How Long Will This Downdraft Last?

"Nobody told me there'd be days like these
Strange days indeed, strange days indeed"
                    -- John Lennon

I have written on several occasions about the likelihood of a
correction and pull back in the venture market. I've also said that it
will be triggered by a correction in the stock market which drives
companies, in order to protect stock price, to slash costs and capital
expenditures. It works like a clock. It happened in 1987/89, 1991,
1999/2000 and now.  The good news is there is no mystery to this. The
bad news is it just hit full force over the past two weeks.

While
forecasting is next to impossible, it is pretty clear what this cycle
is going to look like. This is the first credit driven correction in
our modern history. All of the other ones were triggered by the equity
markets collapsing. Why is this important and what does it mean regarding duration?

Credit
is the oil that greases Main Street. Companies hit the equity markets
from time to time to raise capital. So when it shuts down due to a crash, firms can generally manage status quo using cash flow or their
debt facilities (working capital lines, equipment lines, etc) to get
by. However, a credit crisis is different. Companies use their credit facilities on a daily basis to
fund equipment, inventory, receivables and facilities. When credit
contracts, their businesses contract. They can't buy the equipment they need, fund inventory for
product to sell and such. This means that this is going to be longer
and harsher than before. The last credit driven crash was in the Great
Depression when all of the banks started to go under.

In equity
driven situations, investors need to feel that prices have gotten low enough and they will come back in (fear turns to greed). In
credit driven crashes, the whole system needs to "de-lever" and the process is longer and more complicated. The core issue is that families have too much debt. So, the debt needs to go away to fix the problem. Unfortunately, because of cheap debt, poor oversight and
general greed, this debt party has gone on way too long. Consumers are
underwater on mortgages and credit cards and the government is
approaching the trillion dollar nut. Fortunately, corporations are generally not as bad off though some will get into trouble.

So, how difficult and time consuming could this possibly be? Wipe out a large chunk of debt to get it to an acceptable
level and move forward. One little issue: this would bankrupt all of our
banks and send us into the mother of all black holes. So, how do you wipe out this debt without wiping out our banks. You have to do
it gradually. People and firms use cash flow and savings (remember that
concept?) to pay off debt  while cutting back on consumption. A number of families will be so underwater that a Chapter 11 elimination of their debt is the only way out. With each Chapter 11, the banks will become weaker (reduced lending capital base) and the
government will have to repeatedly step in to "recapitalize" the banks to keep
them solvent. This is why we see infusions, nationalizations,
guarantees and such hitting every month. The bad credit card debt hasn't hit hard nor other types (student loans, etc) so we are going to have a series of these crises rolling through the system. Credit will get harder to obtain as the banks increasingly experience these challenges.

Having consumers save is a good thing, isn't it? Yes, but when people save versus
spend, the economy contracts, putting more pressure on the debt loads as unemployment grows and less capital circulates through Main Street.  You reverse the trends from the past 10 years. Instead of borrowing to spend, consumers will be saving to pay down debt. However, as Japan showed, getting this debt down to acceptable levels can take 7-10 years.

They referred to this process in Japan as the "Lost Decade" in the 1990's. Jim Rogers has said that if we don't take aggressive steps and let institutions fail and accelerate the downdraft, we will see a "Lost Decade" in America as the government tries to orchestrate a softer "de-leveraging" process. Who knows…

Ironically, while this is painful, it is actually a very healthy process. It is eliminating excessive waste and spending. It is encouraging saving and adding fiscal discipline back into the picture. It also rewards well run, efficient firms and prunes the weak and incompetent. This is not the end of the world as some may espouse but it will be tough going for the next number of years.

As with the tech bubble, I believe that we will have 2-3 years of hard sledding. Sales will take longer, marketing budgets will contract and technology expenditures will be slashed. This assumes the government is able to stave off a nuclear meltdown scenario in which case, all bets are off. After the hard sledding, we will have another 2-3 years of modest growth. In year 5 or 6, firms and people will grow more confident and growth will accelerate.  So, entrepreneurs will have a good 5-7 years to build out their businesses and prepare for the next updraft. When this hits, there will be few competitors and a lot of money will be made. The key is being the last man standing.

