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Fear Trumps Greed in Silicon Valley as Some Venture Firms Hedge

Rich Wong, a partner at venture capital firm Accel Partners, doesn’t know if Silicon Valley’s startup boom is at imminent risk of collapse. He does know this: If a founder doesn’t have the stomach to weather a downturn, take the money and run.

“Nobody knows when the windows” to sell are going to close, Wong said. “Now is a very good time to consider all strategic offers.”

While Silicon Valley heatedly debates whether technology valuations have risen to excessive levels, the investors who helped fuel the boom aren’t waiting for an answer. Venture capital firms are starting to take steps to protect themselves in the event of a downturn.

At Sequoia Capital, an early backer of Apple Inc. and Airbnb Inc., a partner Doug Leone said current valuations aren’t sustainable and that the 43-year-old firm has been walking away from deals that may have been attractive in a different environment. Some VCs are urging their companies to build a rainy day fund to ensure their survival. Even T. Rowe Price Group Inc., the mutual fund company that had been pouring money into late-stage startups, has dialed back its tech investments.

It’s a constant battle deciding whether to invest in a potentially lucrative deal, said Philadelphia financier Rudy Karsan: “Greed versus fear.”

Hand Wringing

Silicon Valley is in the midst of one of its most prosperous periods since the creation of the personal computer. More than $47.3 billion in venture capital investments were made in 2014, the most since the dot-com boom of 2001, according to research firm CB Insights.

There are now 119 startups globally valued at more than $1 billion -- seven of them hitting that mark since June 1, showing there remains no shortage of people optimistic about investing in young technology companies.

The prolonged boom has led to hand wringing about whether increasing valuations constitutes a “bubble” that’s approaching a bursting point. Bill Gurley, general partner at Benchmark Capital Holdings, which has backed companies including Uber Technologies Inc. and Snapchat Inc., has been sounding the alarm for months, arguing that many high-value startups won’t live up to their hype.

Tell-tale signs of a peak are all over -- everyone wants to be a startup investor, including the proverbial doctors and dentists, said Sequoia’s Leone.

Downside Protection

“We don’t want to be in a situation where we wake up on a Monday nine months from now and say, ‘What the heck have we done,’” he said.

On the other side, Andreessen Horowitz, one of the most prominent venture capital firms in Silicon Valley, published a detailed report last month insisting that a bubble doesn’t exist. The continual flow of venture money in part reflects that companies are staying private longer, requiring more capital, according to the report.

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Regardless, some investors have adopted a variety of methods to hedge their bets.

Accel has become pickier about its late-stage investments - - opting to avoid some larger rounds where valuations are especially high -- and more aggressive in investing in new companies. These early-stage startups can absorb the ups and downs of the market in the five to ten years while they are growing.

Sell Now

“The best way to invest in them is to invest $6 million in a Series A and not to pile on $50 to $60 million in something much later,” said Accel’s Wong. “There’s a next cycle that’s coming, and this is a buy-low, sell-high game.”

Accel also is suggesting that founders who don’t have the desire to build their company for another three to five years consider selling or going public now, moves that might assure a return to the firm.

Those venture capitalists who continue to invest in late-stage companies are demanding -- and getting -- protections that guarantee them a return even in a downturn, according to a study of 37 startups this year by law firm Fenwick and West LLP.

All of those startups, valued at more than $1 billion each, protected investors in the event the company sold for a lower amount, Fenwick said. About 30 percent of them also offered downside protection in the case of a weak IPO.

When Uber raised money in December for a $40 billion valuation, investors including TPG Capital were assured a return if the car-hailing company gets sold below a certain price. Airbnb investors got similar protections, which typically come in the form of more shares or cash.

No Exits

Underlying the concerns is the lack of investment exits already facing some venture capitalists. Tech startups are staying private longer, either by choice or market conditions, so IPOs and acquisitions have fallen off, the typical way investors realize a return.

Those conditions could worsen in a downturn as capital dries up, so some investors are telling firms they’ve backed to quickly raise as much money as possible and stick it away.

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“When valuations are high, one way you hedge your bets is you take as much capital at the high prices as you can and you hold on to that capital,” said Tim Wilson, managing director at Artiman Ventures, a Palo Alto, California-based firm. “If the market does turn against you, you’ve got cash in the bank to make it.”

Other investors are simply putting less money into startups as the number of so-called unicorn companies -- those with valuations exceeding $1 billion -- soar. The Queensland Investment Corp., a $70 billion sovereign wealth fund in Australia that gives money to several venture capital firms, has trimmed its investments in technology, said Phil Cummins, a principal at the fund.

‘Powder Dry’

“We’ve been cautious,” Cummins said. “You have to be conscious of the cycles. We’re easing off as opposed to going harder.”

Karsan, the Philadelphia financier, who began investing in startups after selling his previous company Kenexa to International Business Machines Corp. for $1.2 billion in 2012, stopped backing technology companies about six months ago. He declined to reinvest in fantasy sports company FanDuel Inc. because of a high valuation.

“I’d rather sit on the sidelines and keep my powder dry,” said Karsan, who runs Karlini Capital, a family-office fund.

T. Rowe Price’s New Horizons Fund, which has backed Twitter Inc. and LendingClub Corp., among others, has disclosed investments in only two deals this year, compared with 14 last year. With valuations skyrocketing, the private asset class is “scary,” T. Rowe fund manager Henry Ellenbogen, who oversees almost $19 billion in assets, told Bloomberg earlier this year.

’Geographic Arbitrage’

Another strategy: Avoid Silicon Valley startups. Low-profile companies based elsewhere aren’t as often targets of heated competition among venture capitalists eager to invest, which drives up valuations.

“You can do a little bit of a geographic arbitrage,” said Artiman’s Wilson. His last deal was in Tennessee.

Accel has been investing in startups in Provo, Utah, and Montreal, for instance. Accel also looks for firms that have strong business models but haven’t yet taken venture capital, such as Provo’s Qualtrics, an online-survey provider.

Some investors still have scars from the dot-com bust more than a decade ago. Wesley Chan, an early Google employee who is now a partner at Felicis Ventures, said he had four roommates in a month because the startups where the people worked kept closing and they had to move home. He now only invests in companies that can withstand a downturn, focusing on startups that build key services to businesses.

“I’m absolutely paranoid,” Chan said. “The music is going, but if it stops will you have a chair to sit on?”

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