DFJ Gotham Is Actively Investing, Others Should Be Too

In my recent post, The State Of Venture: The Ugly, The Bad And The Good, I focused on how the current economic environment will impact the venture industry. What I did not do in that post was discuss DFJ Gotham's investment intentions. After having received a number of emails from entrepreneurs asking if DFJ Gotham is actively investing, I realized that I should write a separate post that outlines our investment strategy in this market.

In a nutshell, we're actively making investments now and will continue to actively invest going forward. There's good reason for this: based on the arguments I made in my The State Of Venture post, now is great time for us to make investments. Here's why:

We're at the beginning of our latest fund, the investment cycle, meaning we are at the right stage of the fund to be investing aggressively. We have only made 7 of the 20-25 investments that we plan to make out of this fund. Our investments have ranged from Drop.io and ExpoTV (B2C companies) to Worktopia and IZEA (B2B companies).

We believe that, in the current environment, companies that we capitalize will have a unique competitive advantage. As I stated in my prior post, while entrepreneurs will have to make the money last, access to capital over the coming years will afford companies the opportunity to build their operations, acquire talent and generally get ahead while many of their competitors are under-funded.

This market has also created a favorable investment environment for VCs. The market is filled with very smart, newly-minted entrepreneurs who recently left their day jobs due to the absence of bonuses or rolling layoffs.

Additionally, our new investments are not likely to be significantly impacted by the current exit environment.  While exceptions exist, many of the companies entering our portfolio in the near term will not be seeking an exit until 2012 or beyond - a period which will likely have a very different exit environment.

The bottom-line is that I believe that it is a great time to make early stage investments. We plan to invest actively and I hope other early stage firms do too – that’s the best thing VCs can do for the venture community and the economy at large.

The State Of Venture: The Ugly, The Bad And The Good

There is one topic on the minds of all entrepreneurs right now: the impact of the economy on their startups. The economy is the centerpiece of every networking event and panel, and it even consumed the Q&A session after my speech at VANJ last week on how to raise VC. It’s inescapable.

The financial crisis has and will continue to effect the venture world. Despite how bad things have become, however, there is a silver lining for the best startups. Here are my thoughts on the good, the bad, and the ugly of the current economic environment.

The Ugly: Economy In Shambles
We all know how troubled the financial markets are right now. The public markets are in an irrational downward spiral, the gears of our credit machine haven’t unlocked despite being greased by the government bailout and the exit environment is as slow as it has been anytime in the last 30 years . In a nutshell, our economy is undergoing a substantial realignment that is leaving the weakest to be killed off quickly by the consummate predator – the global financial community (Thomas Friedman’s so-called "electronic herd”). The casualties have included most facets of the American economy, including financial institutions (Bear, Merrill Lynch, Lehman, WaMu), big corporations (Automakers, Linens ‘N Things, Circuit City), millions of households and, yes, the government, which is watching corporate tax revenue evaporate while the cost of providing life support to the ailing economy is climbing.

The Bad: Venture Market – An Innocent Bystander
While the industries in which venture capital firms traditionally invest (IT, life sciences and, more recently, clean technology) are not directly in the line of fire of this economic downturn (as they were in 2000), the venture space has and will continue to be adversely affected.

An investment banker I know recently stated his view that it will take at least six months for our economic wizards to be able to quantify the size of the financial correction; we don’t even know how bad it is yet. Uncertainty drives corporations and consumers alike to hedge all bets by cutting their spending on everything from advertising to autos. As pockets tighten, it becomes more difficult for companies (whether B2B or B2C) to generate revenue, creating the need to reduce costs or take more capital from investors.

Unfortunately, right when companies need the investment community’s support, venture purse strings will be tightening. There are a few reasons for this conservatism. First, later stage investors (the growth stage venture firms) know that companies that they invest in today won’t be able to exit as quickly as they once might have because the public markets are sick and the corporate buyers are conserving cash until they understand how bad things are going to get. An increased time to exit means lower effective returns.

