Cover Story: Staying Afloat – VCs Raise Annex Funds to Buoy Waning Portfolios –

It’s no secret that venture capitalists are spending more time doing damage control than they are investing these days. Not long ago VCs were hailed as the innovative architects of the New Economy, with investors fighting to get into their funds. Now they are in a position of weakness, trying to restore investor relationships and reverse negative returns. Needless to say, the fund-raising market has gotten a whole lot tougher, investment activity has dropped, and VCs are taking a lot more time on the investments they do make, so as to avoid repeating their mistakes.

Yet in the midst of this shift, a handful of VCs-New Enterprise Associates, Accel Partners and Enterprise Partners among them-are going back to their limited partners to raise annex funds. This latest breed of venture funds, sometimes referred to as “bailout” funds, has put some of the nation’s largest VC firms in the same predicament as their struggling start-ups-asking for more money despite having recently lost some.

The explanation for these annex funds is fairly simple: With the IPO market effectively closed to unprofitable companies, and M&A buyers willing to make purchases only at bargain prices, VCs haven’t been able to exit their investments. That means scores of private companies-many of them technology companies funded during the heady days of 1999 and 2000 – need more cash from their VCs in order to survive. Despite the vast amounts of capital VCs have raised over the last few years, an increasing number of funds are starting to run out of cash. And since fund restrictions can make it difficult to play Robin Hood when one fund needs more money, the call for annex funds has surfaced.

“These VC firms didn’t leave enough gas in the tank, that’s essentially what happened,” says Alan Salzman, managing partner with San Bruno, Calif.-based Vantage Point Venture Partners. “The environment has changed, and some of these firms got caught short. It happens.”

While partners at Accel, NEA and Enterprise Partners say the response to their respective annex funds has been generally positive, the LP community hasn’t willingly obliged. Some of NEA and Accel’s investors turned them down, and even some of the LPs who committed to the funds seem anxious. One nagging question that continues to come up is whether VCs are jumping the gun.

“In my mind, it gets back to the issue of trust,” says Doug Breckel, senior associate treasurer at the University of Washington in Seattle. “Have they [VC firms] explored all possible avenues to get the liquidity they need for existing companies? It’s tough to go out and raise money from other firms because of valuations, and you don’t want to be caught in a falling-knife market.”

Moreover, LPs are concerned about the possibility of throwing more money at bad companies. “For us, it’s a question of motivation: Are they doing this for the right reasons, or just to save their business? Or, are they putting good money after bad money? Or putting good money after decent money?” asks Patrick Hopf, managing partner of St. Paul Venture Capital in Minnesota, which invested in the Accel annex fund.

To be sure, in certain cases, an LP’s enthusiasm is irrelevant, because for some, investing in the annex funds isn’t optional.

“If you don’t participate, you get diluted, which will cost you more than if you do invest,” notes one annex investor.

Thus far, at least three funds have closed annex funds-NEA VIII, Accel VI and Enterprise IV-and market players say there are plenty more VC firms considering annex funds this year. But if the field gets more crowded that could change. “How successful they will be in raising annex funds is questionable,” says one alternative asset portfolio manager.

Too Much is Never Enough

While annex funds aren’t new, the circumstances surrounding them this year have changed. At the apex of the dotcom bubble, firms raised money to avoid missing the lucrative late-stage investments in advance of an IPO. Now, however, the same firms are raising cash to support companies that can’t go public.

“There’s been a dramatic sea-change in the venture capital environment in the last 14 months that’s been slowing down the velocity of the business – time to IPO, time to break-even,” says Josh Lerner, professor of business administration at Harvard Business School. “The company is less profitable, or even more unprofitable, in the time that private investors need to put more money into it. It’s blown out of water the actuarial assumption GPs had.”

Venture funds typically spend the first four or five years of a 10-year limited partnership scouting opportunities and making initial commitments to young companies. A firm will then reserve about 50% to 60% of the fund for follow-on investments. However, calculating an adequate reserve ratio is an art, not a science. Predicting a company’s capital needs going forward factors only unknowns into the equation such as cash flow associated with the business relative to its capital needs and the investment’s time to a liquidity event. When the market’s taste for e-commerce sours or the chance for a positive reception in the public markets fades, as it did at the end of 2000, the company may have only its venture backers to lean on for support.

“Anticipating an adequate reserve level is very difficult. At the time, reserving 50% [of the NEA VIII fund] seemed very conservative,” says Nancy Dorman, administrative general partner in NEA’s Baltimore office. Despite its conservative reserve pool, the fund will have to sell off certain existing equity stakes and recycle that cash into other portfolio companies.

It’s important to note that limited partnerships make it difficult for VCs to mix and match when it comes to their funds. Thus, a firm like NEA, which still has a great deal of cash that hasn’t been spent, may not be able to take money from a recent, largely uninvested fund to invest in a company backed by a previous fund. Thus, the annex fund has more to do with a particular fund’s assumptions than it does with a firm’s overall assumptions.

