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Should the current market environment change your fundraising strategy?

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With the performance of the public markets looking like an EKG read-out, I’ve been asked frequently in the past two weeks what effect this will have on the venture financing market. How tied are private company valuations to the public markets? If you’re planning on raising money in a few months would it be better to go out now or better to keep your original plans? Should companies be altering their cash burn projections to become more capital efficient in the face of potential funding challenges?

Here are a few thoughts:

Generally it takes some time for public market declines to make their way down to the venture market. And while I’m sure you have an opinion about the current state of valuations in the private market (who doesn’t?), there’s not a direct correlation between public market valuations and private market ones (ie., when the Dow drops 10% it’s not like term sheets headed out the door that week do the same). That said, a prolonged period of decline in the public markets, eventually has some effect on private markets as I outline below. In addition, I’d note that in this case we’re not talking about a a shock to the system but rather the natural movements of the market (shocks – such as 9/11 – tend to have more immediate effects across all market segments both public and private).

Different firms will react differently based on where they are in their fund cycle, the perceived strength of their portfolio, how well funded that portfolio is, and their view of how deep and long a downturn is likely to be. It’s worth thinking about all of these potential effects on your fundraising.

A downturn of any length of time is likely to have some effect on the fundraising market for venture capitalists themselves. This market has already been relatively difficult (with a complete bifurcation of funds into a category of “haves” who appear to be able to raise funds at will, and “have nots” who just can’t seem to get any attention from LPs) and a down market will both exacerbate this existing trend as well as perhaps move a few firms from the “have” category to “have not”. And of course there’s the well discussed “denominator” problem (which is really a numerator problem) whereby the actual dollars allocated to alternative asset classes (i.e,. venture) by the large LPs shrinks as the overall value of their portfolio decreases (they tend to allocate based on a % of assets). None of this is likely to be of any immediate concern to a company raising money in the next number of months, and because a large number of funds have “fresh powder” (i.e, money to invest) this is likely only to effect the company fundraising market if the downturn is a sustained one vs. simply short term market volatility. But its a trend worth watching if “volatility” turns into a downturn of any real length or depth.

However the perceived strength of a firms portfolio and the relative capital efficiency of the companies in which they have investeded in (as well as thier current overall funding status) are likely to have some effects – even in the short term and especially if it becomes clear that we’re in a true down market. For starters, as the markets become more uncertain there is a tendency among venture capitalists to batten down the hatches a bit. This was famously done by Seqouia in 2008 with their widely publicized CEO meeting (and accompanying PowerPoint), but was and is done much more quietly by many firms. As funding becomes uncertain VCs tend to focus inward on their existing portfolios.

A derivative of this inward focus is a tendency of VCs in down markets to focus their new investment activities more locally. Over the past few years of relative market strength, VCs have ventured further and further from their respective home bases in search of new technologies and companies (especially right now given the heated state of the funding market in California). If the markets decline for any period of time, I’d expect to see this trend repeated. This perhaps won’t effect you if you’re in Silicon Valley, but for those entrepreneurs in smaller markets – especially those with relatively weak local funding environments – there may be a real effect to their fundraising prospects from this.

So what’s a start-up to do?

For starters, don’t panic! You’re probably not like all those other startups with shitty business ideas, so you’ll be fine.

More seriously, you should think about these trends as you consider both your own fundraising strategy (and timing) as well as your plans to increase cash burn. Down markets favor ideas that are truly capital efficient (and I don’t mean just because you run your business on AWS). Think about your spending plans – you’re probably burning too much cash – and think about taking incremental spending risk, not step function risk. Gauge your current investors. Where are they in their own funds? How likely are they going to be to support an inside round if that’s required for your next round? Ask them their opinion on the current market and its effect on your future fundraising plans. If you’re planning on being out in the market in the next 4-6 months, I’d consider going out now. Better to get market feedback now when you still have more time to react, then 2 months before you run out of cash.

For good or bad, the venture markets always pendulum. And while at Foundry we believe in time diversifying our investing (i.e,. investing at a relatively steady pace), the market as a whole doesn’t work that way. Ultimately the strong venture market that we’re currently in will wane and in the long term this will be good for the overall market (although not necessarily for your specific start-up) as the market swings itself back past what should be its equilibrium to the other side of the pendulum. And then we’ll start the last few years all over again. And while I’m not certain that the current market environment will force the pendulum backward in this way, I do know that something in the future will. It always does.

August 24th, 2011     Categories: Uncategorized    
  • http://www.del-iberations.com Rob Delwo

    Nice post Seth. It seems like the cost drivers of a start up have shifted from infrastructure cost in the 90s to human resources, namely developers. This shift in cost drivers has created a new cycle. The cycle starts with an entrepreneur who raises $300k from Angels and hires a 2-3 person dev team. Since the number of developers in the market is fixed (inelastic) and the demand is increasing the cost of hiring goes up quickly. As a proxy the cost of hiring a 3rd party development shop has gone up roughly 40% in the last 9 months. When the main cost driver goes up 40% entrepreneurs need more money to increase their runway and they often look to Angel networks for this funding. But Angels will often stop making new investments when their personal portfolios are hit by a decline in public markets. My theory is that the Angel activity will decrease (b/c of the downturn in public markets) and reverse the cyclical effect described above. What do you think? Should someone in the early stage try and close that Angel round ASAP? 

    • James Akers

      I think you have answered your own question, Rob. Go for it.

  • Seth Gold

    I think the best VC firms know that their best returns will come during these periods of great uncertainty.  As long as an entreprenuer can catch the right wave and execute appropriately, they should be fine.  With that said, their valuation might be impacted in the beginning, but over the long term will reflect true value. 

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