Venture Capital Goes Back to the Future

Once again, money is hard to come by, so entrepreneurs have to prove themselves -- just like in the good ol' days

By Margaret Popper

John Federman joined Boston-based Newmediary, on Labor Day of 2000, just as the initial public offering market was teetering on the brink of collapse. Three months and 25 meetings later with various venture capitalists, Newmediary, which creates and operates Internet-based directory platforms for publishing companies, closed on its third round of funding to the tune of $15 million. "In the heyday of venture capital -- late 1999, early 2000 -- with this business plan and the experience of this management team, we would have had the money after two meetings," says Federman.

Welcome to venture capital 2001-style. VCs are tougher and stingier. Existing companies are worth less than they were a year ago, even if they have more business. To raise money, entrepreneurs need a proven, operating business with several clients, not just the idea of one. When they finally get the cash, it has to carry them to profitability, not the next round of funding -- and it could be years before an IPO. Indeed, five years has replaced 18 months as the average VC investment time horizon.


  As the venture-capital world adjusts to life without the IPO market, you can understand why a certain illiquidity has crept into the system. Valuations have dropped 50% or more since 2000, and seasoned VCs are putting less money more cautiously into new ventures. Existing ventures are subsuming some of the funds in their hunger for working capital. And while institutional investors are still committed to venture capital, the ones that have traditionally invested in it are reassessing their portfolio weightings in the wake of the stock market decline.

So money is tight. But, far from an implosion, the slower pace of venture-capital investing is the precursor to a return to normalcy.

Money is still being invested in venture capital. The total amount put into new deals in the first quarter totaled $11.7 billion, comparable to 1999's first quarter, but down 56% from the $26.7 billion in the first quarter of 2000, according to statistics from Venture Economics and the National Venture Capital Assn. And the average deal size of around $10 million is 33% lower than it was in the first quarter of last year, say VCs.


  The biggest bottleneck for funding appears to be with the VCs themselves. "All the VCs were putting out so much money last year that they're now on 15 boards and dealing with lots of workouts. They have no time to look at new deals," says Thomas Crotty, general partner at Wellesley (Mass.)-based venture capital firm Battery Ventures.

Some VCs are using newly raised funds to prop up companies in their existing portfolios. Known as "crossover," this practice is frowned upon by more established VCs. "It's making limited partners very nervous," says Crotty, whose firm doesn't do crossover funding.

What Battery and many others have done is increase the reserves in a fund set aside for future investment in the fund's companies. Battery's most recent fund, Battery 6, is a $1 billion fund that is 20% invested. About 50% of the money in the fund will go to future rounds in the companies in Battery 6's portfolio. "Battery 5 [the previous fund] is in a bit of reserve trouble," says Crotty.


  The reserve amount has gone up because with no IPO market, VCs can't count on new funding in the short term. "You have to raise cash today for the next 18 to 24 months," says Michael Frank, general partner of Waltham (Mass.)-based venture-capital firm Advanced Technology Ventures. "The funds have to carry you through to profitability."

Unfortunately for entrepreneurs, profitability is tougher to reach than it used to be because costs have not declined at the same rate as valuations. "Five or six years ago, the rule of thumb was that it took $25 million to $50 million of investment for a software company to reach profitability, and that would be on $25 million to $50 million of revenues," says Frank. "In the past three years that range has doubled."

Of course, it has never been more important to manage costs, and VCs are keeping entrepreneurs' feet to the fire with deals that include special financing structures, such as redemption preferences. These clauses mandate that until twice the VCs' initial capital investment has been recouped, no other investor or employee gets a penny back. "It means the entrepreneur has to be really confident that he or she can bring this company to profitability," says Newmediary's Federman, who doesn't have a redemption preference in his funding contract.


  At the same time, since institutions have less money to throw at venture capital, they're sticking with the top VC firms when they invest. Still, they have adjusted their expectations to 15% to 20% returns rather than the triple-digits they got in 1999 and early 2000. "We fully expect the top-tier firms to continue to outperform the market this year," says Ted Clark, a managing director of Boston-based HarbourVest Partners, a fund that raises money from institutional investors to invest solely in venture-capital funds. But "the performance of the median and bottom quartile will be way down."

For entrepreneurs, the new reality is harsh. The experience and quality of management has become paramount in importance, just as it used to be before the dot-com bubble blinded the better judgment of many a VC and investor.

"We're seeing a correction back to the way things used to be," says Chris Darby, 41-year-old president and CEO of Cambridge (Mass.)-based digital consulting firm @Stake, which successfully closed a $26 million funding round in late October. "They want to know how you'll manage when finding equity is more challenging." That's the name of the game in venture capital these days and will likely continue to be as the private equity markets experience a return to normalcy.

Popper covers the markets for BW Online in our daily Street Wise column

Edited by Beth Belton

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