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Friday, January 9, 2009
Strategies for surviving the current economy
MHT managing editor Rodney Brown on NECN: 22 tech companies give back to community
How is the economic crisis affecting tech companies?
There’s been plenty written about the negative impact of the economy on venture capital markets, particularly for earlier stage ventures.
Venture investors are slowing their investment pace, to take measure of this environment — where it may have taken three months for a company to secure funding from an investor, that “sales cycle” has now stretched by a factor of two or three. Investors are also reserving more money for their existing portfolio, rather than putting new money at risk in new ventures in recognition both that existing companies are going to see economic impact on their customers’ interest and that investors know that follow-on financing from other investors may either take longer or not occur.
To the extent that investors are interested in investing, the perception/reality that there’s greater risk in the market translates to requirement of a greater return for that risk increase. This risk adjustment means investors will need to own more of a company to gain greater upside for greater risk taken.
The current economic situation is expected to last at least 12 to 24 months. In a recessive economy, certain business models (for example, advertising-based models, enterprise software) will be avoided by venture investors given the sensitivity of those models to the environment.
VCs trade equity for a package of risk and reward
While venture capital is much more than just money, venture investors are, at core, managers of other people’s money; VCs raise capital with a view of returning that capital in five to 10 years with a risk-adjusted rate of return. In evaluating investment opportunities, professional investors consider two primary forms of risk: business risk and stage risk. In the context of this economy, business elements of market risk and financial risk translate to higher overall risk and so, a requirement for even higher overall returns.
Investors rely on other investors for next-stage capital
A fund manager who manages a $100 million fund to back 20 companies has approximately $5 million per company allocated for investment. Investors recognize that fast-growth companies in every sector consume capital throughout their early and midstage growth and so plan to spread their capital over two or three of the multiple financing rounds needed to get a company to a liquidity event. With a contracting financing market, investors cannot now readily count on other investors to lead new rounds. Accordingly, VCs need to preserve more of their own capital to support their companies and so will have less capital for new investment.
VCs manage 10-year investment partnerships
Like entrepreneurs, venture investors raise money at a certain stages of their partnership life cycle. Unlike the companies in which VCs invest, venture capital investors organize their funds as ten year limited partnerships. Investors deploy the funds over the first five years, then seek to harvest over the second five years. In between that first and second cycle (e.g. between years four and six), investors set out to raise new funds to invest, and so start another ten year cycle. If investors cannot secure exits or find other investors to pay a higher share price than earlier paid, then fundraising may not be possible. No new funds raised translates to no new investments for owners and entrepreneurs.
Now what?
Given the nuclear winter with no visibility on improvement, what’s a business owner to do for the all-important capital that fuels his/her growth? Here are a few bits of conventional wisdom to make your money last:
• Cut costs: Reducing your cash burn seems obvious but is key to both learning how to live with less and to attracting investors open to investments in a cash-efficient model.
• Evaluate your business model: If you’re operating an out-of-favor business model (for example, ad-based), then consider shifting your strategy to make your story fit this environment, which may last a couple years or more.
• Leverage other sources of capital: Federal and state grant programs are available to companies in certain, typically technology, sectors. Look to suppliers and distributors/customers for financing terms that may translate to better cash flow for you.
As you’ve all heard, we are operating in perhaps the worst economic environment since the Great Depression. So, get depressed, but then do what you can to make sure you can make it to the turnaround that will, eventually, come.
Michael Gurau is managing general partner of Clear Venture Partners, a New England early stage venture capital fund-in-formation based in Portland, Maine. Michael can be reached at mg@clearvcs.com.
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