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November 30, 2008

Why "Flat Is The New Up" and VC Funds Are Under-Reserved

Everyone in the VC business is looking hard at their fund reserves right now.  Very hard.

That's because the two key assumptions regarding how much money a portfolio company would require from start to finish (the exit) have changed:  (1) the length of time before exit; and (2) the number of portfolio companies that would attract outside capital to lead follow-on financing rounds.

The new planning assumpion VC fund CFOs and senior partners are embracing is that each portfolio company's exit forecast should be pushed out two to three years and, further, funds should assume that inside rounds will be the prevailing method for raising additional capital within the portfolio.  For the strongest portfolio companies, it will be a privilege to close a flat round with an outsider.  In other words, "flat is the new up".

Let me first "pull back the camera" for a minute and explain how VCs think about "reserves".  When a VC invests in a company, they set aside "reserve capital" for follow-on rounds of financing.  For example, if a VC invests $5 million in a round of financing, they pencil in an additional, say, $10 million of capital that they set aside in their fund for the company to cover additional rounds of capital in the years.  They calculate this number based on their assumptions of total capital required before exit and the amount of that capital they will be responsible for -- as opposed to other investors who may be investing alongside them.  So, if you assume the company will require $40 million in total capital before exit, then other investors will need to be found to put in the additional $25 million (i.e., above and beyond the initial VC's $5 million plus $10 million in reserve).  Reserves become an important number because VCs need to plan their entire fund structure around them.  If a $400 million VC fund makes 20 investments of $10 million each (for a total of $200 million in capital out the door) and then sets aside $10 million for each investment in follow-on capital (for a total of $200 million in reserves), then when investment #21 walks in the door, they need to have a new fund raised to invest out of - the previous fund is "tapped out". 

When things were going well, VCs could comfortably assume their portfolio companies would achieve their exits 4-6 years after investment and would assume that the good companies would attract outside investors and higher and higher prices.  For the last five years, it was not atypical for a high-quality Series A company that raised an initial round of capital priced at, say, $5 million on a $5 million pre-money valuation to hit a few important milestones (e.g., hire the team, build an initial prototype, identify a few initial customers) and they expect to raise a Series B at a meaningful step-up from their $10 million post-money valuation from the Series A - say, $10 million on $15-20 million pre.

Today, those financings are simply not happening.  Series A prices have come down a bit, but the initial management team needs some reasonable ownership level to stay committed.  Where prices are really getting hammered in the VC-backed world is in Series B and Series C rounds.  Outside of a few notable, and particularly promising exceptions, almost no one is paying up for pre-revenue companies never mind fast growth revenue companies.  If you have a high quality company and it can simply attract outside capital at the same price as the previous round, it's a great outcome.  Hence, flat is the new up. 

Now, back to the reserves analysis.  If your exit timing assumption is pushed back 2-3 years, then you need to raise more like $50-60 million, not $40 million.  And if you thought you could attract most of that from outsiders, you are mistaken.  VC funds need to plan to shoulder a larger part of the load.  So now you're looking at needing $20 million in reserve capital rather than $10 million.  Across one or two companies, a fund can sustain this level of replan.  Across the entire portfolio, it's a bigger problem.  Remember my example of the $400 million fund above with 20 portfolio companies?  If all 20 double their reserves, the fund is way underwater.  And woe to the portfolio company whose VC fund gets tapped out too soon.  It's a bit like pension funds for...er...auto makers.  If the VC fund has under-reserved for the portfolio companies, then everyone gets squeezed.

Entrepreneurs need to get up to speed on this important issue that's echoing through the halls of VC firms and engage their VC partners in open dialog about their reserves.  I've suggested to each of my CEOs that they systematically poll their investors and directly ask, "what do you have reserved for us in your fund?" so that there is no confusion on this point. 

There is no shame for VCs in changing the planning assumptions underlying their funds.  The tragedy would be if VCs don't do it quickly in light of the new facts on the ground - and, in turn, if entrepreneurs aren't aware of the issue early enough to make the necessary adjustments to preserve the value creation opportunity in their companies.

As John Maynard Keynes famously observed when flip-flopping on an important economic policy matter, "When the facts change, I change my mind - what do you do sir?"

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Very useful post Jeff. Thanks,

Mark

Great stuff for startup founders - a real education. I tweeted it.

cheers,
Graeme
www.twitter.com/graemethickins

Interesting post. Quick question - on average how many VC's re-up on the next round?

I don't have any hard data to support my gut instinct, however with so many VC's investing in "common spaces" where only 3 or so companies will survive does it really make sense to keep some money for the next round.

There's a great post out there by Will Price called - When it goes right what does it take to build a software company? It should be required reading for every entrepreneur. If you can't make it on $10 million you're not trying hard enough.

There's always this insane push to grow revenues - what everyone fails to mention is good old fashioned profits. These will be back in vogue in the coming years. 99% of all the startup's out there have some revenue - only the few really good ones are focused on "measurable, sustainable, profitable revenue from volume". It's those 6 little words that most people ignore that change the game.

The whole world is changing right now, both for the VC and the Entrepreneur - the winners will be those that build profitable companies. For the VC's my advice would be as follows - "beware the C round". See Will's blog mentioned above for reasons why - or failing that simply look at the cap tables of your current investments.

Cheers,

Peter

Hi Jeff,

Follow up comment. I was thinking about the time of the exit. On average it's now somewhere between 6-8 years. So now a "new" (old) problem rears it's head. A large portion of software has a life cycle that is shorter than 7 – 10 years. What is hot today, may be obsolete by the projected “maturity date” of the “investment”. Obviously infrastructure products have more longevity and smart companies update, extend or expand their products, but if a software company (which requires the least amount of investment in the tech sector) isn’t capable of standing on its own after 5 years, there is likely a much bigger problem than available cash or the price of B or C round stock.

In other words VC exits are now extending beyond the useful life span of the software.

To avoid the "death spiral" of funding obsolete software and gaining "incremental" % ownership it would (should) be everyone's benefit to build to profitability first vs revenue generation.

VC funding should be available for expansion with profitability the main theme.

Any alternative to this will most likely result in the fund becoming "tapped" out.

In essence the VC model is about to change dramatically - 6-8 year exits will have to either improve or get profitable otherwise the VC's will be out of a job.

Cheers,


Peter

Great post and comments. A clarification for Peter....the average hold for VC investments is now over 8 years. Unfortunately, this is not by choice as the M&A/IPO markets have become constipated. IN all probability this will hurt reported IRR's when liquidity events happen.

A sign of a health(ier) market would be a hold period closer to 5 years for early stage investments.

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