Venture capital portfolio firms typically take years to progress from seed or 1st round funding to a potential liquidity event, such as an M&A or IPO. This long time horizon allows for counter cyclical thinking about venture investments. So why worry about current financial market fluctuations when the exit strategy for most portfolio firms may be years away? While this is a reasonable conclusion and may have worked in the past, things seem to be different this time.
I have surveyed Silicon Valley venture capitalists each quarter since Q1 2004 about their confidence in the future high-growth entrepreneurial environment in the San Francisco Bay Area. On average, about 30 venture capitalists respond to each survey and give a quantitative measure of their confidence (1 low to 5 high) along with commentary to support their ratings. The report I just completed for Q3 indicated the lowest level of confidence since I began the survey nearly five years ago. Please see the graph below for trend data.
Why were VCs decidedly less optimistic? As one might expect, the dramatic deterioration in macro economic fundamentals (e.g. credit crisis, stock price collapse) were at the top of the list. (The survey responses were collected between September 25 and October 5, which overlapped with the market meltdown.) But, more importantly, the VC respondents in this survey directly linked these macro conditions to the potential impact upon the venture capital business model. For example, T.C. Wang of Acorn Campus said "The current financial market mess will essentially block the IPO and most of the M&A deals for quite a while. Without a clear exit strategy in sight, it is hard to finance new deals." And Dag Syrrist of Vision Capital indicated that "Venture funds are frozen with uncertainty . . . Until some prolonged data showing the economy and markets stabilizing appears, funding will not increase again." Each of these investors (more are cited in the full report which can be seen at www.Cannice.net) attribute a decline in their confidence and near-term investment decisions to the current market turmoil.
Other concerns related to the pubic market decline were also given. For instance, David Epstein of Crosslink Capital reasoned that the level of dollars committed to venture funds will likely decline in step with the decline of the stock portfolio of major limited partners, such as pension funds. This, or course, again would curtail the amount of investment dollars available for new ventures.
Worth noting is that VC confidence in the future entrepreneurial environment began to decline markedly in Q4 2007 (see graph above) even though that quarter was a strong one for venture-backed IPOs. Therefore, it appears the insight of the responding venture capitalists in this survey is well tuned to the near-term future functioning of the public capital markets with respect to venture-backed liquidity events. In a related empirical study that examined the relationship between VC confidence and IPOs of venture-backed firms1, I found with my co-author, Cathy Goldberg2, that declines in VC confidence preceded declines in the dollar volume of IPOs of venture-backed firms. Therefore, the current downward trend in VC confidence appears to portend fewer IPO exits in the near term.
So should entrepreneurs give up hope on attracting venture capital now? Not necessarily. Robert Ackerman of Allegis Capital and Chris Rust of US Venture Partners both suggested that downturns have shown to be an opportune time to start new businesses. Further, with investment money tighter, seed-size investments may appear more attractive to some venture firms. Still, entrepreneurs will need to closely manage cash and get to profitability more quickly than they may have first planned. For the moment I take comfort in the words of Venky Ganesan of Globespan Capital Partners who offered ". . . Right now as we navigate through this terrible financial morass, somewhere in a garage two young intrepid founders
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