The next post will be a synopsis of the various VC strategies to their portfolio companies to survive this 5-7 year period.

“Why aren’t VCs freaking out as Wall Street burns?”

Interesting Piece from PEWeek:

"Why aren't VCs freaking out as Wall Street burns? It's a question that I've been asking for more than a week now. There is, of course, the usual litany of responses: we're long term investors, we invest in fundamentals, our LPs are going to be good for their commitments because they're so big and so various….

Then there's another train of thought: VCs and their portfolio companies have actually gotten smarter about business since the dotcom bust. I've identified a few ways VCs and their companies are doing business differently. Help me out, identify a few more.

1. Better Money Management: Milestones matter to VCs. Ask any entrepreneur, and you'll find it's likely he or she are getting money in tranches based on deliverables. Most tranches go through, even when milestones aren't met, but the process allows VCs a better way of keeping track of the progress of their portfolio companies. VCs are less likely to write mega checks in the early stages, many have raised the bar of proof points needed to get a big round. Money is also more likely to go to things that directly drive valuation increases as a smaller percentage of any round is going to PCs, servers and bandwidth.

2. New Sales Models: It used to be about "Big Game Hunting" and multimillion dollar site licenses. It's a model that was great for vendors: get all the money up front, then worry about delivering the product. But Software as a Service permanently transformed the way IT was sold. Now new installations are cheaper and can be scaled slowly. It's a model that's been adopted by IT appliance and PC companies as well. So when Datamonitor finds that IT budgets aren't going to rise in 2009 Datamonitor Survey , there's less reason to freak out. Most IT buyers have already planned their spend out: it'll be re-upping on the services they're already subscribed to.

3. Decreased Addiction to Advertising: The banner ad was a big part of any dotcom business model. When advertising budgets fell, hundreds of online businesses shriveled on the vine. Now, online businesses look less to online advertising for real revenue. Google Adwords had a big hand in that. Suddenly it was a lot easier to install advertising on your site, but it was also less lucrative. Nobody ever got rich putting up Google Ads, but at least using the service saves companies from having to hire expensive advertising sales people. The addiction to advertising has been broken and many companies are looking for other ways to make real value online.

4. Moderate Exit Expectations: If you're not looking to flip a startup to the public market, what do you care that Wall Street's investment banks are falling like dominos? Had this same crisis had happened 10 years ago, you can bet VCs would be pulling their hair out. But when there are already no IPOs, it's hard for the public market to get worse. When exit expectations are more reasonable, it's easier to keep cash burn in check. Startups are less likely to build out sales teams, for example, planning perhaps to later plug in to an exisiting sales organization via aquisition.

What else have you learned from the dotcom bust that's helping out now?"

What Does This Mess Mean to Start-ups

Having been through two market cycles already, I have been waiting for the credit mess to filter down into the start-up world. To date, this effect has been minimal compared to that impacting Wall Street and the buyout world. I would expect this to change in the coming 8 months. The question is how it will happen, to what degree and what are the signs.

I will start off by saying that I am not a great prognosticator. The best I can do is explain how it has manifested itself in the past. So far, we have been buffered by the massive liquidity the Fed has poured into the market, pushing off the onset of a strong recession. When trouble hits, it will come in three areas. First, corporations cut back on capex. Second, corporations cut back on advertising and marketing. Third, corporate acquisition appetite wanes or grows more predatory in nature. The IPO also usually dries up, but that has tepid even during the recent upswing.

What usually triggers the pull back? While there are a wide variety of factors, the one consistent factor I’ve noticed is when corporate profits begin to decline, especially when they miss guidance on the Street. This causes stock prices to drop. Management looks to cut costs aggressively when revenue growth slows and they are watching their options go underwater. Marketing & advertising is one of the first to get cut back. This has been happening gradually over the past 12 months but has not hit with full force. When CPM rates plummet and key word buys shrink, you’ll know things have begun.

Additonally, Capex shrinks and decision cycles stretch out. Enterprise sales become painful. Software, hardware and large service deals all become more difficult.

