VCs Are Tightening Their Belts

December 2008 / January 2009 By: Dean Takahashi Volume 6 Number 6

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Silicon Valley, the recession and how long it is going to last is the subject du jour. Nobody has any answers. We may be in for the worst recession in decades, caused by the collapse of the financial industry. But the tech economy has been healthy. Stalwarts such as Intel and IBM have been reporting better-than-expected earnings. In a tough economy, companies that sell money-saving solutions—€”often the case with technology companies—€”can prosper.
eBay is likely to see used-good sales rise. And the upside: it's a lot cheaper to start a company, hire people and secure office space because prices are falling and there is a lot of talent looking for work.

But that is the pollyanna view. There are reasons why the tech economy and the valley itself are buffered from the effects of Wall Street turmoil. Venture capitalists, for instance, run ten-year funds. There are many more of them than we need. And many of them, including Sequoia Capital, raised big funds this year. They will be able to invest in startups who can fly over the storm. That is, these companies will work on their products in the labs for such a long time that they won't need to depend on a healthy economy for several years to come.

But there are problems with the whole interconnected system of the tech economy. Venture investments fell in the third quarter, according to the MoneyTree Report from PricewaterhouseCoopers and the National Venture Capital Association. VC confidence hit a new low for the fourth consecutive quarter, according to the Silicon Valley Venture Capitalist Confidence Index. There was only one initial public offering backed by venture people in the third quarter, and it doesn't look like there will be any in the fourth quarter. Sequoia Capital itself warned that startups need to cut back on their spending immediately or risk going into a "death spiral." That's because many venture funds have restrictions on their cash. Sequoia can't, for instance, use its newly raised $925 million fund to invest in companies that were funded by its previous funds. Those older funds, which have different investors, have to fend for themselves.

Hans Swildens, head of Industry Ventures, has a bird's eye view of the situation since he runs a secondary fund, or one that buys the holdings of wealthy people or even venture capitalists in a secondary market. He's like a pawnbroker for the rich who suddenly find themselves in need of cash. In the past month, he has seen how the financial collapse has started dragging down venture capital funds.
Private equity funds, which do much bigger deals than VCs, are directly dependent on lending from bankers. So those deals, which often involved mergers, are slowing down, resulting in even fewer exits for venture capitalists.

But Swildens says that VCs are getting hit as well, due to something called "capital calls." Venture funds don't get all of their money at once. They get commitments from limited partners who promise to put money into the fund every year or so. When this "capital call" comes, the investor has to make good on the pledge. But many limited partners—€”such as high net worth individuals, pension funds, or endowment—€”which invest in venture funds are going to have trouble meeting their capital calls because the rest of their holdings have tanked.

If the venture funds can't get more money now, that's a problem. It's almost a certainty that their portfolio startups will need more money because it's going to be harder to get to profitability during a tough economy. So the existing startups will need money. The VCs who have limited partners defaulting on commitments will not be able to give the money. Swildens will buy out some of the limited partners and provide money to the VCs, but it can't shore up everyone. So the money could run dry sooner.

That's why Sequoia is calling for belt tightening at all of its startups. This may even prompt a recession in the tech economy, making a recession a self-fulfilling prophecy. Going forward, it's easy to see more dominoes fall. The tanking financial sector won't be buying many computers. They may even sell off their existing computers, hurting market demand for new computers. That will hurt the information technology sector. Those companies will pre-announce bad earnings, further driving down stocks. The layoffs will come. Valuations of mergers and acquisitions will tumble. Startups who were counting on big companies as customers or acquirers will be disappointed. It is a chain reaction that knows no end until greed once again overtakes fear, entrepreneur Steve Perlman.

Dean Takahashi reports from Silicon Valley for Innovation.