VC Perspectives

I read a really inspiring article today in Dagens Industri with young entrepreneur Diana Svensk. She’s 20 years old and is running her own company making cool knitted hats (something we definitely need here in the Nordics). Although she admits it’s tough being a young entrepreneur, she seems to have that wonderful combination of energy, drive and will to make things happen. Keep up the spirit and best of luck!

Thorugh the article, I also got to know about a network called YEOS (Young Entrepreneurs of Sweden).

Young Entrepreneurs of Sweden is a nationwide network with the purpose to connect, educate and inspire young entrepreneurs in the age between 18 and 30 years.

The network was founded to be an accelerator helping young achievers learn and grow through social interaction and collaboration, breeding business success and enriching private life. The network’s members, Sweden’s foremost young entrepreneurs, control the agenda of the network through their share in the legal cooperative.

Young Entrepreneurs of Sweden arranges regional activities around the country on a regular basis as well as one bigger event yearly. Common for the activities is the fact that they gather Sweden’s most ambitious young people for networking, experience exchange and inspiration. Activities of the network are mainly financed by partners and project assignments.

This kind of stuff makes me really happy, what a great initiative!

Mark Peter Davis posted a blog entry with the title “The Best Time To Raise Money Is When You Can”, which I think is worth a read. This may sounds obvious at least when considering the opposite: raising money when you can’t but there’s actually a bit more too it.

Also, this is not just true for VC-financing, the same logic applies for extending your credit line or negotiating a new loan with the bank. At the moment, it is pretty tough to get any of that from the bank but in general they are much more likely to extend your credit line when revenues are up and you have plenty of cash. Another aspect of this is actually to use some of the credit line even when you don’t really need it. We have seen several cases where the banks withdrew unused credit lines at the beginning of the credit crunch but couldn’t do the same to the ones being used.

This discussion may not be applicable for companies that don’t have the cash to start with but hopefully most will some day come to such a position and then it could be worth remembering that money is never as cheap as when you already have it.

As previously reported, company valuations have decreased significantly. And venture investing is (as most businesses) essentially about selling something (in this case shares) with a margin large enough to compensate for risk and cost.

So, is not the current situation a great opportunity to invest in? It is, or at least we (and many other investors) think so.

But why then is VC investment activity going down instead of up? Well, I’ll try to pinpoint a few reasons and their implications from a VC perspective:

Lack of capital

Many VCs don’t have capital available for new investments. This is true both for VCs investing from their balance sheets (common for strategic/industrial investors) and for VCs investing through a fund structure where investors (Limited Partners) commit a certain amount of money over the fund life cycle, typically 10 years.

And currently it is very difficult for VCs to raise more money due to a number of reasons:

- Price of risk has increased: LPs are less inclined to invest in perhaps the riskiest of all investments types, namely early-stage.

- LP allocation: LPs often allocate a percentage of total investments to alternative (e.g. venture capital) investments. So, when the value of the other investments (e.g. public stocks) decreases, the percentage allocated to venture capital translates into a lower absolute number.

- Venture capital has in general not provided good enough returns: (read for example Fred Wilson’s excellent blog post on this topic). This makes LPs hesitant to invest in anything but the best VC firms (as seen Index didn’t have problems raising a new fund).

- LPs lack capital: Although LPs have committed money to the VC funds, the money is often held in some asset class (stocks, bonds etc) until called upon by the VCs. Unfortunately, with the current situation some LPs are having problems to actually free up enough capital to match the VC’s call for money.

Recession and refinancing risk

Due to the recession and the financial crisis, many portfolio companies are facing a much tougher situation than 1-2 years ago. Therefore, VCs need to spend more time (and money) on their portfolio companies due to decreased customer demand (deals take longer or even get cancelled). There is also the refinancing risk meaning that VCs have to put more money into the companies, money that previously could come from e.g. banks or other investors.

This situation is of course also true for companies that VCs are thinking of investing in. The way to address this is typically to find strong co-investors (called syndication) already from the beginning so that the investors can support the companies longer without having to count on money from banks or new investors.

All this means that there are fewer VCs with capital to invest, which coupled with an increased need to co-invest to handle the increased risk means that fewer companies end up receiving financing.

