"Venture capital: Case of deep pockets and alligator arms?" Tim O'Louglin Article in Mass High Tech
Mass High Tech - Friday December 2, 2011
Moneytree statistics posted on the National Venture Capital Association website paint a potentially troublesome picture for the venture industry. In recent years, VC investment into portfolio companies has far outpaced the inflow of limited partner investments into venture funds. On a year-to-date basis through Sept. 30. 2011, VC investments in portfolio companies totaled $21.2 billion compared to VC fundraising of just $12.2 billion. Anyone with a working knowledge of arithmetic can see that this situation isn’t sustainable.
Based on my discussions with university endowments and pension funds over the last couple of years, the story behind the numbers raises additional concerns. While most limited partners are still clamoring to invest in the top 10 percent of venture capital funds based on performance, the picture for the bottom 90 percent isn’t so clear. Many venture capitalists are not looking forward to the process of raising their next fund and are waiting for a few more successful exits in their portfolios to improve their chances.
Lower fundraising by venture funds doesn’t directly affect today’s venture backed startups because most venture funds don’t cross over from one fund to the next. Fund I companies don’t often get funded by Fund II as there are usually prohibitions in limited partner documents against this to avoid potential conflicts. VC backed entrepreneurs may feel the residual effects of delayed fundraising by their venture investors as reserves constrict. That can set up an interesting dynamic in the board room where an entrepreneur asks for more capital to fund their growth. VCs might suddenly develop a case of “alligator arms” – which aren’t quite long enough to reach those seemingly deep pockets. At the extreme, if the VC is at the end of their current fund, they may not have reserves to support even their successful investments. They are reticent to bring in a new outside investor for fear of a cram-down round.
Leverage in the form of bank loans and venture debt can provide some cash relief in the near term without upsetting the company’s cap table. Sources of venture debt are plentiful. Leverage is tempting but also raises the future burn rate of the business due to required principal and interest payments. Higher burn rates translate into higher risk profiles for entrepreneurial companies and need to be evaluated carefully against projected cash flows.