Lastly, firms will increasingly find it hard to find suitors to buy their businesses. While the market is not as robust as last year, there has still been modest activity this year. Eventually, it will feel like there are no buyers for your firms or the terms that the buyers are throwing out are very predatory. We have not gotten there yet.

Now, it is possible that the Fed will continue to pump so much money into the system and the government will continue to bailout institutions that we never get to this ugly phase (until much later). However, credit card defaults haven’t hit, regional banks haven’t been going under so there are still several chapters to play out here.

While this may be helpful in understanding where we might be in the cycle and what signs to look for, the main question is “what to do”? This is fodder for an upcoming post…

Worst of Times, Best of Times

"It was the best of times, it was the worst of times, it was the age of
wisdom, it was the age of foolishness, it was the epoch of belief, it
was the epoch of incredulity, it was the season of Light, it was the
season of Darkness…"
— Charles Dickens, Tale of Two Cities

While I wrote about my concerns on the coming part of the business cycle, I am actually quite positive about the flip side of this coin. These periods are not kind to existing portfolio companies, but create a very attractive environment for new venture investments. I believe that 2008, 2009 and possibly 2010 will be good VC vintage years. Some of the crazy pricing and activity we have seen over the past year or so disappear and more rational investing takes its place. These times are actually, I would argue, also positive developments for well managed companies.

1) fewer competitors are started
2) weaker competitors go out of business
3) Darwin forces efficiency and laser like focus in your business
4) this discipline continues on when markets open back up, making for more profitable exits
5) less capital consumed means more equity for the founders in the end

Sectors that do well are those with low average burn, those focused on performance (e.g. pay for performance models) versus "productivity" or intangible benefits, and those selling into less recession sensitive customer bases. Life is tough if you sell capital equipment, have asset intensive businesses, have high burn, have impression based ad models or sell into recession sensitive industries. You are going to see a lot of dead Web 2.0 companies that rely on advertising for their revenue.

TechCocktail Conference Chicago

Eric Olson and Frank Gruber are launching their first TechCocktail conference in Chicago this week on Thur, May 29th at Loyola University. You can register by clicking here. They have pulled together a great set of panelist including Dick Costolo from FeedBurner/Google, Jason Fried from 37Signal and a host of other luminaries. They have also thrown in a VC panel which I’ll be on with Brad Feld, Kirk Wolfe, Rob Schultz and Bruce Barron. If you can make it, it is definitely worth attending.

So You Want to Be a VC

"…it’s more about people skills and the ability to assess whether there’s a market for something."
  — Dick Kramlich, co-founder NEA

I was cleaning out my files the other day and came across a 2005 NYT article by Gary Rivlin on the venture industry titled "So You Want to Be a Venture Capitalist". It is well worth a read for any of you inspiring investors. Couple of takeaways from it:
— "Below the surface, there’s a huge amount of turnover."  I did not realize the degree of turnover at some firms, including 70% partner turnover at NEA (1997-2005) and 70+% partner turnover at Kleiner (1997-2005). Some is due to poor performance and other is due to strong performance and retirement.
— Up or out. A large share of a fund’s profits are often driven by 25-30% of the partners. This is a true meritocracy and the results are clear to quantify. Over half the partners will fail in the bigger picture.
— Entrepreneurs have a hard transition to the investing side despite the large trend towards this.
— Success is driven by being a good judge of people and for understanding when markets are getting ready for inflection. "you’re a natural athlete or you’re not"
— It is a mentoring business with a long gestation period…"probably 6-8 years and you should be prepared for losses of about $20 million (per person)".

One last point that the article doesn’t mention is that the entry period can be grueling. It is not as rosy as most people on the outside assume. 60% of a good fund’s deal will lose money or breakeven. The losses come early and winners take time to compound. So, sometimes you have years of carnage while being out in the wilderness hoping for the hits to come through.

"By all rights Stewart Alsop should have been a terrific venture capitalist. So why did Mr. Alsop, long considered a cyber-prophet among technology leaders, wash out in a profession in which he seemed predestined to succeed?

