The Risk To Venture Capital And Startups From The Financial Crisis

from the capital-calling dept

When I wrote my first post about the financial crisis, I noted that venture capitalists and startups were probably more protected than other areas of the economy, noting specifically that I didn't believe limited partners (also known as "investors" in VC funds) would fail to meet their capital calls. The way venture capital works is that the general partners (the folks who run the fund) go out and raise money from limited partners (LPs or investors), who agree to invest a certain amount. However, they don't just hand over the money. The VCs let the LPs hang onto their money until they need it and make a "capital call." For many of the bigger VC firms, the LPs who make up a large chunk of their funds come from huge institutional investors, such as pension funds and university endowments. I thought it was unlikely that they would fail to make their capital calls, because (a) they're huge and (b) they tend to only set aside a rather small percentage (5% is what I remember being told is standard) to put into high risk investments like venture capital. So, even if they were having trouble elsewhere, it seemed unlikely that they would bail out on the money they committed to VCs.

That might not be true, however. Immediately after the post, I heard from a few VCs who indicated it might be much tougher to get LPs to meet their capital calls than I expected. First, especially with smaller VC firms, the LPs might not be huge institutional investors who can shrug off losses elsewhere. Second, my original statement was before two straight weeks of a tumbling stock market (though it's bounced around since), meaning that the hurt put on the rest of the LPs portfolio may have been much bigger than originally estimated. Finally, while these big institutions may focus on only putting about 5% into high risk offerings like venture capital, they may have just realized that a much larger percentage of their money was already in high risk investments -- it's just that they didn't realize it. Thanks to badly rated collateralized debt obligations (CDOs), many people who thought they had put money in super safe AAA rated investment vehicles, quickly realized that they had actually invested in high risk vehicles. That might make them think twice about throwing any more money after high risk ventures.

And, indeed, that appears to be happening. Firms that are willing to "buy" the obligations to fund VCs are finding strong demand as various LPs look to get out of their obligations before the capital calls come. Unfortunately, there's a pretty small market of folks willing to take on these obligations, so there's a chance that the "fund" that a VC has officially raised, may turn out to be much smaller than they really believe. If an LP is unable to meet a capital call (or simply refuses to do so), the VC firm is basically stuck holding the bag. It effectively means that the size of the fund that they raised is actually smaller than announced. While that can mean fewer investments (especially if the GPs are nervous about their LPs), it can be a lot more disconcerting for startups on the funding conveyor belt. Usually startups go through multiple rounds of funding, which the VC firm bakes into its calculations when doing the initial funding. That initial firm may not lead later rounds (in fact that's rare), but it usually will participate, and now that may be more difficult. That could cause some VCs to push their portfolio companies to sell off or close up shop much faster than they normally would.

My guess is that this is still a temporary phenomenon. After the dot com bubble burst, there was lots of talk about how VCs would have trouble raising new funds, and that didn't happen. The big institutional investors know they need to allocate some portion of their holdings to high-risk/high-return vehicles, and venture capital is always a good place for that bet. Given Wall Street's implosion (and the resulting impact on east coast private equity and hedge funds as well), it's likely that venture capital will still appear as a good long term bet for high risk capital -- perhaps even better than in the past few years when there were suddenly many more options. In the short term, it may be a bit painful for startups (and VCs worried about not actually having the money they thought they had), but it still doesn't seem likely to have a huge impact on Silicon Valley. As for all the headlines you're seeing about layoffs at startups these days, don't read too much into them. A lot of companies are using the market as an excuse to effectively dump underperforming employees in a big "layoff." This way they get rid of the bad employees, and there's no negative connotation associated with the layoff like there might be in normal times.
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Filed Under: financial crisis, venture capital


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  • identicon
    Lonnie E. Holder, 21 Oct 2008 @ 4:58pm

    Venture Capital After the Dot Com Bubble Pop

    Mike:

    I am unclear as to the precision of your statement "After the dot com bubble burst, there was lots of talk about how VCs would have trouble raising new funds, and that didn't happen." According to my memory, and confirmed by Wikipedia, venture capital contracted significantly after the dot com bubble. The Wikipedia article on venture capital includes the following two statements:

    "As a percentage of GDP, venture investment was 0.058% percent in 1994, peaked at 1.087% (nearly 19x the 1994 level) in 2000 and ranged from 0.164% to 0.182 % in 2003 and 2004."

