By way of introduction, I have interviewed Steve Kann on DealFlowDiaries in the past regarding his thoughts on the market, economy and within the small cap arena. He will be a recurring guest contributor giving us his perspective on how he views the financial world. Steve Kann is an accomplished investment banker, entrepreneur, stock analyst and a talented musician. Some say this qualifies him as a renaissance man but I look at it from the standpoint that he can give the readership a very unique viewpoint on deals, stocks and the economic landscape. Below is his first post.
Nothing Ventured, Nothing Gained
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This current downturn - especially the contraction in personal and business liquidity - has been hard on everyone, no doubt, but, as with most trials in life, there have been a number of positives that have come from it. Businesses are tightening up bloated overhead and maybe even (gasp) trimming corporate retreat budgets, focusing more on the things that matter most in generating long-term sustainable growth. Consumers are more conscious of the credit card debt they carry. They’re working a little harder on the job to make sure they’re not the next ones to pull a pink slip out of their inbox. People are learning to be content with what they have while they pursue what they want, rather than be ruled by the culture of immediate gratification that says “go get what you want NOW, while you pursue the means to pay for it LATER.” The former is much healthier, and a much more solid foundation on which to build future prosperity. These are all positives.
However, one result of the downturn that is undermining a turnaround and inhibiting growth is the morphing of VCs (venture capitalists) into VCs (very cautious). There is almost no “venture” in venture capital right now, and that means fewer “next generation” technologies are getting vital capital for early R&D, fewer high-energy, creative entrepreneurs are getting from prototype into production, fewer new and exciting brands are able to go from local distribution to regional/national, and so on.
According to the most recent National Venture Capital Association report on the state of the industry, venture capital investment in Q2 2009 was at mid-1990s levels, and this was up from Q1 levels. The $6.9 billion invested in the first half of 2009 was essentially the same amount invested in 1996, the year of that seminal Internet event, the Netscape IPO. First-time financing (companies receiving venture capital for the first time) dollars for the second quarter was reported at $678 million, which went into 141 companies, the lowest number of first-time deals since 1994. Let’s think about that for a minute: fewer than three companies per state received first-time financing of less than $5 million each, enough to hire, say, 35 employees per company, or barely 5,000 new jobs created by this particular cog in the capitalist machine.
Cited among reasons for the fall-off is the lack of certain exit options such as an IPO, VCs conserving cash for existing portfolio companies, and dismal results leading to VC staff reductions which ultimately reduce the number of deals that can effectively managed and in turn make it necessary for VCs to invest in fewer companies.
In 1999, start-up entrepreneurs were getting $20 million in start-up capital based on an idea scribbled on a napkin at a bar. This clearly was a case of VCs being too venturesome, and they paid the price. $52 billion was invested by VCs that year. With easy money - and lots of it - came extreme valuation inflation at all levels of the capital ecosystem, from start-ups to public companies. (Note: just before the end one analyst pointed out that Amazon, in order to justify its then-current valuation, would have to grow at 100% for 20 consecutive years just to justify its price then). The same VCs who wouldn’t invest $5 million in an idea at a $5 million pre-money valuation in 1996 were falling all over themselves to invest $20 million at a $50 million pre-money valuation for the same idea three years later. And we all are painfully aware of the bubble, its pricking and the aftermath.
So there’s a valuation bubble where there is a fire hose of easy capital. So what happens when there’s barely a trickle of capital? The pendulum swings to the other (unhealthy) extreme and we see valuation compression and, worst for companies in need of capital, a smaller strike zone in terms of having a story that is on-target with a particular VC. This time around in the down-cycle it appears that the strike zone has shrunk from top to bottom (size/stage) rather than corner to corner (industry/sector). The effect is that once “venture capitalists” are now demanding meaningful market traction and growing revenues where they once needed only revenue; or multiple customers where they once needed only one “reference account;” or production level vs. prototype; or a complete management team vs. a charismatic CEO and a whiteboard. In fairness to VCs they look out at the horizon right now and believe that they might not ever get a chance to raise more capital and they might be running their last fund. They’re being Very Careful with the deals they invest in.
The net effect is that VC’s are stuck in a conundrum which is being conservative to a flaw, which could jeopardize their capital under management actually being redeemed and being aggressive in a time of no liquidity. Angel investors haven’t been able to fill the gap and a lot of well-conceived business plans or even going concerns run by qualified and passionate entrepreneurs are going unfunded -the wealth creation process abandoned. The venture capitalists are cautious because they need to see a trend in the markets improving for liquidity, they need to see a more balanced M&A market not just a buyers’ market and last but certainly not least they need to see the next BIG thing. It may be “cloud computing”, it may be mobile services or it could be SaaS (Software as a Service). There is no clear direction and the VCs are stricken with the old adage “paralysis by analysis.”
As always, the numbers will improve and the pendulum will swing back towards the middle, but until then we need to keep the entrepreneurial spirit alive.Working for Peanuts movie download
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