To Prep for Downturn, VCs Turn to Triage

The credit crunch has scared America straight for a few quarters at least. This means that consumers aren’t buying, and corporations are putting spending on hold. As such, venture firms have been sowing panic among their portfolio companies, telling them to cut early and cut often. The resulting layoffs are already filtering through the startup ecosystem.
Layoffs are one thing, but it’s the wholesale shutdown of companies during a downturn that epitomizes the Darwinian nature of capitalism. Survival of the fittest doesn’t just mean that those with cash can eke through. Those with some customers and cash flow, but a smaller market share, will get rolled up into larger portfolio companies, as Faysal Sohail, managing director at CMEA Ventures, proposed on a conference call last Friday. Others will head to bankruptcy — and some will be killed by their backers.
Venture firms ranging from Morgenthaler, which held a meeting of general partners last Thursday to figure out where the firm should allocate its cash in the coming downturn, to Benchmark, which recently announced a new focus on investing in public companies, are figuring out how to move ahead. For those wondering, Morgenthaler is still forging ahead with its focus on early-stage companies. The bad news is, beginning in 2009, we’ll likely see lots of venture-backed startups hit the wall, unable to raise more cash — especially if this downturn is as protracted as many in the Valley seem to think.
Fred Wang at Trinity Ventures says his firm is already planning for lean times and will assess which companies have the chance to make it through. He’s dividing companies up into those that the firm knows will need more capital but fundamentally believes in, those that can continue on without needing new cash and those that the firm should cut.
But Wang won’t be hasty when it comes to cutting investments. During the last downturn Trinity kept up its investments in Speedera (which sold to Akamai in 2005), BlueNile (which went public in 2004) and Loopnet (which went public in June 2006), despite their funding needs, because partners at the firm believed in those businesses. This time around he doesn’t know what percentage of the firm’s investments might be affected, but he compared the process of decision-making about further investments to playing cards.
“It’s a little bit like poker in the sense that if the company is not burning a lot of capital and the cost of buying a card is low, it’s a little bit easier,” Wang says. “If $1 million buys them another 12 months that’s easy to call, but if the cost of a card is $5 million to $10 million then it’s a lot harder.”
He estimates that we’ll start seeing companies forced to shut down next quarter as funding dries up, and says he believes the carnage could continue through 2009. John Steuart, managing director with Claremont Creek Ventures, which closed a $175 million second fund in September, agrees that we’re in for the long haul. He says since most startups take enough cash for about 18 months, the fallout could continue for about that long, as some companies seek — but are unable to find — cash. Steuart says some 75-80 percent of Claremont’s existing portfolio will need capital in the next year and half.
“We’re now more thoughtful about reserves and are prepared to finance a company without new partners,” says Steuart. But he’s also prepared to pull the plug on those companies that don’t perform, calling it prudent in this new environment. “If something doesn’t work, you’re not going to give it time and extra money; we’re just going to shoot it,” Steuart says. “That was part of the message our [limited partners] had coming to us with more money. They told us, ‘Shoot the losers faster.'”
Instead of the rustle of pink slips, it sounds like Silicon Valley should prepare for the thunder of bullets.
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