Venture Capital Confidential
Entrepreneurs Get a Peek Behind The VC Scenes

(MacLean, VA) -- March 27, 2002) It may sound like alphabet soup, but the interrelationships between LPs and VCs have big implications for entrepreneurs, as a group of them learned at this morning’s Netpreneur Coffee & DoughNets meeting.

LPs are “limited partners,” the institutions and individuals that supply the money for the venture funds raised by VCs. VCs? Well, you know what they are. They’re the ones who have been saying no to a lot of entrepreneurs lately. This morning’s event, billed as a confidential peek behind the closed doors of the venture capital industry, explained how the two are related. It featured a panel of VCs and LPs and was inspired by the results of recent quarterly surveys conducted by Netpreneur and the Mid-Atlantic Venture Association (MAVA). Those surveys showed a disconnect between the attitudes of entrepreneurs and VCs on the current funding environment. It became clear that one reason for the divergence was that many entrepreneurs do not have a clear understanding of how the venture industry operates or how its current dynamics are affecting VC decision-making. To shed light on both sides of the subject, Netpreneur assembled a panel that included VCs Jack Biddle of Novak Biddle Venture Partners and John Burke of ABS Ventures, and LPs Catharine Burkett, Director of Private Investments at the University of Richmond; Brian Wade of Virginia Retirement System; and George Wilcox of Bessemer Trust.

And just why has venture money become so tight for entrepreneurs recently? There are many reasons of course, though one of the most important is that, ironically, there is actually too much money in the system.

Like tulips in the 17th century and software in the 1980s, what happened during the Internet bubble of 1999-2000 was too much money from too many new investors chasing too many bad deals and driving prices up higher and higher. As a byproduct, many of the industry’s traditional processes and models were simply blown out of the water. For example, while, as recently as three years ago, a $100 million fund was considered a giant player, suddenly $1 billion funds became common. Biddle tried to put that into perspective, noting, “Historically, to make a billion dollars on an investment, you would have had to have invested in DEC in 1954 and held it for 40 years. I don't think the economics work for an investor in a billion dollar partnership.”

Today, even though normalcy has largely returned, a vast amount of money sits on the sidelines, committed but neither invested nor called. Some people have estimated that the amount is as much as $150 billion, money that the investors have become fond of calling “dry powder.” One of the main reasons for keeping their powder dry is to protect current investments.

With money tight and good companies still needing more, the terms and conditions on new funding rounds have become considerably tougher. The people who get crammed down -- even wiped out -- in these rounds are the previous investors, and VCs are keeping money ready so that they can write a check, or at least threaten to, to protect the funds they’ve already invested. Perversely, these situations can actually be a boon to an entrepreneur who sold a large chunk of his or her company, because when the early investors get pushed out in a restart round, the entrepreneur may get more of his company back in the renegotiation.

“The past 24 months have brought out a couple of phrases that we haven't heard around our shop in a long time,” said Wilcox. “The first was: Recessions catch what the auditors miss. The second is: Investing money is easy, getting it back isn't.”

VCs find themselves caught between two sometimes conflicting imperatives. On the one hand they must make money for their LPs by investing in solid, high-growth companies; on the other, they must retain enough liquidity to sustain their existing portfolios while the markets continue to readjust and they await the return of exit vehicles such as IPOs and acquisitions.

Entrepreneurs may take some grim pleasure in noting that this leaves VCs behaving toward LPs in much the same way that entrepreneurs behave toward VCs. As Netpreneur’s Executive Director Mary MacPherson noted, “The LPs look carefully at the VC’s focus and discipline, performance over time, the right people, sensible market dynamics, and strength against the competition. Entrepreneurs know that the rules have changed for them, and this morning we’ve heard how the rules have changed for the VCs as well.”

After all, LPs have a variety of other places in which they can invest their money, and many of them are demanding more from the VCs in order to get it. During the discussion, panelists explored the variety of strategies and concerns held by LPs today, such as why they invest in venture capital markets, how they choose the funds in which they invest, how they monitor their performance, and, especially, what they’re doing differently today, as well as how those changes are affecting entrepreneurs at the other end of the food chain. For example, some LPs are negotiating new models for management fees (one of the two ways that VCs make their money), and some LPs are withdrawing their commitments to certain funds. There have even been some highly publicized law suits recently between LPs and VCs.

One result of the post-bubble environment is that many venture funds have already folded, especially the newer ones that got in late, and more will follow as they run out of money. Some will be unable to get new commitments from LPs, and returns will be bad for all VCs this year, even the good ones.

For established VCs like Biddle, this means: “We're in the situation where the absolute dollars are so big that it's going to create a lot of pressure from the boards that oversee these institutional investors. There's going to be pressure to shrink the pool, so my competition is getting a lot tougher,” he said.

And for entrepreneurs, he predicted, “It's going to take twice as long and twice as much money for half the return. The wealth that the company has to create to justify the investment is much higher than it was a couple of years ago.”

Happily, at least, in the recent Netpreneur/MAVA survey, 44% of VCs reported that they believe the region is beginning to see an upswing in investments. Yet despite their guarded optimism, Wade believes that there is still another round of business failures that may be coming within the next two to three quarters. “Some companies that were over the hurdle in the last go-round aren't going to make it,” he said.

While Burkett isn’t making any predictions about that, she does see the next several months as a critical juncture for future conditions. “Some of the funds that I've been looking at lately have one or two really good companies that are coming along. If those don't make it,” she said, “the fund is not going to make it. We may not see the drastic number of write-offs, but some of the write-offs going forward could be key.”

On the bright side, at least that doesn’t mean that LPs are abandoning the venture business. Like everybody else, however, they’re becoming more conservative and realistic. Wade, for example, said that Virginia Retirement System traditionally has between 5% and 10% of its assets in venture investments, and they are currently at a little over 6%. The others are in the same range.

According to Wilcox, in fact, it’s time to start putting some of that dry powder to work again. “The worst is definitely behind us. It's not all doom and gloom for the entrepreneurs.”

Copyright 2002, Morino Institute. All rights reserved.