Second, many VCs expect growth stage capital to become less accessible (for the reasons described above) and, as a result, are increasing their capital reserves for their portfolio companies.  VCs hope to fill part of the follow-on financing gap, enabling their companies to stay afloat while holding out for growth capital. While this is good for portfolio companies, it does mean fewer deals in the portfolio. VC funds are fixed in size, therefore allocating more to each company generally means fewer new investments.

Third, some limited partners (the investors in venture funds) are reducing their allocations to venture capital, despite the fact that venture capital traditionally performs well in recessionary market environments. With the net asset value of nearly all liquid assets devastated by the market crash, many limited partners are now experiencing what is being referred to as the “denominator problem.” For example, if an institution had originally planned to have 10% of its assets in venture, the decline in value of the other 90% of its assets effectively increases the percentage of the portfolio that venture capital represents. An LP may have seen the percentage of his/her assets in venture capital increase from 10% to 14%, leading him to pull away from the very asset class that is likely to provide the best returns in this environment. The magic of this math is that it encourages LPs to invest more in the most troubled asset classes, not the healthiest. While some LPs will follow this logic and cease to make investment in venture until the value of their other holdings rebounds, others will invest more in venture because the fundamentals of the venture sector are even more attractive now. Without new commitments from LPs, there will be less fresh capital coming into venture funds. The net effect is likely to be fewer investments at all stages of the venture market.

In sum, revenues are going to be lower and less capital is going to be available. This of course leaves entrepreneurs with one option: reduce costs. Coincidentally, reducing costs often means making layoffs, exacerbating the downward spiral of consumer spending. It’s hard to buy Christmas gifts without a job. Additionally, the decline in capital means that valuations will drop substantially–a trend that is already visibly taking hold in the market. Times in the venture world are challenging. As any good entrepreneur knows, however, change creates opportunity.

The Good: The Weak Will Die Quickly; The Strong Will Win Big
In this new economic environment, access to capital will become an increasingly important differentiator. If venture investing contracts substantially, a strong balance sheet will no longer simply be a means of staying with the pack, it will increasingly become a substantial advantage, enabling some companies to get way out in front of their competition. While many startups are deploying limited resources, trying to manage costs and weather the storm, the few well capitalized players in each market segment will be positioned to invest for the future, laying deep roots into their markets that can support rapid growth with the drought ends. Furthermore, as layoffs continue to take place at the corporate giants (such as American Express), startups that are well capitalized will have an opportunity to hire high caliber people now looking for work, increasing their advantage and mitigating the human capital constraint that traditionally plagues new ventures in booming economies.

This is a virtuous cycle for the winners. As competition becomes more polarized, the leaders will eat even more of the laggards’ lunch making it even more difficult for the back of the pack to compete. Customers naturally gravitate towards the financial stability of the winners and in tight economic times the second tier players may not be able to reduce their margins to win over the more price sensitive buyers, limiting their means of catching up. These dynamics will likely kill the weak off more quickly, enabling the winners to more quickly separate themselves from the pack.

While I believe the frontrunners will come out of this downturn positioned to win big, the story isn’t entirely bleak for the second and third tier players. Once the end of the downturn is in sight, corporations will likely exploit the financial woes of startups to make low cost acquisitions. The hunters will be coming. For some entrepreneurs this could yield decent (if not life altering) returns.

Conclusion
There is no doubt about it—times are tough for the overall economy and that has, and will continue to, impact the venture marketplace. The companies that are not going to succeed will likely discover their fate more quickly (a blessing in disguise), the companies that might have otherwise squeezed by in a better economy should be sure the corporate sharks smell their blood and the winners should be opportunistic and cautiously thinking big. In sum, I think it’s a great environment for the best entrepreneurs. While at today’s valuations it will likely cost founders a pound of flesh to acquire the capital they need to win, they’ll be able to turn a pound of flesh into a mountain of gold.

The J-Curve Is Becoming A Hockey Stick (In The IT Sector)

 In my post, The J-Curve: The Evolving Value Of A VC Portfolio, I describe the two factors that create the perception that a VC’s portfolio loses value before demonstrating value creation: unsuccessfully companies shutting down quickly and a delay in re-valuing successful companies. However, it appears that the companies poised to fail aren’t shutting down as quickly as they have in the past.

