear a venture firm to its investors – after all the job is to INVEST the money!

[Side note – I suspect our neighbors in the LBO world are soon to experience this phenomena – tight credit, gloomy public markets in a slide (why buy now? It will be cheaper tomorrow), aren't conducive to putting billions of dollars to work either].

It's not easy to shrink the size of a fund once you've started investing it – fees are paid on committed capital, not the capital that has been drawn down. Shrink the fund size and the investors want the excess fees paid back… That puts a big dent in current income levels for a venture fund; if the VC has a lot of infrastructure it might be impossible to shrink the fund without shrinking the overhead – that can be a death spiral decision.

Even the VCs that raised smaller funds post-bubble suffer with the lack of exits in their portfolio. Lack of exits mean the portfolios are heavy with later stage companies – fine if they are cash flow positive but bad if they still need to raise additional capital to get to break even. One investment banker I met last week described the IPO market as the worst he had ever seen (in his case, that's about 30 years – can you say ugly?)

Here's a thumbnail of many VC firms facing this perfect storm of woes:

• Heavy board load per partner as there have been few exits…
• Fund returns hit as there have been few exits…
• Pessimism pervades…
• Still have to invest the latest fund

Faced with these dynamics, many VCs are looking for investments that:

• Don't need as much time from the partner
• Have been mostly "de-risked"
• Can put $10+M dollars to work at a slug (more is better)
• Have a 2-3 year time horizon to an exit

This last point isn't dysfunctional for a pessimistic investor – after all, the only thing you can say about the financial markets (IPOs and enthusiasm for M&A from buyers with money) out 2-3 years is… It will be different and probably not worse than now!!!!

The same dynamics explain the general lack of interest in making early stage investments whose characteristics are diametrically opposed to the current "good" investment. Early stage investments need:

• A lot of time, even with great teams
• Have all the risk you can think of… market, team, technology
• Don't need a ton of capital upfront
• Current statistics show the median time to exit is 6.5 years

If you want to raise a smaller amount of money for a brand new company, your best prospect is a smaller fund where the folks running it firmly believe that investing smaller amounts of capital, earlier and often represents the best strategy. Those funds are out there but you will have to work hard to get them as investors as they have little competition right now and can afford to be very picky.

While this post isn't going to help you raise money, hopefully it sheds some light on what's going on and why it's a challenge to raise first money. I really liked the closing quote that RAGZ gave on his first comment:

"Champions take chances. Pressure is a privilege."
- Sharapova winning speech, Australian Open 08

Time to take a chance!

 

Comments

[Uday Subbarayan]

Excellent insight. IMO, things may even become uglier before it turn around...

But there is a good news here for (good)startups. The ideas with good business plan(yes, business plan that has plan for generating revenue early on) will still may get funded and this is one of the best time to start...

In next couple of years, from renting office space to hiring employees may become less expensive and can build the product efficiently. When the economy turn around, these companies may poised to grow and become attractive for exit.

The companies with no business plan to make money and think that VC's will keep pouring the money are the ones will go down in the tube.

-Uday.

[marco]

Hi Stu,
another great article, I appreciate your "technical inside look" at the VC feelings about the situation and how they react to it.
You speak about the smaller funds and how they could be the solution for the early stage needs.
a couple of questions:
The experiences I had taught me that the smaller funds are locally oriented, is it true?
What about the angels? They behave as the smaller fund or maintain a different approach?

Cheers

marco

[RAGZ]

Hi again Stu,

Thanks for your last comment on this post. This last post is almost as if you know the investor I am dealing with.

Regarding today's market: I think that most startups and VC's are followers, at best, and bad followers, at worse. It's the nature of the VC-entrepreneur relationship, but there really is a fundamental flaw in it:

Supercalafragialisticxpalidocious startup investments don't come along whenever a fund is ready to invest, and supercalafragialisticxpalidocious investors don't come along when a startup needs funds. (The long word is from Marry Poppins. The definition is an adjective that is too amazing to describe.)

I think that VC's, particularly in the consumer internet space, have been chasing fads with micro-investments, just like most of those that they choose to invest in. I say this, because knowing someone in the fund very personally is a written requirement on almost every fund's homepage. This is the most incomprehensible characteristic of VC's to me, and I think those types of investors will always be marginal, at best.

Recently, Thefunded.com has gotten a lot of press, and there are several smart VC’s actively engaging with entrepreneurs in a community style ratings atmosphere. One VC I’ve interacted with, only through email and my post on TheFunded.com, is Mike Maples. He’s smart and a first-mover, with a very “new feeling” fund. He responds to everyone that contacts him, or leaves feedback, and is exhibiting the needed trait that I have been referring to: he’s engaging with strangers, even though his fund is maxed to even here anyone pitch. Another good example VC is a guy named Lars Leckie. He’s not at all in my space, but damned if he didn’t offer to have coffee with me, and I saw him at every Snap chat so far.

Sorry for the length, this is my last point: I don’t believe that a recession affects the quality of the opportunities out there at all. I think it affects would-be entrepreneur’s willingness and ability to follow-through with their opportunities.

I wrote some related posts early on my blog, IMAGDG.COM.

Good luck all!