what goes up . . .
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the panel: analysis and commentary
Our survey results, combined with what we are hearing in the marketplace, leads us to some key points which we are going to have the panel discuss today. These include:
on the decline in dollars
Mr. Ayres: Investments for the third quarter were obviously down. The consensus now is that it's much, much harder for a company to raise money, regardless of the round. What are the market drivers that you think led to our first down quarter since Q1/1999?
Ms. King: It's a pretty easy question. Obviously, the market is down, so our exit opportunities are down. I'll give you an example. Last year NEA had 22 companies go public and 48 sold. From that standpoint, we had more capacity to take on new companies. When the window slammed shut, as it has this year, we don't have as many companies going out of our portfolio, so our inventory of companies has built up and the capacity to take on new deals has shrunk. Our philosophy is to only take on so many new companies because we are early stage investors and we are active investors. At times like this, we have to turn more of our focus to helping our existing companies, so we just don't have the capacity to take on as many new deals. As a result, the threshold of what we do as a new deal goes up. As evidence, I was just looking at this handout of yours which says that we were the second most active investor in the region, but all four investments we made in the third quarter were follow-on investments to existing companies we had invested in previously. I think it just proves the point about what we have had to focus on in this market.
Mr. Biddle: Suzanne is right. The key thing that people in the venture business are worried about is that the model has changed. There is not enough cash to provide the capital for all the companies that have been funded in this region. A lot of these companies are just not going to make it, so we are all scrambling, trying to make sure that our companies are the ones that get funded, which takes a lot of time.
The other thing that's fundamental is that VCs and our limited partners chase returns. The fact is that the returns have been negative for the last year, so you have to raise your bar, not just because of bandwidth, but because it's harder to make money. One hundred percent Internal Rates of Return (IRR) have been the norm for most of us the last few years, and, I have made this comment before, but for that rate of return to be sustained, last year's crop of startups would have to produce the entire gross national product in a decade. You could see that something had to give, and it snapped. Now we are seeing what happens in these cycles. The pendulum will go too far the other way.
Mr. Ayres: Rich, you can add to that, but let me ask you a related question: What are your predictions? What will next quarter look like and the quarter after that? Are we stabilized or will these numbers decrease? Are we looking at a down trend?
Mr. Harris: Well, I certainly wish I could predict the future, but I can't, although I think I have some insight into it. I think if you look at the numbers, yes, it's a down quarter, but it's still the second highest quarter ever. With the public market volatility and the VC reality check we are talking about, VCs are reserving more money and there is pent-up demand of companies trying to get out. I think that we are going to see a continued slowdown with probably less money invested, maybe fewer deals going next quarter, but I think it's going to continue to be cyclical. I think it's going to be a down trend for a while, but the public markets will come back some day. They always do, and, when they do, I think you'll see VC investments increase.
on changing investment strategies
Mr. Ayres: I have heard over the last six months the argument that “good deals are going to get done.” A lot of companies are hearing it. They have a great team and a defensible model, with customers that are paying and willing to talk, and they hear “good deals are going to get done.” Are even good deals going to get done, now?
Before you answer, let me make a couple of quick observations. Obviously, the IPO market has virtually come to a standstill. Valuations are down, limiting the use of stock for some companies as a currency for acquisitions. Fewer “sure-thing” portfolio companies are requiring investors to spend a heck of a lot more time working with existing portfolio companies versus pursuing the opportunities. When I look at this, I think fewer deals are going to get done, more scrutiny will be applied and a longer term vision will be needed. So, if we could start with you, Jack. In response to what's going on in the market, has your fund had to change the way you look at deals or your strategy for investing?
Mr. Biddle: We have done so a little bit. For early stage funds in the last couple of years, it's kind of been a racket. We could put up a little bit of money at a low price, help the company and then other people would swoop in, take a little of the stock and put up the rest of the capital.
The very aggressive investors over the last few years, both public and private, have just lost all their money, they are not there anymore, so we are going to have to carry these companies ourselves for a longer period of time. We are relatively small, so it's economic for to us do early stage deals, but we can't get involved in a longer project that's going to take $20-30 million. We have always avoided them (although not completely) because we don't have the ability, ourselves, to guarantee that there is that much capital available. Five or ten million we can commit to, but not a really capital-intensive project.
As far as good deals getting done, Blackboard is closing a round right now at a step up, something on the order of $50 million. The elite companies will still get nice rounds done, although not at absurd valuations, but still up. The top quartile companies will get funded, but at kind of flat rounds or just a little bit up. Probably about half of the companies aren't going to get funded. Many companies that have already been in business, ones that you read about in the paper every day and that are considered hot, will just go away over the next six months.
Mr. Ayres: Do you have anything to add to that somewhat depressing note?
Mr. Biddle: I should note, however, that NEA just raised $2 billion. We just raised $100 million. There is a lot of cash around; it's just a higher bar.
