Money Crunch Pressures Startups
First, the lack of liquidity has forced VCs to scale back investment activities, making it more difficult for startups to raise money. Another effect: Valuations of private deals are plummeting, forcing many startups to seek money at a lower valuation than their previous rounds of investment -- known in the startup community as the dread "down round."
For example, many latter-stage optical networking deals last year were getting pre-money valuations in the range of $700 million to $1 billion. Several VCs indicate that the same companies looking for funding now would be forced to accept valuations half that size.
What's driving the market? The Nasdaq Composite, whose plummet has shut down the IPO market and reduced the valuations of most public technology companies anywhere from 50 percent to 90 percent.
Recent data from VentureOne, a venture capital research firm, says that only five venture-backed firms went public in the first three months of 2001, while 40 firms withdrew their offerings.
Things were just as bleak on the merger and acquisition front, with only 75 transactions involving venture-backed companies during the quarter. Worse, though, was the 45 percent decline in what was spent on M&As, VentureOne says. The largest M&A deal of a venture-backed firm completed in the quarter was Ciena Corp.'s (Nasdaq: CIEN) purchase of Cyras Systems (see Ciena Completes Cyras Purchase).
This confirms what VCs already know: The returns on their investments are getting smaller, and the opportunities to get those returns are becoming scarce (see Optical VCs Grow Wary).
In the final quarter of 2000, returns to VC fund investors fell for the fourth quarter in a row, according to Venture Economics and the National Venture Capital Association. And though the venture capital industry saw a 37.6 percent return during 2000, the last quarter's returns were (6.3%), the first negative quarterly return since fall 1998.
For some optical and networking VCs, such numbers mean simply that they'll be funding fewer startups, in fewer rounds, with smaller investments. All the while, their portfolio companies are having to find ways to stretch each invested dollar... or else (see Sedona's Sad Demise and BrightLink Slims Down).
Not everyone sees this as damning. "We're finally seeing pre-money valuations that are in the single-digit millions, as opposed to tens of millions of dollars," says Chris Kersey, a general partner at Blueprint Ventures, which invests in early-stage telecom firms. "The good thing here is that as valuations creep down, then not as much money is raised overall."
In short, this results in less competition, but, in theory, a higher overall level of quality among companies in the market.
The capital crunch puts more emphasis on the financing and business skills of startups: They must be crafty and make do with what they get. In many cases, startups that may have previously counted on an easy IPO or an endless supply of VC capital must now engineer creative financing deals to stay alive. The choice can come down to taking a painful down round or going out of business.
Many startups are downplaying the capital crunch, but the effects can be seen everywhere -- in the number of layoffs and the cost-cutting measures taken to preserve valuable capital. And many companies that had been counting on IPOs have scaled back their ambitions.
"Yes, we may have to settle for a down round, but we don't need to raise that much money," said Bill Diamond, CEO of WaveSplitter Technologies Inc. -- an optical components startup that pulled its IPO -- when asked about the funding environment at the recent OFC trade show.
Some venture capitalists are less sanguine, contending that many of the startups are in denial, refusing to accept money at lower valuations.
"Ultimately, for many companies, it will come down to 'raise money or die,' " says one VC, asking to remain unnamed. He notes that several of the companies that took money at large valuations last year are refusing to lower their sights, jeopardizing their very survival. "There are some companies I wouldn't fund at one-tenth the valuation they received last year."
Many early-stage VCs, including Blueprint, plan to be involved with fewer deals this year. Kersey says Blueprint has gone from a new deal a month to one every two to two-and-a-half months since late last year.
How does this affect liquidity strategies? Kersey figures the one-product companies are more likely to be acquired, while the “platform” companies with several different products will hold out to go public.
Still, even if the road to liquidity dries up even further, good ideas still have a way of finding funding. "Eight weeks after the crash of 1987, when the only sound in the air was of checkbooks slamming shut, Sequoia Capital became the first investor in an unknown company," wrote Sequoia Capital partner Michael Moritz, in a recent issue of Time. "Its name was Cisco Systems Inc."
-- Phil Harvey, Senior Editor, and R. Scott Raynovich, Executive Editor, Light Reading http://www.lightreading.com