Low valuations

Actually the low valuations also represent a problem in itself. Firstly, lower valuations make it more tricky to make good exits which means that VCs need to hold on to existing companies for a longer time (again often requiring more time and money). Secondly, the lower valuations create problems for entrepreneurs and investors to make deals, since the entrepreneurs may not be willing to accept a lower valuation just because the economy in general is in a sour state.

UPDATED: And then the South Park take on it…

This week, Fredrik and I attended Riskkapital 2009, an annual event organized by SVCA covering the Private Equity industry (including business angels, venture capital and buyout).

During the event, I had the pleasure of listening to a very interesting presentation by Deborah Magid, Director Software Strategy at IBM Venture Capital Group, on how IBM works with acquisitions.

IBM has made 77 acqusitions since 2003 of which almost half were VC-backed. What IBM usually can bring to the acquired companies is increased reach, Deborah mentioned that their acquisitions generally double their revenue within two years. Almost all of the acquired companies were partners of IBM in one form or another but ranged from stealth projects to giants like Cognos.

For IBM an acqusition decision is very much about a build vs buy vs partner decision menaing that they are interested in acqusitions when it takes too long to build it themselves or when an acqusition can increase the strategic value more than a partnership.

Finally she gave some advice to entrepreneurs:

• Build the best company you can (good companies are bought not sold, and IBM only wants to buy the best companies out there)
• Hire the best people you possibly can
• Understand your market and your customer, and put the customer above all else
• Form strategic alliances. Don’t try to go into the market alone to get reach into the market

Wheras I fully second the three first points, I would like to issue a few words of caution on the value of partnerships from a start-up perspective.

Partnerships are only as good as the actual financial benefits they bring to both parties. Just adding a sales partner does not necessarily add value unless the partner actually works hard to sell your stuff (and remember that they probably have lots of other partners and usually some own products & services too).

They best way to build a good partnership is often to build it on actual business opportunities where the customer sees value in your product or even better if you have managed to close a deal under the nose of the potential partner. But it doesn’t stop there, to really get a partner promoting your products or services, you usually must put in a lot of effort in making life easy for the partner. This means training of sales reps, providing sales material and support, and being out there together with the partner selling (after all, who knows your stuff better than yourself).

So yes, partnerships can be a great way to scale up the sales and to increase reach (and in some markets you even need a partner to be able to sell at all) but it won’t just happen without lots of hard work and actual profits in the pocket of the partner.

According to Alarm:Clock, Danish firm GoViral has raised €6.5 million from Kennet Partners. GoViral is a viral marketing agency which provides seeding and tracking of viral marketing campaigns (primarily video content).

This is positive news for several reasons. Firstly, it is one of the larger Nordic start-up rounds in recent times. Secondly, it is encouraging that an international investor is willing to invest in the Nordics at a point in time when most investors don’t invest outside their domestic markets. And finally, although no other details were disclosed about the deal, the deal size could indicate a decent valuation (although it of course potentially could be made up by tranches and milestones).

So does this mean that things are heating up again with capital inflow, increased deal sizes and valuations?

Not necessarily. Although GoViral was founded less than four years ago (thus still a start-up by age), it was profitable and had revenues of 21 million DKK in 2007 (probably higher in 2008 since profits soared from 2.5 million DKK in 2007 to 8.7 million DKK in 2008).

Despite the gloom and the general pessimistic view in the venture community, among both investors and startups, excellent companies still manage to attract financing. Edgeware last week announced both a new $8M financing round led by Micron Ventures and the opening of a US office.

The new round was an significant upround to the last round and compared to our initial seed investment in Edgeware one order of magnitude up.

There are lots of lists right now, last week Internetworld selected Sweden’s hottest web entrepreneurs, this week two of Sweden’s most influential business and technology magazines, Affärsvärlden and NyTeknik, present Sweden’s 33 hottest technology startups (max 7 years old).

Although these kind of lists are highly subjective and a bit populistic, Affärsvärlden and NyTeknik have a thorough process where readers and the journalists nominate companies and then the magazines select the 33 most promising companies that have the potential to become internationally successful.

This year, 3 companies that we have invested in made it to the list: Spotify, Videoplaza and Edgeware. Congratulations to them and to the other 30 companies on the list.

