As an entrepreneur, I often find myself defending venture capitalists. For some reason, they have acquired a terrible reputation. During downturns, I often hear first time entrepreneurs complaining that VCs are sheep: “like everyone else they get frightened and run for the exits.” There is some truth to the charge as illustrated by the number of me-toos that typically get funded when market conditions are good. However, the reality is much more complex. There are two major reasons VCs invest less during downturns: their sources of capital dry up and entrepreneur valuation expectations take time to adjust creating a time lag before the market clears.
1. VCs need to hoard cash in downturns
Venture capital firms are structured as partnerships. Their investors are Limited Partners “LPs” which are typically university endowments, pension funds and wealthy individuals. These investors commit to a sum they are willing to invest, but don’t pony up the cash immediately. They only provide the funds when the venture capitalists make investments and issue a “capital call” requiring their investors to send their pro-rata share of the investment. Often, if successful exits happen relatively rapidly the investors don’t need to put in their full commitment as the cash from the exits funds the remaining commitments.
Eventually, when the full fund is allocated the VCs raise another fund – before the prior fund is fully exited given that it takes 3-5 years to fully invest a fund and another 3-5 to obtain exits for the portfolio. As a result, VCs are typically raising new funds every few years.
VCs make money by charging 2% management fees annually of the money under management and 20% of the returns.
In downturns, multiple things happen:
- Given that there are fewer exits at lower multiples, VCs end up calling more of the capital contribution from their LPs.
- At the same time, LPs often face cash constraints in downturns are credit tightens and they need to de-lever.
- Pension funds and university endowments usually don’t want to allocate too much of their capital to alternative investments. If the rest of their portfolio is down 20%, what they thought was a 10% allocation to venture capital now becomes a 12.5% allocation which they might want to pare back.
- Liquidity comes at a premium and investors want to pare back illiquid investments like those in venture capital firms which are typically locked for 7-9 years.
As a result, during downturns VCs, especially second tier firms, find it almost impossible to raise new funds. We even see university endowments seeking liquidity putting part of their venture allocations or portfolios on the secondary market (as Harvard has recently done) at discounts of up to 50%! When things turn really ugly you can also see LPs default on their commitment or tell VCs to slow down their investment pace to prevent that from happening.
Knowing they can’t raise funds for a while second tier VCs decide to stretch out the capital they already have a few more years as they live off the management fees. They slow down their investments and become much more selective. In addition, as other sources of capital have dried up for their portfolio companies, the VCs reserve a larger share of their remaining capital to support their existing investments.
All of the above factors severely restrict the capital available for new entrepreneurs to raise money.
2. Valuation mismatches lower transaction volumes
In a previous post, why the startup market is like the real estate market, I explained that it takes time for entrepreneurs to adjust to the new reality and reset valuation expectations. As a result, transaction volumes fall for many months and only start to recover once valuations fall enough for the market to clear.
In the current market, valuations might have to fall a lot given how cheap public companies have become. There are many profitable micro and mid cap tech companies trading at 1.5x to 2x their cash on hand and/or EBITDA. In this environment, most VCs are probably better served by trying to take them private rather than doing series A rounds for new startups.
Unfortunately for entrepreneurs there are many good reasons for VCs to dramatically scale back their investments in downturns. As a result it’s time to be scrappy. Focus your resources on the essential. Get to profitability as fast as you can. All throughout rejoice in knowing that the market will be much less competitive and that if you can survive, you will be in great shape to thrive!