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Why “Flat Is The New Up” and VC Funds Are Under-Reserved
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Everyone in the VC business is looking hard at their fund reserves right now. Very hard. That’s because the two key assumptions regarding how much money a portfolio company would require from start to finish (the exit) have changed: (1) The length of time before exit; and (2) The number of portfolio companies that would attract outside capital to lead follow-on financing rounds. The new planning assumption being embraced by VC fund CFOs and senior partners is that each portfolio company’s exit forecast should be pushed out two to three years. Moreover, funds should assume that inside rounds will be the prevailing method for raising additional capital within the portfolio. For the strongest portfolio companies, it will be a privilege to close a flat round with an outsider. In other words, “flat is the new up.” Let me first “pull back the camera” for a minute and explain how VCs think about “reserves.” When a VC firm invests in a company, it sets aside “reserve capital” for follow-on rounds of financing. For example, if a firm invests $5 million in a round of financing, it pencils in an additional, say, $10 million of capital that it sets aside in their fund for the company to cover additional rounds of capital in the years. It calculates this number based on assumptions of total capital required before exit and the amount of that capital the firm will be responsible for — as opposed to other investors who may be investing alongside of it. So, if you assume the company will require $40 million in total capital before exit, then other investors will need to be found to put in the additional $25 million (i.e., above and beyond the initial VC firm’s $5 million plus $10 million in reserve). Reserves become an important number because VCs need to plan their entire fund structure around them. If a $400 million VC fund makes 20 investments of $10 million each (for a total of $200 million in capital out the door) and then sets aside $10 million for each investment in follow-on capital (for a total of $200 million in reserves), then when investment #21 walks in the door, they need to have a new fund raised to invest out of - the previous fund is “tapped out”. When things were going well, VCs could comfortably assume their portfolio companies would achieve their exits 4-6 years after investment and would assume that the good companies would attract outside investors and higher and higher prices. For the last five years, it was not atypical for a high-quality Series A company that raised an initial round of capital priced at, say, $5 million on a $5 million pre-money valuation to hit a few important milestones (e.g., hire the team, build an initial prototype, identify a few initial customers) and they expect to raise a Series B at a meaningful step-up from their $10 million post-money valuation from the Series A - say, $10 million on $15-20 million pre. Today, those financings are simply not happening. Series A prices have come down a bit, but the initial management team needs some reasonable ownership level to stay committed. Where prices are really getting hammered in the VC-backed world is in Series B and Series C rounds. Outside of a few notable — and particularly promising — exceptions, almost no one is paying up for pre-revenue companies never mind fast growth revenue companies. If you have a high quality company and it can simply attract outside capital at the same price as the previous round, it’s a great outcome. Hence, flat is the new up. Now, back to the reserves analysis. If your exit timing assumption is pushed back 2-3 years, then you need to raise more like $50-60 million, not $40 million. And if you thought you could attract most of that from outsiders, you are mistaken. VC funds need to plan to shoulder a larger part of the load. So now you’re looking at needing $20 million in reserve capital rather than $10 million. Across one or two companies, a fund can sustain this level of replan. Across the entire portfolio, it’s a bigger problem. Remember my example of the $400 million fund above with 20 portfolio companies? If all 20 double their reserves, the fund is way underwater. And woe to the portfolio company whose VC fund gets tapped out too soon. It’s a bit like pension funds for…er…auto makers. If the VC fund has under-reserved for the portfolio companies, then everyone gets squeezed. Entrepreneurs need to get up to speed on this important issue that’s echoing through the halls of VC firms and engage their VC partners in open dialog about their reserves. I’ve suggested to each of my CEOs that they systematically poll their investors and directly ask, “What do you have reserved for us in your fund?” so that there is no confusion on this point. There is no shame for VCs in changing the planning assumptions underlying their funds. The tragedy would be if VCs don’t do it quickly in light of the new facts on the ground - and, in turn, if entrepreneurs aren’t aware of the issue early enough to make the necessary adjustments to preserve the value creation opportunity in their companies. As John Maynard Keynes famously observed when flip-flopping on an important economic policy matter, “When the facts change, I change my mind - what do you do sir?”
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December 1st, 2008 at 10:26 am
Jeff, another point that I don’t think has reverberated through the VC/startup world yet is how the lengthening hold time of portfolio companies will stretch VC partner resources. I blogged on this a while back, but the general point is that if partners at venture firms want to sit on 6 to 8 boards and get “stuck” on existing investments’ boards for longer than anticipated they may end up raising the bar for new investments not due to capital reasons but due to time allocation issues. My post on this: http://www.startable.com/2008/10/08/vc-portfolio-hold-times-and-the-poor-exit-market/
December 1st, 2008 at 1:44 pm
“If your exit timing assumption is pushed back 2-3 years, then you need to raise more like $50-60 million, not $40 million. ”
Why is this statement? Is it not better to get focused, cut costs to the ground using crisis as leverage, turn steadily profitable and instead of raising extra cash go out later at a much higher multiple?
December 2nd, 2008 at 9:38 am
Great Article. So if I understand this right you need to look at asking what you will need with the fact that series b and c probably won’t be available?
December 2nd, 2008 at 11:13 am
VC Experts has some interesting data on this. go to http://www.pedatacenter.com
December 2nd, 2008 at 12:21 pm
[...] Bussgang (of Flybridge, and focused on internet investments) wrote a very interesting column over at PE Hub yesterday (sub req’d), where he made a few arguments about the overall VC environment right now that are worth noting: [...]
December 2nd, 2008 at 5:41 pm
Don’t forget the second turn of this crank.
All the VCs know that they’re all under-reserved for a crisis like this, so they will earmark capital for their best deals and try to get their co-investors to carry their water on the marginal or worse deals.
It will be a return to the days of pass-the-hat financings where suddenly every VC at the table has alligator arms, and those insiders who do eventually step up to fund will mercilessly punish those who don’t, via pay-to-play clauses, forced conversions to common of round non-participants, and so forth.
Nobody will tell the truth about their reserves like Jeff intimates. They’ll all say “enough” and when the hat is passed there won’t be enough, and then the knives will come out.
It’s about to get rough out there for the marginal VC with a portfolio full of marginal quality companies and reserves structured for normal economic times. The shakeout that started in 2002 will resume in earnest.
December 2nd, 2008 at 6:12 pm
I believe that Jeff article is in the right direction, jut not bold enough. I suspect that the situation is far worse. In Europe i believe that “any company that is not profitable cannot raise an upround’. Is the USA any better? Facts have changed much more than having a crisis on B and C round, a good chunk of the VC industry is probably going out of business.
Mauro Pretolani (VC in London, and Jeff’s section mate at HBS)
December 29th, 2008 at 3:20 pm
Why does the longer period to exit imply a portfolio company will take a similarly elongated period to reach positive cashflow? CEOs should not consider exit timetables, they should focus instead on reaching profitability as quickly as possible, plain and simple. If anything the current “belt tightening” at operating level should improve results, and LPs can generate returns via dividends. You know, the old fashioned way investors made money before we all got drunk on IPOs.