An interesting fact perhaps is that out of the 33 companies at least 23 had received venture capital. The magazines also asked these investors (in the 33 companies) what their investment activity in 2009 will be like. 5 investors (Creandum, Industrifonden, Investor Growth Capital, Northzone Venture Partners & SEB Venture Capital) said that they will continue to invest as much in 2009 as in 2008 whereas 4 (Exero Capital, Jane Walerud, Kreos Kapital & Provider Venture Partners) mentioned that they would invest less.

UPDATED: The list in NyTeknik (Swedish Only) and Affärsvärlden (Swedish Only)

Last week Internetworld.se announced their list of Sweden’s 25 hottest new web entrepreneurs (Swedish only but pretty easy to understand anyway). The published list so far only includes place 2-25 but the winner Fraktjakt.se has been published separately. New in terms of that they haven’t been on the list before (since quite few have been at it for several years) and hot in terms of their likelihood of being successful during 2009.

Success is hard to measure in early stages of a company but going back to last year’s list actually reveals a pretty good hit rate. Quite a few companies have developed positively, at least a handful have raised capital from VCs and business angels (including Spotify, Bambuser, Videoplaza, Tailsweep, Xcerion, Yubico, Momail and probably more) and at least one was acquired (Viewserve). Hopefully, this year’s bunch will be able to defy the tough financial climate and develop their ideas and companies further.

By the way, are there similar initiatives in the other Nordic countries?

Many consumer-facing web companies are relying on advertising in one form or another. Therefore, the internet ad spending (or lack thereof) will have a great impact on many companies.

Some data points on ad spending in Sweden (source IRM, as published in Internetworld Nr 3, 2009):

• Internet ad spending grew from 1.5 billion SEK in 2004 to 4.8 billion SEK in 2008 (CAGR of 34%)
• During the same period, total advertising grew from 25.5 billion SEK to 32.3 billion SEK (CAGR 6%)

So far so good, with growth in both offline and online but with online increasing its share of total ad spending radically (up from 6% in 2004 to 15% in 2008). Although I don’t have the data points, I would expect a similar development in the other Nordic countries.

But what will happen next?

According to Veckans Affärer (Swedish Only), ad spending in Sweden is expected to drop 20% during 2009, primarily affecting traditional media but also affecting internet advertising (down 31% in January 2009). A few months earlier, Internetworld (Swedish Only) reported that IRM expects a drop of 4.7% in total ad spending and internet ad spending growing 7% (still significantly slower than previous years).

On a European level, Forrester Research (as reported in Internetworld nr 3, 2009) expects internet advertising to grow on average 9% per year until 2013 instead of 13% which they previously forecasted (and compared to 30% growth in 2007).

To conclude, the recession has already impacted both offline and online advertising but relatively spending continues to move online. As for online, search is expected to increase its already strong position and grow faster (11% CAGR from 2008-2013) than display and classified ads (8% and 3% respectively) according to Forrester Research.

Usually, less established forms of advertising suffer more from a recession so my guess is that for example mobile and in-game advertising in the short term probably will grow much slower than previously forecasted and from very small volumes.

Ville Vesterinen at Arctic Startup notified me on Facebook about an article by Tim Walker in The Independent called Why Sweden rules the web where Stockholm is heralded as the world’s new digital capital.

The article is centered around the Pirate Bay trial and the Spotify launch but also covers other Sweden-related web business/services including Skype, Stardoll, Tradedoubler, Joost, Headweb, and Kazaa (even though a few are left out such as Rebtel, King.com as well as the whole gaming scene).

But the article is also unbashingly (and uncritically) promoting anything Swedish and goes on to explain that technology adaptation is in the Swedish genes using very ad-hoc and simplified indicators such as that Stockholm had more telephones than London and Berlin in 1900, the heroine of a recent movie release is a young computer hacker (have we not seen that in the US for at least 10-15 years?) or that the royal family announced an engagement through a web clip on the royal website (the Obama campaign anyone?). It also forgets to point out that some of the companies were more Nordic than Swedish including Stardoll and Skype/Kazaa/Joost.

Anyway, it is well worth a read and no doubt excellent PR for Sweden and Swedish web entrepreneurs, and perhaps worth using as part of a pitch to international journalists.