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Friday, May 1, 2009
Inside Venture Capital
Entrepreneurs need more than great ideas to land VC funds
Interactive map of Greater Boston tech layoffs in 2009
How is the economic crisis affecting tech companies?
Flash Slideshow: Mass High Tech All-Stars Thought Leadership Roundtable
News of the credit freeze is splashed across headlines daily. Still, misconceptions abound, and many assume that because it is primarily a Wall Street problem, the freeze does not affect venture capital funding. However, VC-funded companies are indeed impacted, in that priority is given to existing portfolios.
As background, VC funds are raised from limited partners (mostly institutional investors). So, when the stock market dropped — losing nearly half of its value since last September — institutional investors pulled back their investments in technology startups as they looked to realign their asset allocations. VCs took a more conservative approach to risk and looked for traditional safe havens of profitability and predictability.
Worse still for many startups, with an IPO market that’s all but disappeared existing VC-backed companies find themselves in a situation where their exit strategy, be it by IPO or acquisition, has quickly disappeared as well. This creates a financial “perfect storm” for startups. Unless a startup has broken even financially, or is very close to meeting its monthly obligations through its own revenue-generating activities, getting additional financing from new or existing investors is exceptionally difficult in today’s risk-adverse climate.
Keep in mind that all VC funds go through a multi-year investment cycle. That is, a fund must set aside enough future investments to back up its existing investments in “portfolio” companies before it looks for new opportunities. Typically, a VC of an early startup will invest with the idea that there will be an exit within four to seven years. A VC that invests in late-stage companies will look for a shorter horizon.
In the past year, with the number of existing portfolios growing, blocked by weak IPO and acquisition markets, VC funding has turned increasingly inward, focusing primarily on nurturing their existing portfolio companies. This has resulted in far less cross-investment by VCs than in past years, especially for VC funds that are more than halfway into their multi-year investment cycle. No longer can a seasoned management team or a sound-but-early innovation guarantee funding or even secure continued investment until an exit strategy can be determined.
Today, for a VC to continue to invest capital in a startup, a path to profitability must be viable. The most important questions that VCs ask businesses they are investigating today include:
• What is the company’s monthly burn rate?
• How quickly will the startup begin to generate revenue?
• What is the startup’s exit strategy, and how realistic is it?
• Who is a likely suitor to acquire the startup?
• What is the return on investment if the business is sold?
There are a number of other items to take into account in this new startup era.
First, capital efficiency is of paramount importance. Yes, great ideas are still in great demand, but great ideas that are capital-efficient are the only ideas that are fundable today. The reason is obvious. With market caps of leading public companies halved, return on investment for startups can only be maintained with 50 percent or less capital. VCs’ overwhelming focus now is in making sure that existing portfolios have enough capital to weather the credit storm and slower sales cycle. Unless a startup has a great idea, strong management, a product that solves a market problem and insulation from competitors, its chances of being funded are greatly diminished.
Second, finding VCs who are fully committed to an idea and are willing to back a startup all the way is not just a plus, but a necessity.
Third, deep pockets help. No one knows how long this financial downturn will last. Startups have not been operating based on the assumption of earliest possible break-even. Now, many of them must have a realistic path to profitability just to get additional funds from original investors. There is no glory for a big vision if there is not enough financial runway to flight the idea.
Last but not least, startups today must strike a balance between achieving financial independence and shooting for far-reaching innovation. More than ever, a startup needs to focus, have a real sense of its market potential, know how long it will take to become profitable and be the beneficiary of great market timing. Achieving all of these elements, all at the same time, is hard but necessary in today’s new reality.
Cheng Wu is co-founder and chairman of Azuki Systems Inc. and a serial entrepreneur.
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