Mr. Harris: I agree, and I think we are seeing something of a flight to quality. People are certainly instilling a little more discipline in their investment criteria. They are less likely to look at something as a momentum play and more likely to concentrate on value investing, which I think is what venture capital has always really been about. You are going to see, as Jack said, more of the higher quality companies getting funded. They still will get funded, but the bottom third of companies that perhaps might have gotten funded over the last year or two, those companies probably won’t get funded now.
Mr. Ayres: Suzanne, you can answer that question, too, but let me ask you this one as well. You are all with well-established funds that have successful portfolio companies. What is the most important lesson you have learned that you might offer to newer funds that are trying to make it in this market?
Ms. King: NEA has been around for a long time, so I have the advantage of being a younger partner in a firm that's still has the founding partners who have been doing this for 22 years. They are people who have been through other down cycles.
The moment the market started to show any signs of shakiness, we went to Plan B, which was to focus on existing companies, focus on burn rates and make sure that we have a lot of cash reserve in our funds for follow-on investments. It's going to go back to how it used to be, holding companies 5-7 years before they go public; not this one-, two-, three-year type of phenomenon we saw recently.
As to how our investment strategy has changed, yes, we just raised $2.2 billion, but we are being very patient and we are being very focused on the fundamentals of companies. We are looking for true technology advantages versus execution plays. We are in capital-intensive businesses, but we look for strong management teams. All the fundamentals that you always check off, we are just being extra careful in evaluating them. We are looking for potential with big, stand-alone companies, not just as an M&A opportunity but in terms of multiple options for exit.
As to the single most important lesson learned: Understand that we had never invested in retail, but when the whole B2C thing happened, a lot of firms were out there making lots of money and we kind of felt a little left out. People were calling us stodgy and conservative, and we got a little upset about how we were portrayed in the press. We said that we should be looking at this stuff, and we made a couple of those investments, even though we didn't really think there was a good business model there. We knew that we weren't very good at it, but we did it anyway. I can tell you that one of those investments is now trading at about 25 cents on the dollar on the Nasdaq right now. I think the lemming effect is the lesson learned. No matter what you do, no matter how exciting it gets, at the end of the day, you have to look for the true fundamentals of a company¾look under the covers, look under the hood, is there a real business underneath?
Mr. Ayres: It sounds like going with your gut.
Ms. King: Yes. Is this a real company? Can it become a big, stand-alone company at the end of the day or is it just hype or smoke-and-mirrors?
Mr. Ayres: Jack, you have been investing for a long time in this region. What insights and what lessons can you offer?
Mr. Biddle: I agree with Suzanne. I was in the venture business in the 1980s, as was my partner. About six months ago, we turned down a couple of deals that one of my other partners badly wanted to do. He called us wimps, so we had to ask ourselves, “Are we sure that we are right not to do these things?”
This has all happened before. It happened in the 1980s. Then you had the PC, which, just like the Internet, was revolutionary. Ben Rosen put $750,000 into Compaq for half the company and $750,000 into Lotus for half the company, and he made a bunch of money. A bunch of capital flowed into VCs and out to a bunch of companies. The winner only lost a little bit of money because the other companies in the space had wrecked the market. Returns dropped¾they actually went slightly negative¾and the limited partners ran for the door. In the late 1980s in the venture business, Oak II had a 6% IRR, and they were a top quartile fund. They beat the public market by something like 15 points, I think. We are in the same kind of environment¾a lot of money was made, capital chases returns until it becomes over-invested in the space and now we see the shakeout.
It will take a couple of years to come back. The numbers you see in the MoneyTree actually lag reality by about a quarter because, when we make a commitment to do a deal, it takes six or eight weeks to do the documents and make our commitment. The deals that have already been agreed to in the third quarter will close in the fourth quarter, so the drop will be quite significant. I would speculate that the fourth quarter will probably see more than a 50% drop in venture investment.
The key lesson is, as Suzanne said, you don't make your money in the venture business with your home runs. You make your money by getting your bait back on your bad deals and making a little bit of money, or a medium amount of money, on your good deals. That's the way the business really works. In the last few years it made no sense to worry about your bad deals because you made so much on a home run like Sycamore or Juniper. With what's happening in the industry now, your bad deals are actually going to determine whether you are a top quartile or bottom quartile fund. Everyone is focusing now on trying to preserve their bait in their bad deals.
Mr. Ayres: It sounds like maybe we should have played Taps as the song coming in here this morning.
Mr. Biddle: There were a lot of companies that were founded in the late 1980s that got to be huge corporations, so the business goes on. There will just be less fantasy and it will be hard work again.
Mr. Harris: I think there is going to be a lot of patience involved. As Suzanne said, the one- to three-year phenomena and exit at a billion dollars just is not going to be around very often anymore, at least for a temporary period.
Mr. Biddle: Or exit in six weeks . . .
Mr. Harris: Or six weeks.
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