The Risk To Venture Capital And Startups From The Financial Crisis

Venture Capital

from the capital-calling dept

When I wrote my first post about the financial crisis, I noted that venture capitalists and startups were probably more protected than other areas of the economy, noting specifically that I didn’t believe limited partners (also known as “investors” in VC funds) would fail to meet their capital calls. The way venture capital works is that the general partners (the folks who run the fund) go out and raise money from limited partners (LPs or investors), who agree to invest a certain amount. However, they don’t just hand over the money. The VCs let the LPs hang onto their money until they need it and make a “capital call.” For many of the bigger VC firms, the LPs who make up a large chunk of their funds come from huge institutional investors, such as pension funds and university endowments. I thought it was unlikely that they would fail to make their capital calls, because (a) they’re huge and (b) they tend to only set aside a rather small percentage (5% is what I remember being told is standard) to put into high risk investments like venture capital. So, even if they were having trouble elsewhere, it seemed unlikely that they would bail out on the money they committed to VCs.

That might not be true, however. Immediately after the post, I heard from a few VCs who indicated it might be much tougher to get LPs to meet their capital calls than I expected. First, especially with smaller VC firms, the LPs might not be huge institutional investors who can shrug off losses elsewhere. Second, my original statement was before two straight weeks of a tumbling stock market (though it’s bounced around since), meaning that the hurt put on the rest of the LPs portfolio may have been much bigger than originally estimated. Finally, while these big institutions may focus on only putting about 5% into high risk offerings like venture capital, they may have just realized that a much larger percentage of their money was already in high risk investments — it’s just that they didn’t realize it. Thanks to badly rated collateralized debt obligations (CDOs), many people who thought they had put money in super safe AAA rated investment vehicles, quickly realized that they had actually invested in high risk vehicles. That might make them think twice about throwing any more money after high risk ventures.

And, indeed, that appears to be happening. Firms that are willing to “buy” the obligations to fund VCs are finding strong demand as various LPs look to get out of their obligations before the capital calls come. Unfortunately, there’s a pretty small market of folks willing to take on these obligations, so there’s a chance that the “fund” that a VC has officially raised, may turn out to be much smaller than they really believe. If an LP is unable to meet a capital call (or simply refuses to do so), the VC firm is basically stuck holding the bag. It effectively means that the size of the fund that they raised is actually smaller than announced. While that can mean fewer investments (especially if the GPs are nervous about their LPs), it can be a lot more disconcerting for startups on the funding conveyor belt. Usually startups go through multiple rounds of funding, which the VC firm bakes into its calculations when doing the initial funding. That initial firm may not lead later rounds (in fact that’s rare), but it usually will participate, and now that may be more difficult. That could cause some VCs to push their portfolio companies to sell off or close up shop much faster than they normally would.

My guess is that this is still a temporary phenomenon. After the dot com bubble burst, there was lots of talk about how VCs would have trouble raising new funds, and that didn’t happen. The big institutional investors know they need to allocate some portion of their holdings to high-risk/high-return vehicles, and venture capital is always a good place for that bet. Given Wall Street’s implosion (and the resulting impact on east coast private equity and hedge funds as well), it’s likely that venture capital will still appear as a good long term bet for high risk capital — perhaps even better than in the past few years when there were suddenly many more options. In the short term, it may be a bit painful for startups (and VCs worried about not actually having the money they thought they had), but it still doesn’t seem likely to have a huge impact on Silicon Valley. As for all the headlines you’re seeing about layoffs at startups these days, don’t read too much into them. A lot of companies are using the market as an excuse to effectively dump underperforming employees in a big “layoff.” This way they get rid of the bad employees, and there’s no negative connotation associated with the layoff like there might be in normal times.

Filed Under: financial crisis, venture capital