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July 13, 2009 Venture Builder

Mind the gap | Dynamics of supply and demand stretches venture capitalists

It should be no surprise that the current economic environment has had a dampening effect across all industries, and venture capital is not immune. The capital gap — the difference between supply of and demand for capital, which most define as the availability of early-stage funding up to $3 million — has long been a characteristic of the venture capital market. Most early-stage VC funds manage hundreds of millions in capital and need to put more money to work. This gap has widened considerably over the last three quarters.

Venture capital investors have suppliers — institutions, companies and individuals that provide us capital to invest in high-growth businesses — and we have “customers” to whom we, in a sense, “sell” our capital and value-add in exchange for an ownership stake in their business. Institutional investors --pension funds, university endowments and insurance companies — manage large reserves of cash, most of which are committed to “safe” investments with a smaller, defined portion (typically 5%-20%) allocated to higher-risk, higher-reward “alternative” assets like venture capital, real estate and hedge funds. Since the fourth quarter of 2008, two things have happened to dampen this investor class’ appetite for new commitments:

  • First, the denominator effect: Institutions’ investments in “safe” assets like public stocks have, since Q4 2008, degraded in value, as much as 30%-40%, so their alternative investments represent proportionately more of total assets and their safer investments represent proportionately less. This dynamic — called the denominator effect, from the impact of a given alternative commitment (numerator) over a declining total asset base (denominator) — results in these investors pulling back from commitments to alternative assets. So, VCs have less access to new supplies of capital.

 

  • Second, VC liquidity: VC funds to which these investors have committed are having a hard time in the current market realizing value for their investments, whether by sale, merger or IPO. This is the case both because the economic downturn has negatively affected their portfolio investments’ sales and because buyers are also suffering. Without the ability to realize value for their investments, venture capital funds can’t provide capital returns to their institutional investors, compounding those investors’ cash-flow challenges. Institutional investors’ existing fund commitments are harder to fund without expected capital returns from existing mature funds, which further reduces their appetite for new fund investments.

Push and pull

Concurrent with the decreased supply of capital is an increased demand for capital from growth companies. Companies that have already raised capital from outside investors (or were about to) are finding their needs for capital have ratcheted up. Lower-than-projected sales, for many, translates to greater cash consumption, as most companies’ expense base assumes a given revenue growth. A lower top line translates to higher operating losses — early-stage, VC-backed companies expect and plan to lose money in early years.

Companies that were planning to raise capital are also in a fix. The coupling of demand from both existing venture-funded companies and as-yet-funded companies translates to greater overall demand for capital. Venture capital funds are focusing on their existing portfolio investments and reducing new investments. So, the capital gap gets worse.

Individual investors, also known as angels, have a similar dynamic to both institutional investors and VC funds. Like institutional investors, angels have lost net worth and so have less to invest. Like their VC brethren, individual investors find their now needier portfolio drawing more of their attention, resulting in less capital available for new investments.

So what’s an early-stage growth company in need of capital to do?

  • Decrease expenses. Move from growth mode to survival mode, reducing your expenses to allow you to live with cash on hand for as long as possible.

 

  • Increase sales. Offer value to your customers, like larger quantities at lower per unit prices for consumer products. Provide payment terms that recognize your customers’ resource constraints, such as software on a monthly payment plan vs. an upfront payment model.

 

  • Find alternate sources of capital. Federal, state and local grants are available for a variety of purposes. Also, leverage your suppliers and customers for improved terms or even investment.

Have other ideas? Email them to me and I’ll post them on my blog, clearventurepartners.blogspot.com.

 

Michael Gurau, managing general partner of Clear Venture Partners in Portland, can be reached at mg@clearvcs.com.

 

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