A crisis in venture capital

Cash-burning portfolio companies, dissent among co-investors and a tepid response to fundraisings are making life difficult for venture capital firms. We speak to key players about the industry's future.

Venture capitalists are usually thought of as an optimistic – almost gung-ho – lot, but there isn’t a great deal to be gung-ho about at the moment.

According to research from Business XL, venture investment in the UK has shrunk from almost £2 billion in 2006 to an estimated £750 million this year. As the recession hits firms’ existing portfolio companies, they have to reserve more of their cash to support those investments, letting new opportunities pass by the wayside.

Exits are difficult – especially those spectacular exits that in the past have made up for less successful punts. Even with their knack for accentuating the positive, investors themselves have to admit that these are lean times.

‘VCs are finding the business very long-winded at the moment,’ says Jon Moulton, who sensationally quit Alchemy Partners, the private equity firm he founded, as we were going to press. ‘There is no easy route to a public market, trade sales are not simple and very often an investor is put in the unpalatable position of having put £10 million into a company that eight years later is only worth £10 million.’

Raising new funds has become a problem. Ted Mott, CEO of Oxford Capital Partners, confirms, ‘Less money is flowing into all kinds of venture funds. Early-stage, late-stage, development stage, whatever stage – all are suffering.’

Damp squib

Though some players have achieved excellent results, overall returns from VC investing, as reported by the British Venture Capital Association (BVCA), are poor. As an asset class, venture has returned 0.6 per cent per annum in the five years to 2008. If you go back ten years, thanks to the fragile euphoria of the dot-com boom, that figure turns negative. Buy-out funds, on the other hand, achieved double-digit annualised returns over both periods.

It’s a bleak picture for anyone trying to make the case for investing in young, innovative companies – as Moulton says, ‘Over any reasonable period of time you’d be better off with a Northern Rock deposit.’

Simon Walker, chief executive of the BVCA, argues that venture is still suffering from the fallout of the dot-com crash, and indeed the data provides some justification for his view. Funds raised after 2001 have done modestly better than their predecessors, returning an annualised 2.7 per cent over a five-year period, compared with minus 0.3 per cent for the period prior.

‘The most pressing concern [for our members] is the reluctance of some institutional investors to give venture capital another look after their experience during the technology boom and bust,’ says Walker. In a general climate of risk aversion, those burned fingers smart all the more.

Funding dilemma

Charles Armstrong, CEO of enterprise software company Trampoline Systems, has been on the receiving end of the VC industry’s problems. Trampoline raised £3 million in a Series A round in March 2007, the bulk of it from US investor Tudor Group. At the time, says Armstrong, ‘we were being approached by most of the top VC firms, who said they’d love to invest in a year’s time when we were closer to profitability’.

Two years later, when Trampoline went back to the market for funding, things had changed. ‘The whole atmosphere was so different. It wasn’t only a struggle to get funding, but it was also on such dreadful terms that it would have wiped out most of the people who had invested in us right at the start.’ Rather than lay off staff and ‘batten down the hatches’, Armstrong is now aiming to raise £1 million from private investors.

It stands to reason that when funding is in short supply, those with money to invest will attempt to drive a hard bargain. Patrick Reeve, managing partner of Albion Ventures, says, ‘Because the economy is depressed, you can take a more jaundiced and realistic view of [a company’s] forecasts without losing a deal.’ He also hints that there are opportunities to be had by investing in ‘VC-backed companies whose existing investors haven’t got pockets as deep as they’d like’.

Keep it simple

Moulton says that “down rounds”, in which money has to be raised at a lower valuation than in previous fundraisings, are creating particular problems, especially when deals have been structured to give an existing investor preferential treatment. ‘If you have [an existing investor] with a preferential return, the only way to do the round is to wipe out everyone else. Preferential capital structures work very badly in a downswing, which is causing a lot of rows around the industry.’

Indeed, some VCs have been guilty of over-complicating deals, in Moulton’s view. ‘If you can’t work out what the shares of a company are worth, then using preferences and so on is largely a waste of time, especially when you factor in legal costs. It is usually done to protect an artificially high price per share.’

Even where there are no complex structures involved, infighting can still develop between VCs if there are differing levels of commitment or ability to follow on. Fred Destin, a partner in the technology group at Atlas Venture, explains, ‘A lot of venture firms have become capital-constrained themselves, and their ability to follow even good portfolio companies is in jeopardy. You might have two investors with few reserves, and two with good reserves, leading to a misalignment of interests.’

Bright spots

Though the problems facing VCs and the companies they back are formidable, it would be a mistake to paint a picture of unmitigated gloom. Some firms do have money to invest (see bottom of article), and over the summer three UK-headquartered companies – short-term consumer lender Wonga.com, online takeaway service Just-Eat and iTunes challenger Spotify – raised more than £50 million of VC cash between them. All are potentially ‘disruptive’ companies in the classic venture mould.

