The greatest tension in a venture capital partnership is the debate between the risk of missing the next great opportunity and the risk of losing money. One of the complaints often expressed today is that the VC industry is too risk averse. Arguably there have been times – most notably late 1990’s – where capital has been too plentiful and risk aversion was virtually non-existent (and aren’t we still paying the price from that insanity?). Importantly the risk tolerance of the VC industry at large seems to track the capital in-flows into the industry – perhaps not unsurprisingly. This year VC firms are on pace to raise approximately $12 billion (as compared to nearly $30 billion only two years ago). The high water mark in 2000 when over $105 billion was raised is something we may never see again.
Is it oxymoronic to be a “value-oriented” VC investor? Certainly in the early stage marketplace there are no meaningful – perhaps sensible – historical financial results to which one can point to precisely determine fair value. And doing discounted cash flow analysis would be laughable. So how do we know when to pay up for a deal?
At Flybridge we are very energized by what we are seeing in the market today. We tend to frame the diligence around a basket of risks – and has the team developed plausible strategies to knock down those risks within a reasonable amount of time and capital. We back people first and foremost so the first risk item which we focus on is:
· Team: How relevant is the team, particularly the CEO, as well as the VP’s of Marketing and Engineering? Has the team been successful before – ideally in a venture-backed company? Compelling teams command premium valuations.
· Product Development: How developed is the product? How much is novel and patentable? We often have technical consultants go deep into the product development plan. Ideally good customer testimonials which endorse early versions of the product tend to support higher pre-money valuations.
· “Go-to-Market”: For me this is the trickiest risk to assess; it is around the likelihood that the company will achieve “escape velocity.” Early customer traction is interesting but does it prove the case? How do we know that there is a large market just waiting to be built? The more precision one can provide around the sales cycle, channel strategy, having sales infrastructure in place, the greater the valuation. Pointing to analogous companies and business models helps.
· Capital Formation and Liquidity: Great companies should always be able to attract capital. Being heads down building a great company more often than not will translate into value creation and liquidity. But these capital flows are cyclical and out of any of our control. Being able to handicap the next round and what the exit looks like is critical. VC’s love externally led “up financings.”
The lack of liquidity today has colored the decision-making processes in many firms. For the first time in a long time VC’s are being asked to be both effective portfolio managers and good “stock pickers.” How we think about capital reserves will weigh on any given investment decision and that is out of the control of the entrepreneur.
So where are we? Firms not worried about raising new funds are active and excited about the level of innovation across nearly every industry sector. Unfortunately too many VC firms have questions about their ability to raise a new fund and are therefore on the sidelines.
I am reminded of my ten year old son’s “social dance” class where the boys and girls are glued to walls on opposite sides of the gym – and no one is dancing.