In recent months, as venture capital firms have announced the formation of new investment funds, a hot topic among the Silicon Valley cognoscenti has been the exodus of "tourist V.C.’s," as people from nonfinancial backgrounds are known here. Some have left the field because they did not pick enough winners; others have gone on to pursue different projects. Whatever the reason, there are hundreds fewer venture capitalists around today than just two years ago…." (click here for rest)

It’s for the Dogs

The nice thing about doing angel investing on the side is that I can invest in fun, if not wacky, ideas from time to time. I put a little money into a friend’s (John Funk, wonderful serial entrepreneur) IP incubator called Evergreen IP. His partners come out of the CPG world and they have licensed an array of innovations/patents and are now bringing several to market. One of these is the Dog Pause Bowl (www.dogpausebowl.com) which is targeted at obese dogs or dogs that eat too quickly. Look out Weight Watchers… He describes this better than I in his post "We Have Liftoff!".

Video Tsunami Coming

I was looking at the global statistics page at the back of the most recent Economist Magazine and noticed that it had a chart laying out the % of households in each country that use IPTV (internet) as their primary means of getting their television services (vs. cable, satellite, etc). Below are the top 7 countries on the list:

Hong Kong 31%
Iceland 27%
Estonia 10%
France 10%
Cyprus 10%
Sweden 8%
S Korea 7%
(US <1%)

Much like cellular has leapfrogged land lines as the primary telecom pipe in developing countries, many countries are going with IPTV as a prominent source of distributing content. Homes can get both internet access and video/TV delivered through one pipe. We have seen this phenomenon up close through our Growth Fund’s investment in UUSee, the leading IPTV P2P provider in China with over 30 million users.

In addition to this IPTV trend, we are also seeing videos come at us from the hosted video sites like YouTube, Metacafe and specialized channels like Celebtv. My kids are watching entire episodes of their favorite shows on the show’s website. While people complain about having too diverse a choice through the hundreds of cable/satellite channels, imagine the complexity when thousands of IPTV channels emerge. With the low cost of production and low cost of distribution, people will be able to set up extremely niched “channels”.

This will create quite the challenge for advertisers, who are still trying to figure out how to use banner ads. Instead of a simple decision of what image to put in a banner that is broadcast out, they will have to figure out if they want to use pre/post roll advertising, sponsored advertising, contextual text links beside videos, overlays on top of videos or jump into the creative game and produce content itself. The permutations of types of content with types of channels is becoming mind boggling. However, for creative lead gen players, this will present a terrific opportunity to capitalize on the complexity and the glut of ad inventory arising.

Of course, this doesn’t begin to get into the challenges of integrating cross-media promotions (text/SMS, website, etc) or the rise of mobile advertising. It’s going to be a great couple of years here as the IPTV revolution swings through!

The VC World Inflates as Well

Following up on my post on the buyout world, the VC world has also experienced valuation inflation over the past year. As more and more liquidity comes into the sector (mostly acquisitions), VC’s are beginning to feel bullet proof again. We are starting to see VC’s promising entrepreneurs $80m and $90m pre-$ valuations if they can get some proof points in a given area (we’ll see if they come through). Since venture does not use much debt, the debt crisis has not hit home yet (it will should the economy go into recession and ad budgets and cap-x budgets get slashed). If you want to get a sense of what is driving the increasing craziness, check out some members of the asylum. Slide at $550m and Rockyou at $325m??? While we have several on here (and fingers crossed they hit Henry’s values!), I scratch my head a bit. While not the extremes of 1999, there are a lot of $’s for eyeballs (or "attention" as it is now called these days). Here is Blodgett’s estimates of property values:

