Venture Capital and Startups Feel More Pain, Study Says

Startup valuations are falling and venture capitalists are driving harder bargains, according to a survey by California law firm Fenwick & West

Like the rest of the economy, the world of venture capital and startups is starting to feel more pain from the deepening global financial crisis.

That's the main takeaway from a new survey detailing trends in venture capital investments during the fourth quarter of 2008 by the California law firm Fenwick & West.

The survey, which analyzed the terms of venture deals for 128 companies headquartered in the San Francisco Bay Area, found that valuations are falling for startups and that venture capitalists are driving harder bargains. The silver lining: The fallout so far is not nearly as bad as it was during the dot-com bust, when hundreds of companies went under and stratospheric valuations came crashing down to earth.

Down Rounds on the Rise

Sure, there were some startups last quarter that secured a higher value on their latest investment round, such as online vacation rental site HomeAway. But, of the 128 companies that received financing, 33% of them experienced so-called down rounds, or an investment that placed a lower valuation on the company than it received in the previous round of investment. More ominous, the percentage of down rounds rose every month at year's end, hitting 45% in December. "Each month things got worse in the fourth quarter," says Barry Kramer, the Fenwick & West partner who runs the survey. The highest percentage of down rounds occurred in the first quarter of 2003, when 73% of the companies surveyed by Fenwick & West suffered down rounds.

With the recession worsening, most financiers and lawyers do not expect the situation to get better anytime soon. They predict valuations will continue to decline until the overall economy begins to improve. "Private values really do lag," says Kate Mitchell, managing director with Scale Venture Partners. "More down rounds will come in 2009."

Overall, the prices venture firms are paying for equity are not rising as much as they have in the recent past. Companies that received venture financing in the fourth quarter saw an average price increase of 25% compared to the previous financing round, a significant decline from the 55% average price increase reported in the third quarter of 2008. One factor that is depressing prices is the continuing lack of an initial public offering market. The prospect of a public offering often helps entrepreneurs to extract higher prices from a venture capitalist. Last year, there were only six public offerings of venture-backed startups, including RackSpace Hosting (RAX), ArcSight (ARST), and IPC The Hospitalist Co. (IPCM).

"Multiple Liquidation" Preferences Gain Favor

As venture capital firms retreat and finance fewer deals, the financiers that do move forward are continuing to extract tough terms from the entrepreneurs they go into business with. Of the companies that received financing, 41% of the deals contained "liquidation preferences," or provisions obligating that the most recent investors get their money back first if the company is sold or acquired. That's about the same rate as the previous two quarters.

However, many more firms that do receive liquidation preference are getting "multiple liquidation" preferences, which state that a venture firm will get back as much as two or three times the amount of capital it invested. In the fourth quarter, 23% of the companies that secured preferences negotiated a multiple preference, up from 16% in the third quarter.

Another painful and little-known practice on the rise is the use of what VCs call "pay-to-play" provisions. When companies can't find new investors to bring into a company, they sometimes will try to corral a new round of financing from existing investors. Some may balk. To force all of the current investors to pony up the money, venture capitalists who are willing to play will create a provision stipulating that if others don't participate, their existing equity, which is usually in preferred stock, will convert into common stock.

Remembering Lessons Learned

Common stock typically has fewer advantages than preferred stock, such as the right to be paid first in the event of a sale. In the fourth quarter, 15% of all financing had pay-to-play provisions, up from 12% in the third quarter and 7% in the second quarter. "Insiders are putting tough terms on each other in order to get them to put money into the company," says Kramer.

About the only good news in the survey is that the venture ecosystem seems to be benefiting from the painful memories of the last bust. Entrepreneurs and financiers say that more firms are likely to survive this crisis since some of them, remembering how hard it was to raise money during the last crisis, brought in money before this downturn. Plus, many startups are getting much more aggressive about cutting costs, which should lower the failure rate. "VCs went through this eight years ago," says Kramer. "The last few years have seen more reasonable valuations. We're not going to fall as much."

The number of startups that are shut down is likely to climb in 2009, and some venture firms may also disappear. But many venture capitalists say that is not such a bad thing. A pruned tree will be healthier, so goes the thinking. "The most healthy thing for this industry would be a clearing out of people who don't have the stomach for it," says Paul Holland, a general partner with Foundation Capital. "It's a very healthy sign for our business."

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