The New England Venture Summit started with a VC panel "Bridging the Capital Gap". VCs are still investing but only in high quality companies, with proven revenue models, focused on a growing market segment. Of the 7 VC firms represented on the panel all but one made investments in the last 8 weeks. A poll of the VCs on the panel revealed 10 follow on investments to existing portfolio companies, and 4 new investments in just the past 8 weeks. This mirrors the results I am seeing from VCs I have talked to over the past month or so. Most VC firms are focused first on their existing portfolio companies by making sure they have capital reserved for when they need it over the next two years. One VC on the panel, the one that hadn't made any recent investments, said that 7 of their 8 portfolio companies have enough cash to carry them through 2010.
Valuations coming down - Other VCs have said they are actively looking for good companies to invest in. Valuations are coming down to more reasonable levels. Later stage companies that raised money during the boom years are seeing valuations down 40% or more. That isn't too surprising given that most public technology companies are down 40% or more too.
Startups with advertising driven revenue models are being pressed to prove the numbers, show comparables, and really drill down on CPM rates and CPC click through rates. The reality is that there are very few web sites or services that can build a large enough audience to generate $1M in monthly advertising revenues. CPM rates are falling across the board, especially in the social networking area.
Management Investment Partnership – John Giannuzzi of Sherbrooke Capital introduced an interesting concept for aligning the interests of VCs with entrepreneurs. Sherbrooke asks its founder entrepreneurs to invest with them and invest 10% of the first round capital raised. For example, if a company is raising $2M, the founders would take $200K of the round, with 15% ($30K) up front and the balance financed over time. The company issues a 3 year note to the founders for the remaining $170K. If the founders meet their projections at the end of year one they get one third of the note forgiven and get the stock for free. If they miss their numbers they would pay for the stock...just like the VC. If the founders meet their projections in all three years they get the entire note forgiven and keep the stock for free. In essence the founders get to own 10% of the round for 15 cents on the dollar if they meet their targets. If they don't meet their targets they get to buy the stock at the same price as the VCs.
Do stock options motivate? – John Giannuzzi says "Stock options are a free pass. There is no downside risk. They don't motivate founders, and don't align interests." Hmmm…interesting viewpoint, one I haven't heard before. Founders are certainly motivated by stock options and market valuations, but it is true that there is usually no downside financial risk, or annual measurement. The Management Investment Partnership that Sherbrooke proposes is a novel approach to aligning interests with a "carrot and stick" model. It will be interesting to watch Sherbrooke portfolio companies to see if the concept works, and if the idea catches on with other VCs.
Founders Fund approach – Founders Fund has a completely different approach, allowing founders to cash in some of their stock in the first funding round. Founders Fund, as the name implies, is a VC firm started by founders of startup companies. Peter Thiel and two other PayPal principals, along with Sean Parker (Napster, Plaxo, Facebook) are the partners at Founders Fund, and each has been through all the phases of starting a company. They feel that investor's interests are more aligned if the founders have some money on the side so they aren't compelled to accept the first exit opportunity that comes along. They feel the startup founders will be more willing to hang in there for a longer period of time and hold out for a bigger exit.
There are very strongly held beliefs on both sides of this issue. Each side makes compelling arguments. In the end entrepreneurs need to decide which VC firm they will partner with based on shared vision and values. Taking on VC money is a big and long lasting decision. Entrepreneurs often quip "you can divorce your spouse…you can't divorce your VC".