Post-Crisis Equity Financing for Startups

Venture capital returns over the past decade deserve two thumbs down. $100 invested in a venture capital fund in 2000 is worth slightly more than $98 today, once you factor in fees and expenses, according to research by Boston-based investment consulting firm Cambridge Associates. With such returns, why not buy into a lemonade stand? Not surprisingly, fundraising activity has dropped precipitously to $13.7 billion in 2009, down 66% from 2007, when the financial crisis began.

Venture capitalists are taking meetings—to maintain the mystique. But things are far from business as usual. Some funds are looking only inward, dedicating capital to support a struggling portfolio. Others that are nearing the end of their life cycles are winding down altogether. The industry has proven that it can no longer support an endless stream of me-too investors and entrepreneurs.

With a longer path to liquidity and lower valuations on exits, entrepreneurs seeking early-stage equity investment need to prepare for a different set of investor expectations.

Jennifer Sargent and Gregory Ellwood, founders of Los Angeles-based entertainment news site HitFix, beat the odds by completing a $980,000 seed round right after the collapse of Lehman Brothers. Anticipating a tough climate for follow-on funding, they took drastic steps to reduce spending and nonetheless managed to acquire 500,000 unique users, a key milestone. But in October 2009, as Sargent and Ellwood started pitching investors for a $1.5 million institutional round, they made a disturbing discovery: The VCs that they had sacrificed to impress were no longer investing actively.

That's because investors, even brand-name players, can no longer raise as much cash. With midsized funds diminishing, new money flowing into the industry resembles a barbell, with blue chip Sand Hill Road funds at one end, and smaller, laser-focused funds on the other.

smaller checks chase smaller ventures

It takes more than twice as long to realize an exit—10.4 years for an initial public offering and 5.4 years for a strategic sale, when you compare 2000 to 2009, according to Dow Jones VentureSource). Not all venture-backed companies even make it that far. For those who reach a point of liquidity, the overwhelming majority exit for $20 million to $70 million, including public sales, according to data from VentureSource. These numbers are a fraction of the big game that most investors and entrepreneurs talk when courting one another.

Niche funds manage smaller pools of money, typically $25 million to $100 million, which limits the checks they can write. As smaller checks chase smaller companies, capital will inevitably flow to the early stage. This is good news for companies such as HitFix, although the money may come with new strings.

After a dozen meetings and little conversion, Sargent and Ellwood turned to Golden Seeds, an angel network that invested in their seed round, to lead the Series A. Having witnessed HitFix perform under pressure, Golden Seeds was more comfortable doubling down. With an anchor investor in place, others followed suit, including small institutional funds that previously wouldn't have dreamed of investing in a round led by angels.

There is a noticeable difference in conversations from 18 months ago. Investors now require HitFix to reach profitability with the Series A alone. Sargent and Ellwood are expected to treat this round as if it were their last. Capital efficiency is a common theme, with early-stage investors focused on making more with less and investing in businesses such as e-commerce, new media, and financial services where go-to-market costs have come down substantially.

For HitFix, an IPO is completely off the table. Although market comparables allude to an exit valuation 10 times the original investment, informal investor conversations confirm that even half of that sum exceeds expectations. Investors want out within the next 2 years and are coaching Sargent and Ellwood to position HitFix for a strategic sale.

VCs will be the last to confess their failing grades. Who wants to post a report card like this one on the fridge? But the best chance at securing capital will rely on knowing these trends and the changes that must accompany them.

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