The New VC Style: Deep Pockets, Short Arms
The post-September 11 economic rubble is so thick that even some venture capitalists -- who are supposed to be good at scanning the horizon for opportunities not obvious to others -- are having a hard time seeing past it. What, before the terrorist attacks, had been a slow slog through tough terrain has now become temporary paralysis for some.
"It's an industry in a bit of turmoil, frankly," says Matt Harris, chief executive of Village Ventures, a network of about a dozen funds located in university towns. "We have models that suggest how customers behave during recessions, but not during terrorist attacks."
That makes it difficult to predict how much money and time a company might need to get off the ground. Another difficulty is the clampdown on corporate and consumer spending, which is the lifeblood of a startup. "Young companies need companies willing to try new vendors," Harris says.
Right now, when the old wisdom that there's no such thing as a sure thing is even more pertinent than normal, many VCs are leery of funding new companies. Others can't afford to. "Lots of VC firms aren't really doing new deals anymore, even though some won't admit that," says Michael Littenberg of the New York law firm Schulte Roth & Zabel, which represents several VC funds and emerging companies.
Even before the terrorist attacks, venture capitalists' fund-raising and investment returns had fallen steeply from last year's levels, as dot-coms and other venture-backed businesses required extensive financial life-support. In the second quarter of 2001, commitments to venture-capital funds fell 42%, to $9.7 billion, vs. the previous quarter, according to figures from the National Venture Capital Assn. Venture-capital investments suffered an 8.9% loss for the first quarter of 2001, the fifth consecutive quarterly drop. As a result, VC firms' investment in young companies has fallen by at least 50% compared with last year.
Some of the survivors of the Internet shakeout had been licking their wounds and waiting for the IPO climate to improve. Then the terrorists hit -- setting off a war and, almost certainly, a recession. Now, the emotional fallout is blurring the economic picture for many VCs. "If you look at projections for an economic rebound in late 2002, and you consider the long-term horizon of venture capital, then VC investing should not be affected by September 11," says Littenberg. "But it is -- because limited partners and VCs are reacting viscerally."
Not all of them, though. "As a veteran of the VC industry, I thought I had been in pretty much any war you can imagine," says Art Berliner, who founded Walden Venture Capital in San Francisco in 1974. He is not among those suffering paralysis, even though he acknowledges WaldenVC's deal-making has slowed. "It's our job, really, to not be panicked by what's going on," says Berliner, who "definitely" would fund a new company in this climate. Areas of interest at WaldenVC, a $350 million fund, include e-learning, wireless enterprise software, and electronic design automation.
Although Berliner isn't looking through rose-colored glasses ("I don't think in terms of what happens if there is another terrorist event, I think in terms of when, because it's inevitable"), he thinks it's a good time to take advantage of the generally negative psychology out there.
That dour outlook means company valuations, already low, aren't likely to bounce back anytime soon. So WaldenVC is keeping its eye out for promising young companies, initially backed by others, that represent bargain investments as they look for second- or third-round financing.
Nobody is expecting a speedy recovery in the VC arena. For the next year at least, startup funding will be difficult, but it won't dry up, says Littenberg. Companies will have to be very smart about how they spend their money, and VCs need to be careful not to overpay, to focus on the management team, and to be prepared to stay in for the long haul, he says. (For a look at how one venture-backed company plans to weather the investor drought, see BW Online, 10/15/2001, "Getting Lean and Mean in a Hurry")
The fact that venture investment is down reflects a move to quality rather than an abandonment, says Tom Kinnear, executive director of the Institute for Entrepreneurial Studies at the University of Michigan Business School. The school's $3 million Wolverine Fund, which invests in venture companies with a Michigan affiliation, is looking at a number of potential investments, he says. It's not, however, investing as much today as it was two years ago and hasn't done a deal since January.
Before the economy will be ready for more IPOs, Kinnear foresees a recession for the next three quarters, followed by a slow year. "If you want a safe harbor, there are none," he says. "If you want a safer harbor than some, invest in technology with intellectual property."
Areas drawing VC interest these days include nanotechnology, biotech, genomics, security, enterprise applications, health care, and business-process outsourcing. Venture firms are more interested in long-term gainers than in technology, such as videoconferencing, that might benefit in the short term from current events.
If investment has slowed, students' interest in entrepreneurship hasn't. The University of Michigan's 22 entrepreneurship courses are full. "What we're not seeing now is students jumping ship mid-MBA to go chasing a dream. It may be that a lot of the students here see entrepreneurship as a long-term goal, not a short-term one," says Kinnear. "What I smell around here big-time is: 'I'm going to have myself ready when I want to jump.'"
Will VCs be willing to help them jump? For now, lots of money -- an estimated $45 billion -- is sitting on the sidelines. Even though the $9.7 billion raised in the second quarter is a steep drop from the first quarter, the National Venture Capital Assn. still expects 2001 to be the third-best fundraising year in the industry's history.
Village Ventures' Harris says the investment inertia can't last. "Our investors believed us when we said we saw opportunities, and will begin to question us if we don't avail ourselves of those opportunities." For months, VCs have been expressing relief that the dot-com craziness is behind them. Now their challenge is figure out what's ahead.
By Theresa Forsman in New York
Edited by Robin J. Phillips