The speed at which they close shop is partially a function of the VC market. When capital is easier to acquire companies can be kept on life support for longer periods of time. However, as the venture capital market continues to cycle in and out, the companies don’t appear to be failing as quickly.

My assumption is that this phenomenon is tied to the declining cost of technology. Technology costs have continued to decline as open source software has become more robust and widely available, and the costs of bandwidth and storage have plummeted. During the boom every startup owned servers. Hosting is now outsourced to companies that realize the benefits of scale and can provide those services at much lower rates. Similarly, writing code was at one point done in 1’s and 0’s, but has now been simplified by languages and platforms that expedite programming.

As tech cost have dropped, startups have been able to maintain lower and more flexible burn rates. When times get tough, startups strip down to their core teams and make the money last much longer.

This behavior ends up impacting the J-curve. If poor performers don’t close their doors relatively quickly, the value of VC portfolios may not decline before the successful portfolio companies have their valuations marked to market through a subsequent investment round. This appears to be flattening out the bottom of the curve, creating more of a hockey stick shape.

Unfortunately, changing the shape of the J-curve probably won’t affect actual returns much (unless a second chance is really all some of the would-be-failures really need). However, it does point to an important operational consideration for VCs; they may sit on the boards of companies that will eventually fail much longer than they used to.

VC Fund Lifecycle: Harvesting

The third and final stage of a VC fund takes place when the majority of the surviving portfolio companies begin to prepare to exit. This stage is typically referred to as the harvesting stage.

During the harvesting period VCs will be working with their portfolio companies to prepare for acquisition or an IPO. VCs help in this process by working with management to continue to refine their operations (processes, corporate governance, etc), evaluating investment bankers and making introductions to potential acquirers.

In some instances, the portfolio companies may not be poised to realize an exit in a timeframe that meets the needs of its investors. Prevailing economic conditions can limit exit opportunities. In these scenarios, VCs might engage in secondary transactions where they sell their ownership stakes to other investors. While these are generally relatively complicated transactions and not the preferred strategy for VCs, they can provide liquidity in a manner that is good for investors and the company.

While exits might be realized throughout the fund lifecycle (even before the investing and growing phases are complete), this stage of the business typically takes two to four years.

The J-Curve: The Evolving Value Of A VC Portfolio

The value of a venture capital fund’s portfolio typically falls below the value of the invested capital before increasing to provide a positive return. For example, if a VC invests 100 dollars, it’s likely that the VC fund will be worth only 80 dollars (according to the accountants) shortly after the investments are made. Eventually, if all goes as planned, the value of the portfolio will increase be 200 dollars (or more), creating a curve sort of shaped like the letter “J”. As a result, this phenomenon is commonly referred to as the J-curve.

This short-term decline in value is created by two factors:

First, historically, accountants have only changed the value of portfolio companies when they take a new investment at a new valuation. While, in theory, the value of a successful portfolio company is constantly increasing, the value was only changed on the books periodically - at the time of a valuation event. Since portfolio companies typically raise additional capital 12-24 months after their first investment, their valuations were not updated frequently. More recently, accounting rules for private companies have changed to encourage VCs to adjust valuations more frequently, commensurate with significant developments for portfolio companies. Even so, accountants and VCs tend to be conservative in their valuations of successful portfolio companies.

Second, companies that don’t succeed have traditionally shutdown relatively quickly. They burn through their cash and are unable to raise more money since they haven’t demonstrated enough progress.

As a result, less successful companies are written down or off quickly before the successful companies are re-valued, creating a distortion that appears to be a loss of money.

Who Invests In VC Funds?

The National Venture Capital Association (NVCA) recently released report that details where the money invested in VC funds comes from.  I have pasted one of their charts below that breaks down the sources of capital that VCs invest. 

I think it sheds some light on how the VC 'capital supply chain' works and will help illuminate my post about the market for investable capital.

The Longtail Of Venture: Why Some Companies Will Continue To Need VC And Others Won't

There has recently been a lot of discussion in the venture community about the declining cost of starting an IT company. Lots of very smart and thoughtful VCs have written about this topic. Here’s a link to one popular article on the subject.  However, there seem to be two contradicting viewpoints in the market.  One that arguing that traditional early-stage VC will die out, another that indicates that the early-stage VC market is improving.  This is my attempt to rationalize the two perspectives.

