VC Perspectives

In the VC community, there’s an ever-ongoing debate about if the business idea (=the horse) or the team (=the jockey) matter most.

I would say that the most common viewpoint is that the team is more important for several reasons:

• A great team can make also a mediocre idea successful or they will come up with a new more successful one
• A mediocre team can mess up even a great idea
• As markets change (and they do), a great team will adapt to the required changes

However, when Steven Kaplan (one of the leading researchers on private equity) and his research team studied VC-financed firms from early business plan to initial public offering (IPO) to public company (three years after the IPO) they found that on the margin, you should bet on the horse.

Why? First of all, the study showed that it rarely happens that a good team is successful with a poor idea. Secondly, it showed that you can have a good idea and a poor management team and still end up winning (VCs change management teams frequently). In other words, a bad management team does not necessarily kill a good idea, but a bad idea is rarely overcome by a good management team.

Personally I think that in early-stage venture you need to bet on both. The idea has to be good enough and it needs to be in an interesting enough market. Also, if the idea is not very good, it says something about the team as well. But the earlier you invest, the more the jockey matters. In the early stages, a good idea is only a rough diamond that needs polishing. It is hard to recruit new management in an early stage and get the same commitment and hard work as from founders. Also, no idea or product sells itself so you need a great team that can sell the idea or product to customers, employees, advisors, and investors.

Link to the study

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…