Friday, August 8, 2008

How I See It

VCs facing the dilemma of to have and have not

“The Sun Also Rises.” I vividly remember reading that classic Ernest Hemingway novel in prep school English class and spending weeks analyzing every facet of the story. I find the title even more relevant today as we all shake our heads in collective bewilderment about what is happening around us.

The economic environment is terrible — full stop. We are suffering through the echo boom of the credit crisis from this past spring, we are a nation at war, we are confronting rising inflation, the stock market volatility whipsaws us every day, and we have the political indecision that inevitably settles in before fall elections.

I wanted to write an upbeat piece that would highlight the great innovation discovered all around us at the local universities and hospitals or that would say there is plenty of capital in the system or that would suggest the environment will return naturally to its harmonic mean (as bad as it is now, it cannot help but improve) — and all of that is true and cause for optimism — but it is important for entrepreneurs and investors to recognize that our behavior needs to adapt to the harsh realities of today’s economy.

It is best not to overreact, but one still needs to act. I have posed to the CEOs of my portfolio companies the question: “What would we need to do differently if we were not able to raise any more capital?” Venture capitalists today are obsessively focused on capital efficiency: How can we get to important milestones on less capital? How can we extend the runway with the capital resources we have today? How do we recruit and create incentives for employees who may not value equity as much as they once did or who seek the comfort of large-company payrolls? How can we build great and valuable companies without suffering significant dilution for management and investors?

Many entrepreneurs have commented to me that they believe VCs have become too risk-averse. While perhaps a natural reaction to the hostility some entrepreneurs have faced on the fundraising trail, it is important to understand what is happening now in many venture firms. For each portfolio company, VCs have made follow-on investment reserve assumptions. As the financing environment has become so much more challenging, many VCs are discovering that they have either under-reserved or will need to support unexpectedly additional “inside rounds.”

Each general partner at a venture firm expects to make between one and two new investments a year. If (because of the heightened level of insider follow-on investment activity) that number is between zero and one new investment over the next 12 months, the local economy has just lost the ability to fund many new companies. While this will be a temporary phenomenon, it has profound implications for entrepreneurs who are considering raising venture capital.

It is not that the industry has suddenly lost its nerve — although there may well be evidence of that in certain over-funded sectors — but rather VCs are very inwardly focused on the entrepreneurs whom they have already backed.

Historically CEOs could expect to take typically three to six months to raise a round of venture capital. Anecdotally it may be taking from six to nine months or longer to raise that same round of capital in this environment. Additionally, round sizes are smaller and often tranched as investors are reluctant to expose too much capital before near-term milestones are met. This is actually a good thing for entrepreneurs. As I am quick to highlight to CEOs, it is not how much you raise but how much you own.

The New England Venture Capital Association over the past few years has had as its rallying agenda “Building the Next Billion-Dollar Company.” I continue to believe as passionately as I did years ago that we have the ingredients to do that consistently and predictably in New England — it is just that the approach we take to do that needs to accommodate the challenging times ahead.

So, of course, the sun also rises.

 

Michael Greeley, a general partner of Flybridge Capital Partners, serves as chairman of the New England Venture Capital Association.