Underlying Causes
While I think the various pundits have identified the presence of companies that do exemplify lower capital needs, there seems to be limited exploration into all the trends that are driving this change.

Two underlying causes of this phenomenon are the declining cost of developing technologies and acquiring customers.

The cost of developing technologies has declined, as:

• Software design tools have become more advanced,
• Hardware and storage costs have decreased, and
• Infrastructure companies (e.g., hosting services) have realized increasing scale, reducing costs and improving quality.

The cost of acquiring customers has also declined, as:

• Web 2.0 services (e.g., Facebook, del.ico.us) have made it easier for customers to recommend products, and
• Internet-based advertising channels have become more targeted, track-able and dependable.

Who This Affects
While most software and Internet companies benefit from the declining infrastructure costs, not all business models equally benefit from the changing marketing costs. Specifically, models leveraging the Internet as their primary channel for customer acquisition benefit more from this trend than models which require sales personnel, as is common for companies selling to enterprises.

Anecdotal Evidence
Before I continue, I want to point out that my conclusions about the situation and the conclusions drawn by others appear to be based on anecdotal evidence. So, take my perspective with a grain of salt. Nonetheless, I hope this viewpoint will provide another chapter in the on-going dialogue on this matter.

A Potentially Superficial Contradiction
I have spoken to a handful of other VCs about this matter recently and there seems to be some consensus that there has been no decline in the number of IT ventures that require substantial capital. Put another way, VCs are still seeing lots of companies seeking full Series A, B and C rounds. These companies need to purchase considerable advertising inventory, employ sophisticated staff to perform critical functions and build a strong business development team in order to secure partnerships with other companies. Those expenses accumulate, creating a need for multi-million dollar investments.

Furthermore, it seems likely that the need for capital is here to stay. Marketing costs are likely to increase as ad dollars continue to migrate to the web. Wages also continue to rise and we have yet to replace business development executives with software. So long as these cost centers exist there will be a need for venture capital.

On the surface, this conclusion seems to contradict the vision of pundits who expect the need for traditional levels of capital infusion ($2-5MM Series A rounds) to disappear over time.

While the evidence that I have heard for both sides of this trend to date has been anecdotal, both arguments seem reasonable and compelling. As a result, I began to wonder whether the trends seen by both camps are correct. I asked myself, “Do these trends have to be mutually exclusive? Is this a zero sum game?”

The Longtail of Venture: An Attempt to Rationalize
In an attempt to rationalize how the venture market could have both a consistent number of startups with traditional capital requirements and a host of new startups with less robust capital needs, I developed a hypothesis on the matter that appears to support both trends. I believe that companies that do not need traditional venture capital investments make up the longtail of venture.  For simplicity, I am going to refer to these as the venturetail going forward. The fact the venturetail exists does not implicitly mean that all companies need less capital. It is possible that venturetail companies are being started in addition to companies that have traditional capital requirements.

[Diagram]

My intuition tells me that there are two reasons why lower costs lead to more companies being started. First, some of the Internet companies being launched may not have been profitable endeavors when startup costs were higher; with lower costs more business models are economically viable. Second, the risk associated with these ventures has declined, enabling entrepreneurs who don't want to 'stake it all' the opportunity to pursue a startup in their free time or without betting the house.

The venturetail represents, in my hypothesis, a new class of companies that is comprised of both:

• Companies that would have been pursued when costs were higher but are now benefiting from substantially reduced costs, and
• Companies that were not economically viable in past (costs were too high to generate a profit).

If this intuition is correct it supports the idea that venturetail companies have not displaced the traditional companies, rather, the venturetail companies are being launched in addition to traditional startups.

In sum, it seems that the presence of companies that require less capital doesn’t seem to negate the need for venture capital. Rather, it’s possible that a new class of startups has emerged that will be served by a different venture model. 

[Diagram]

It's unclear exactly how this market will evolve.  However, my hope is that this hypothesis will help to rationalize some of the latest market trends.