‘There’s a two-tier market emerging,’ says Destin of Atlas. ‘A few new deals attract all the hype and attention, and it’s the same group of VCs with active money fighting to get into those deals. They are pretty hot, and therefore expensive in valuation terms. Then there is the remaining 75 to 85 per cent of the market – what I call the grey zone. This is made up of existing portfolio companies, which may be interesting but they are not really hot enough for an investor to go crazy about.’

So what is the secret to becoming one of the “hot” companies, the ones that are fought over by VCs? Destin references operating system developer Jolicloud, which has funding from two of the investors in Skype. ‘They’ve been all over the papers making the grand statement that they are going after Microsoft and they are funded by the Skype group. That mixture of a bold story – so bold it almost beggars belief – and a good early-stage funding crowd helps you immediately get the hype.’

Hot sectors

It’s even easier to attract interest if you happen to be operating in one of the two industries that, relatively speaking, are currently in favour: cleantech and life sciences. The two sectors are seeing ‘tremendous’ interest, according to a survey of venture capitalists from business advisory firm Deloitte.

‘With cleantech, the problem is that there’s a shortage of good deals,’ says Moulton. ‘Potentially it’s a large area, one we’d like to see a lot more choice around.’

Reeve agrees: ‘Over the long term, health and the environment are two issues that are not going to go away. For that reason, these are the two sectors we have started to concentrate on more and more.’

Hard sell

Beyond these popular industries and a few exceptional web ventures, would-be innovators are going to struggle to get their pitches heard. But is it just a case of hunkering down for a year or two until the market recovers, or has the global recession delivered a chastening lesson to the industry that will alter it for good?

‘Venture is at a crossroads,’ says Destin. ‘It has been losing money for quite some time, or at best not making that much money. There is concern that there are too many funds out there and that their offerings are not differentiated.’

That note of realism is echoed by Mott of Oxford Capital Partners. ‘The US model of venture capital – where you invest in a company, boost it, list it and get out – doesn’t really work in Europe. We don’t have enough Amgens, Qualcomms and Googles.’

Instead, European VCs need to focus on investments where they can add value beyond the cash, carefully grooming companies to be acquired by an international corporation. ‘That doesn’t mean to say we can’t build [billion-dollar] companies in Europe, but not enough for every VC fund to be happy with,’ says Mott. ‘We need to be pragmatic rather than over-ambitious – we need to be very applied and operational, rather than broadly strategic.’

Moderate expectations

Mike Chalfen, general partner at Advent Venture Partners, says that the key to survival in a post-credit crunch world is to accept that businesses are going to sell for less. It follows that investors need to put smaller amounts of money into more “capital-efficient” companies in order to generate attractive returns.

‘That is how venture has always been done, until funds got very big. The larger the fund, the bigger the company you have to create to make a dent when you sell. That means you have to hold on for the big exit,’ he explains.

Accompanying this mood of moderation, there is a growing acceptance that the state will have an important part to play in venture capital. More than half of the 725 VCs in Deloitte’s survey expect to see increasing public sector investment in the asset class: the figure rises to two-thirds among UK respondents.

Developments such as the launch of the UK Innovation Investment Fund, which is expected to inject up to £1 billion into VCs, have been broadly welcomed and may go some way towards filling the funding gap, though there is a degree of scepticism from Moulton about what he calls ‘the development agency syndrome of dependent companies’. Equally, tax breaks such as those offered by venture capital trusts (VCTs) are vital for driving money towards ambitious companies: Reeve points out that VCTs can take a ‘longer-term view’ than conventional funds targeting an exit after five years.

But though VCs may be rubbing shoulders more frequently with politicians, they’re not going to start wearing ties just yet. Fred Destin of Atlas argues, ‘Venture capital relies on the suspension of disbelief. The industry wasn’t built on forecasts and five-year plans, it was built on backing generally inexperienced entrepreneurs who don’t even know their own limitations.

‘People who call themselves VCs but don’t really like risk earn the market a bad name. That’s not how the West was won.’

Now that’s fighting talk.

Recent VC fundraisings

Fund – close – amount raised

Wellington Partners IV Technology – Jan 2008 – £225m
Kennet III – Jul 2008 – £170m
Accel Growth Fund – Dec 2008 – £290m
Accel London III – Dec 2008 – £320m
Atlas Venture VIII – Jan 2009 – £170m
Balderton Capital, fourth fund – Jan 2009 – £260m
Index Ventures V – Mar 2009 – £300m
UK Innovation Investment Fund – still open – £300m-£1bn

To see a list of top equity providers by number of deals, click here.

Research on venture capital investments from 2006 to July 2009 was compiled by Bureau van Dijk from its ZEPHYR database. Deals had to involve the acquisition of a minority stake in a UK company and were capped at £500 million.

Nick Britton

Lexus Ernser

Nick was the Managing Editor for growthbusiness.co.uk when it was owned by Vitesse Media, before moving on to become Head of Investment Group and Editor at What Investment and thence to Head of Intermediary...

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