THE SAI 25: THE WORLD’S MOST VALUABLE STARTUPS

Rank
Company    Valuation
1.    Facebook $9 billion
2.    Wikipedia $7 billion
3.    Craigslist $5 billion
4.    Betfair $5 billion
5.    Mozilla Corp $4 billion
6.    Yandex $3 billion
7.    Webkinz $2 billion
8.    LinkedIn    $1.3 billion
9.    Habbo    $1.25 billion
10.    Oanda    $1.2 billion
11.    Linden Lab $1.1 billion
12.    Kayak $1 billion
13.    QlikTech $850 million
14.    Ning $560 million
15.    Slide $550 million
16.    TheLadders $500 million
17.    Stardoll $450 million
18.    Ozon $450 million
19.    Thumbplay $400 million
20.    Glam Media $400 million
21.    Rock You $325 million
22.    Tudou $300 million
23.    Efficient Frontier $275 million
24.    Zazzle    $250 million
25.    Spot Runner $250 million

Contenders
Federated Media    $245 million
Yelp    $225 million
Meebo    $220 million
Indeed    $200 million
Zillow    $200 million
LoveFilm    $200 million
Metacafe    $200 million
Adconion    $200 million
4INFO    $175 million
Photobox    $150 million
Vibrant Media    $150 million
Gawker Media    $150 million
Mahalo    $150 million
56.com $150 million
Youku    $125 million
Digg    $125 million
Etsy    $115 million
LinkExperts    $100 million
Powerset    $80 million
Trialpay    $80 million
Huffington Post    $75 million
Associated Content    $65 million
Live Gamer    $60 million
Twitter    $75 million
Mint    $50 million
Prosper    <$50 million

Didn’t They Learn from 2000?

Daniel Primack wrote a great piece on the continuing insanity in the buyout world. It is amazing that the writing is clearly on the wall and is nearly identical to the venture world in 2000 and yet the LP’s and funds continue unabated. VC’s kept raising massive funds even though it was clear that the liquidity engine (IPO’s) had died. This capital festered in the funds and either a) was returned or b) was pumped mindlessly into misguided companies. With the credit markets down, the LBO world has lost its primary liquidity engine (dividend recaps, etc). So, I am amazed that LP’s are going along with these funds doubling their size. More on the Venture cycle version of this soon…

Warburg Follows the Herd
Warburg Pincus yesterday announced that it has closed its tenth fund with $15 billion, or nearly twice what it secured for its ninth fund in 2005. It’s also $3 billion more than the firm was targeting when it began fundraising last May.

This certainly fits the recent mega-firm pattern, in which Bain, KKR and others have raised record amounts despite a paucity of new deal opportunities. Fee today, call-down in a few hundred tomorrows (unless they spot a problematic PIPE or cratering leveraged loan portfolio).

I had really wanted Warburg Pincus to help retard this trend, which skates the thin line between optimism and greed. Few other firms exude the same spirit of independent thinking – having been an early adopter of globalization and stubborn defender of transacting both massive LBOs and early-stage venture deals out of the same fund. If there was any firm willing to stand on objectivity, it would have been Warburg.

But, alas, it was not to be. Maybe I should have been stripped of my delusions when Warburg propped up MBIA, in a bid to replicate its long-ago success with Mellon Bank (Question: Did LPs who came in on the final close get some sort of discount?). I guess Warburg is willing to stand apart, but not too far apart.

So Blackstone is the now the only fundraising firm left with enough gravitas to help stem market overcapitalization, but looking to Blackstone for moderation is like looking to the Boston Bruins for a Game 7 goal. Sure a few big firms will claim fundraising sanity, but beware the difference of intentional and unintentional fundraising scale-back (yeah, I’m gazing toward Chicago)…

Warburg Pincus would likely respond that it has a flexibile enough investment strategy to handle macro-economic fluxuations, and that it’s investing for the long-term (Note: It declined to comment for this piece). Fine, but it’s a specious argument.

How can any private equity firm claim that it requires the same amount of money today that it did in May 2007? Even if Warburg plans to do the exact same number of deals, many of them will require less cash due to decreased valuations. In fact, the only reason Warburg was raising more money in the first place was because the private equity targets were getting larger and more expensive. Doesn’t what goes up also go down?

Finally, it’s worth emphasizing that LPs share much blame for this fool’s goldrush. I keep hearing investors complain about 2008 fund sizes and strategy drift, but then learn that Warburg got its highest-ever level of LP re-ups. If you don’t want mega-firms raising so much money, then don’t increase your commitments. It’s just as simple as it sounds…