A few weeks ago, Scott Duke Harris of the San Jose Mercury News wrote an article titled, “Will Undone Deals Be The Next Big Thing in Silicon Valley?”. The article evolved from a conversation about two recent ExpertCEO posts. The posts were entitled “VCs Yanking Funding” and “Series A Deals Getting Undone”.
A friend of mine, who is a general partner of a top tier venture fund, related another “busted financing” anecdote. His firm is a shareholder in an early-stage company that, like many others, found itself unable to find a new investor when it sought financing about six months ago. The existing investors agreed, instead, to raise an “inside” round, to be parceled out in two tranches, the second of which would be triggered by the company’s achievement of three milestones. The first tranche was funded, as expected, in late summer. Subsequently, the company met 2 of the 3 milestones, and the investor syndicate agreed to loosen the criteria of the third milestone, making way for the last tranche to be paid out. However, one of the investors also decided to require the company to make a final presentation to its partnership, prior to closing. The presentation took place in mid-December, but ultimately, the partnership elected not to participate in the final tranche. This unfortunate surprise left the remaining investors with two options: put in more money than they had planned to support the company, potentially indefinitely and in the face of a no-confidence vote from an existing, top tier investor, or drop out, leaving the company high and dry. In the end, the existing investors opted for the second option.
Issues Faced by VCs are Similar to Those of Venture-Backed Companies
Many venture capital firms are either experiencing or are fearful of facing their own cash shortfalls (just like their portfolio companies). Their source of funding (their limited partners) have been hard-hit by the market’s precipitous decline. Venture funds collect or “call” cash periodically as they need it. As these capital calls are issued, some venture firms are finding that their limited partners are either unable or unwilling to meet their contractual commitments, leaving the funds with fewer resources than they’d anticipated.
As a result, venture firms, which typically “budget” funds for each of their investments, are being forced to rethink these plans (again, just like CEOs) – because of the possibility of the reduced size of their funds, as well as the probable need for greater total investment in each portfolio company than was budgeted. And liquidity events will be few and far between due to a less forgiving stock market and a reduced pace of acquisitions at lower valuations.
Facing these new realities, many venture funds are carefully re-evaluating their portfolios, deciding which companies to support with their scarce cash and which to “abandon.” To conserve cash, venture firms must categorize their investments. They are requiring those with existing revenue streams, where expenses can be cut to quickly achieve positive cash flow (the Sequoia Capital approach), to survive on their own, while supporting those that are promising but pre-revenue. Others will be allowed to fail or forced into a sale. These issues are well chronicled in the following two articles.
What Should Venture-Funded CEOs Do?
The operational aspects of managing in this environment have been discussed at length (cutting costs, etc.). A more complicated task for a CEO is how to manage his or her investors! Assuming you can’t reach cash flow breakeven via the Sequoia route:
1. Be creative when considering funding sources. The organized venture community is one, but by no means the only option when seeking financing for your business. Identify potential strategic partners or large customers with a vested interested in your success. They can fund development, make large purchases, and provide cash in a variety of other ways. One company I work with just received a 7 figure (cash) payment on a large product license from one of the big 3 U.S. automakers!
2. Communicate often and frequently with your investors. Level with them about your opportunities and challenges. Let then know you expect the same from them. Don’t be afraid to probe the extent of their commitment and understand their problems in a respectful way—you owe the diligence to all the shareholders. Most of all, be prepared for necessary financing parameters to change often.
3. Don’t rule out acquisition as a potential avenue. What was unthinkable just months ago could well be the best outcome for you and your shareholders. If you’re flush with cash or have liquid stock to use as currency, acquisition opportunities will be more numerous than your ability to consolidate them—so prioritize! And if you’re running low on capital, don’t wait to explore possible combinations. The process is time-consuming, and many more potential marriages are considered than are consummated.
4. Plan for the worst – hope for the best. Whether you’re seeking funding or a merger partner, assume the process will take longer than you think. Read my blog entry titled “Crisis Management.”