The economic downturn is creating headwinds for every industry, and venture capital is no exception. Here’s a look at the good, bad and ugly in the VC arena, in reverse order:
The Ugly: Elimination of the IPO as a viable exit strategy
This has gotten huge amounts of press because of the profound effect it’s having on the VC industry. As reported by Ryan McBride, it has now been eight straight quarters since a venture-backed company completed an IPO.
Here’s Jessica Canning, global research director for Dow Jones’ VentureSource:
“The IPO market is totally closed and there is no clear indication right now that it will revive any time in the next quarter or two.”
That means acquirers are gaining control of the M&A market and paying less for their acquisitions. For the first quarter of 2009, the average acquisition price for medical device companies was $22 million, versus $60 million for the same period last year (excluding the recent Medtronic/CoreValve blockbuster — and outlier — at $700 million).
In any case, companies must be built with an eye toward an exit by acquisition, even though the IPO market will eventually open up again.
Several concerned stakeholders are looking to open up the IPO market. NASDAQ shifted its strategy to be more focused on getting new IPO listings and other IPO-friendly exchanges are intensifying their efforts, such as the NYSE’s IPO boot camps.
The National Venture Capital Assn. offers suggestions for its members, including combining synergistic portfolio companies to both reduce the sheer number of holdings and to improve the likelihood of exit, as with the 2002 merger of SpineWave and VERTx.
Another suggestion is working with portfolio companies to consider using mid-range and smaller investment banks rather than going for the big brand-names.
The Bad: Development of a risk-averse culture
Brian Gormley of Dow Jones Financial Services recently reported that total investment in healthcare companies plunged 50 percent from the first quarter of 2008 to the first quarter of 2009.
Venture investment also posted a meteoric descent, going from $2 billion to $1.35 billion over that period (a 34 percent decrease). Of the various sectors within healthcare, only the medical software and information services sector was up (by 11 percent). Anyone smell an electronic medical record stimulus package? More typical was the medical device sector, where investment was down 51 percent to $477 million across 42 rounds.
As I reported back in March, VC funds are circling the wagons to focus on keeping their current portfolio companies afloat rather than going out and looking for new deals. If this reduces the inventory of portfolio companies to levels more appropriate to the current exit atmosphere, it may be a good thing. But it could lead to a shortage of companies in the pipeline that will hurt returns down the road.
More Bad: Fundraising difficulties
Be candid with your LPs — they need to know where things stand. As Rebecca Connolly of Fairview Capital told VentureWire, “You’ve got to tell us the bad news with the good. It’s okay.”
Considering that she’s seen some venture fund write-downs reach 20 percent, your fund may not be in that bad shape. In that same article, Nick Harris of Lexington Partners stated that the firm is not expecting any capital to be returned from the venture funds that they have recently purchased on the secondary market until the end of 2010.
When you do go out fundraising for a new fund, you can take consolation in the fact that many funds are having final closings well below their target levels. Of 53 VC funds we counted as holding final closings in 2008 or 2009, ten closed below their publicly-disclosed targets and only eight closed above. A couple have even re-opened in an effort to bring in additional investment capital. If nothing else, be happy that you are in good company — we count over 70 funds actively trolling around for additional funding.
As you prepare your investor presentation, you might consider avoid providing too narrow of a view of your fund. Don’t get boxed in as a specific fund type that the LP happens to not need for their portfolio. But if you truly have a very specific and narrow field focus, this will come through when the LPs are doing their due diligence and you’re better off not trying to present yourself as something that you aren’t.
If all else fails, consider increasing the percentage of the fund supplied by the partners. After all, nothing aligns everyone’s interests like having a little skin in the game, right? What’s good for the managers of our portfolio companies is good for us too. Geoff Love of the Wellcome Trust may have said it best: “Show us that you have the ability to eat what you’re cooking.”
Still More Badness: The tax man cometh
Much has been written about Treasury Secretary Timothy Geithner’s proposal to consider venture capital and hedge funds in a similar light (including by me), with the bottom line being an increase in the tax rate for VCs as their profits are taxed as ordinary income rather than as capital gains. Obviously, the NVCA is committed to avoiding this change and several proposals to maintain the current situation and even offer tax advantages were presented at the annual meeting. It might be a good time to start contacting your congressmen/congresswomen and senators, although at least this proposal seems to be losing steam and it will likely be 2010 before any changes are made.
The Good: Entrepreneurship is up
A recent study by the Kauffman Foundation detailed an increase in the monthly rate of entrepreneurship of nearly 10 percent for 2008, compared with 2007. The overall rate for 2008 ended up at 0.32 percent, but the rate for women especially increased, going from 0.20 percent to 0.24 percent. This bump in entrepreneurial activity has even hit the mainstream press, with a recent article in USA Today about teen entrepreneurism. All of this new activity means increased deal flow for VCs.
The Schadenfreude Factor
Plenty of distressed companies are available at low pre-values. For VC funds with dry powder, there are lots of opportunities around for purchasing good companies at great prices. I’m sure we’ve all heard “Flat is the new up” many times over the past few months. However, as with most things, good news and bad news are really just a matter of perspective. If you don’t have dry powder in your fund you’re likely being forced to pare down your portfolio at fire sale prices. If you do have plenty of dry powder, then you have all of these choices from which to choose.
In summary, the news isn’t all bad, although that may depend on your perspective. Of the four pieces of bad news and two pieces of good news, which is most profoundly influencing the face of venture capital? My bet is on the lack of an IPO as a viable exit scenario. Although losing our IPOs is simply a symptom of the larger meltdown in the US financial system, virtually all of the other pieces of bad news stem in some way from VCs not being able to exit from their current investments.