Winter is Coming: How Venture Capitalists are Preparing Their Portfolio Companies

In talking with our venture capital clients (pure play and corporate VC), many of them have expressed concern about a fundraising, exit and larger economic slowdown. Of course, opinions on the magnitude and when such a downturn might occur vary significantly. But for those who see problems on the horizon, we are starting to see many of them take actions to prepare themselves and their portfolio companies for leaner times.

We wanted to share some of the strategies we see them employing below and which we’re helping them with using CB Insights data.

First, what has them worried?

There are numerous things but a few we’ve heard regularly are below:

• IPO market is slow – There was only one US VC-backed tech IPO in Q3 2014. Box and Good Technology have delayed their IPOs until 2015 amid stock market volatility/uncertainty.
• Warnings from prominent investors – Well-respected VCs have rung the warning bell including Jim Breyer of Accel Partners who warned that startups should raise now and Bill Gurley of Benchmark who helped kick off the bubble and startup burn rate angst.
• “Dumb money” pouring in – VCs see the pouring in of corporate, hedge fund, mutual fund and sovereign wealth fund money flowing into the market as alarming. Especially to investors who share the Warren Buffett maxim, “Be fearful when others are greedy”.
• Macro concerns – Compounding these issues is a more recent concern we’ve heard about things like ISIS or Ebola being potential black swans that could completely change the game.

So what are VCs doing about it?

For venture capital firms who are worried about a coming chill, there are a few things they are doing and which we’ve been working with them on.  It’s worth noting that their strategies vary based on two factors:

1. Their fund size
2. Their prognosis for each portfolio company

For their portfolio companies, their strategies largely center around:

• Fortifying their winners
• Exploring all options for the middle of the pack
• Offloading their duds

We’ve also heard about more complex structures in term sheets (ratchets, better liquidation preferences, etc) to limit investor downside but we’re going to focus on the more tactical things we see investors doing using our data.

Fortify their winners

This is the easy and obvious one.

For the small group of companies in the VC’s portfolio which have broken out or which appear to be poised for a breakout, venture investors are helping these companies raise more money.  Of course, multi-stage funds can continue to fund these companies on their own (although not many do what Sequoia does).  But for earlier stage funds, building target lists and analyzing syndicates for these follow-on rounds becomes important.

We are also seeing several funds go back to their LPs for these high-flyers to see if their LPs are interested in investing directly in these companies.

Because of the power law nature of VC, this is where a lot of VC attention is focused.

Fortifying goes beyond financing and also includes talent

We’re also seeing VCs work hard to help their winners recruit talent. One of the ways they are doing this is by identifying dying startup companies based on fundraising gaps or which have negative performance metric trends in the hopes of poaching or acqui-hiring talent.

Explore options for the middle of the pack

The companies who aren’t the clear winners yet appear to be the most “difficult” in some sense as they require the exploration of multiple options, namely:

1. Raise additional financing
2. Explore exit options

Raising additional financing for these companies is harder because they’ve often not demonstrated the metrics or had enough time to make them a slam dunk for further investment. As a result, we see VCs doing work to build investor target lists for these companies as well as actively trying to expand their network of potential syndicate partners. This is where looking for non-traditional investors (corporates, hedge funds, mutual funds) seems to be a favored activity. With these “middle-of-the-road” companies, the money can come from any source as the VC’s focus/concern is ensuring the company has enough money to prove out their hypothesis or business model. In addition, these non-traditional investors are not facing the same desired exit economics as VCs. While some VCs are targeting a 5x-10x exit multiple, a mutual fund, hedge fund or corporation may be willing to risk capital at the later-stages for a 2-3x exit multiple.

Some VCs have even openly acknowledged that they’re willing to take “dumb money” if it will help a company that they think is promising live to fight another day.

The other alternative venture investors are exploring for these companies is an outright exit with a view to recovering their investment or seeking out a modest return.

Offloading duds

For the portfolio companies that VCs have effectively written off (mentally at least), the options are limited. What we’re seeing some VCs do is look at acqui-hire exits to high profile, well-funded startups who are increasingly acquisitive.  The ability to find a soft landing for a team, have an “exit” at least from a PR perspective, and get some equity in a high profile startup that might be worth something in the future, is the best option for investors in these portfolio companies.

If you are a VC, do you think “winter is coming” and what else are you doing to prepare for winter?  If you are a portfolio company of a VC, how are you preparing for a potential downturn and how are your investors working with you on this?

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