    "...as a percentage of the overall private equity market, venture capital has still not reached its mid-1990s level, let alone its peak in 2000."

    These statements seem to conflict with yours that VC's did not have trouble raising funds. Did you mean that VC's were still able to raise funds, just not to the levels they previously were able to reach?

    reply to this | link to this | view in chronology ]

    • icon
      Mike (profile), 21 Oct 2008 @ 5:07pm

      Re: Venture Capital After the Dot Com Bubble Pop

      Your numbers are off on two points. First, you're discussing VC *invested* not raised. VCs did cut back on investing as much after the boom (for good reason), but they didn't have much trouble raising funds. Second, you're looking at % of GDP which is meaningless here.

      There were certainly some smaller VCs who had trouble, so perhaps on the margins there was less, but the main VC firms had absolutely no trouble raising new funds -- and many of those funds were bigger than any of their older funds.

      I didn't hear of a single major VC fund that was unable to raise a significant new fund (with the possible exception of Sevin Rosen, but... er... there were other problems there).

      reply to this | link to this | view in chronology ]

      • identicon
        Lonnie E. Holder, 21 Oct 2008 @ 5:31pm

        Re: Re: Venture Capital After the Dot Com Bubble Pop

        Finding VC money raised was a bit more of a challenge than spent, but it is available at:

        http://www.nvca.org/pdf/fundraisingQ308.pdf

        The money raised in 2003 was approximately $10.5 billion (http://www.nvca.org/pdf/fundraisingQ308.pdf), versus $19.7 billion dollars spent (https://www.pwcmoneytree.com/MTPublic/ns/moneytree/filesource/exhibits/NatlAggSpreadsheetQ3_2008.xl s).

        2003 Raised: $10.5 billion
        2003 Spent: $19.7 billion

        2004 Raised: $19.1 billion
        2004 Spent: $22.4 billion

        2005 Raised: $28.6 billion
        2005 Spent: $23.1 billion

        These numbers seem to suggest that there were problems raising venture capital up to 2004.

        reply to this | link to this | view in chronology ]

        • icon
          Chris Maresca (profile), 21 Oct 2008 @ 7:01pm

          Re: Re: Re: Venture Capital After the Dot Com Bubble Pop

          VC funds have a 5-10 year lifecycle, and fundraising is often synchronous (e.g. many firms are out looking for money at the same time). It is almost never done on a yearly basis.

          2008 was a year a lot of funds were raising money, and 20 new funds were created in Q2 alone, and VCs raised record levels. Any institutional or other investor that has been around a while knows that a downturn is the best time to invest in startups, but the timing of a downturn might countercyclical to VCs fund raising cycles.

          In the current downturn, VC fund raising was coincidental, but the sill managed to raise record amounts.

          Chris.

          reply to this | link to this | view in chronology ]

        • icon
          Mike (profile), 21 Oct 2008 @ 7:04pm

          Re: Re: Re: Venture Capital After the Dot Com Bubble Pop

          These numbers seem to suggest that there were problems raising venture capital up to 2004.

          Again, not necessarily. VC fundraising isn't a constant thing, but tends to go in cycles. Anyway, again you're looking at it in the aggregate. Do you have any examples of top VC firms that had trouble raising money (outside of the one I mentioned)? I don't know of any, and almost every VC I know said it was still quite easy to raise money post bubble. Most were pretty surprised by how easy it was.

          reply to this | link to this | view in chronology ]

          • identicon
            Lonnie E. Holder, 22 Oct 2008 @ 5:09am

            Re: Re: Re: Re: Venture Capital After the Dot Com Bubble Pop

            Aggregate or otherwise, the numbers for 2003 (I tried to look for amounts raise in 2002 and 2001, and was unsuccessful) seems to agree with the Wikipedia article assessment that venture capital was significantly reduced in the period from 2001 to 2003. Your original statement seemed inclusive of all VC's rather than "top VC firms," which is why I asked the question in the first place.

            reply to this | link to this | view in chronology ]


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