But suffice it to say VCs are rethinking their strategies toward reserve levels. “All these 1997 funds were operating under the same two-thirds/one-third principle, but liquidity seemed so great, people got overly aggressive and over-invested in more companies than should have been [in the portfolio],” says Andy Chedrick, chief financial officer and operational officer with Enterprise Partners.

Adds Vantage Point’s Salzman: “Each round is getting tougher, and you may not have enough rations to get to [where you want to go] without a bailout, and yet the capital intensity of these companies is still high. It’s a problem. There’s no such thing as having too much in reserve.”

Irrational Exuberance

Annex funds, most often, are barred from initiating investments. While they do retain features of a stand-alone fund, they are created to invest alongside their parent fund at a pro rata share of the investment round.

NEA’s annex fund, for example, will share follow-on investments at a 50/50 ratio with NEA VIII, while Accel’s fund will invest in a subset of Accel VI portfolio companies.

Late in June, NEA closed its $150 million annex fund to its 1998 early-stage investment vehicle, the $565.7 million NEA VIII. In the early days of July, Accel added a $50 million annex fund to its pair of early-stage communications and Internet technology funds also raised in 1998, the $275 million Accel Partners VI LP and the $35 million strategic side fund, Accel Internet Fund II LP. Enterprise Partners, a diversified early-stage fund based in La Jolla, Calif., began raising a $20 million annex fund in January to supplement Enterprise IV, a $220 million fund raised in 1997.

Like a large number of VC funds, NEA VIII, closed in the heady days of the dotcom craze, stuffed its portfolio with Internet, software and communications plays. In the last six months of 1998 – just after the fund’s close – it poured $50.77 million into 24 companies. NEA VIII ramped up investment to a frenetic pace throughout 1999, investing another $277.91 million in 78 new companies. Of the 153 companies now held in NEA VIII, 16 went public and eight were acquired. Only one, according to Venture Economics, filed for Chapter 11 protection, while the rest remain privately held and looking for additional rounds of venture financing.

Announced at the firm’s annual meeting May 2, the NEA annex fund drew on commitments from NEA VIII’s existing LPs and others who have invested with NEA in the past. Although each of the existing investors was offered a pro rata share of the annex fund, some chose not to participate (NEA and its LPs refused to comment on which LPs declined to participate). Investors in NEA VIII include the California Institute of Technology and the Ford Foundation.

Accel, burdened by a portfolio of 33 mostly Internet and networking technology-related companies, and with limited exit opportunities on the horizon, approached its limited partners for additional capital in a letter dated at the end of April.

In the letter, Alan Austin, partner and chief operating officer with the Palo Alto, Calif.-based firm, said: “1998 was a very busy time and a time when a lot of traditional assumptions about the way things work just disappeared. In retrospect, we should have stopped [investing out of] Accel VI and gone into Accel VII LP [a $480 million fund raised in 1999] a lot sooner.”

While Accel VI cashed in on the IPOs of portfolio companies iBeam Broadcasting Corp. and NetZero Inc. before the market came to a screeching halt, both stocks as of mid-July were off more than 95% from their offering price and languishing under a dollar per share on the Nasdaq. The fund also sank almost $9 million in now-defunct online sports network Quokka Sports Inc.

For Accel, although many LPs did exercise their pro rata shares into the annex, some fund-of-funds and corporate investors in the original funds declined to participate (Accel and its LPs also declined to comment). Investors in Accel VI include Nassau Capital (Princeton University’s endowment), Hewlett-Packard, Horsley Bridge Partners Inc., HarbourVest Partners LLC, J.P. Morgan, General Motors Investment Management Co., Delaware State Board of Pension Trustees, Memorial Sloan Kettering Memorial Cancer Center and the Kresge Foundation.

Before returning to its LPs for additional funds, Enterprise set a target between $20 million and $35 million, hoping to close the fund as soon as it reached a minimum target so not to strain already-tight resources. Investors in Enterprise include the endowments of Columbia, Princeton and Yale universities as well as Pantheon Ventures, Colorado PERA and The Ford Foundation. Of the 34 portfolio companies in Enterprise IV, Chedrick expects that a handful will be written off, a handful will reach liquidity and the remainder will need additional capital – some of which will be provided by the annex fund – to survive.

There’s no question these firms’ reputations as longtime investors in venture capital helped make the annex funds possible. Indeed, for firms with a long history as a top-quartile performer, a history of continuity in its strategy and management, and a solid, open relationship with its LPs, the market’s response to the annex funds seems relatively positive. Conversely, for younger firms, especially first-time funds raised in the opportunistic days of 1997-1999 with few hits in an Internet-laden portfolio, LPs may be less tolerant.

“In Accel’s case, we don’t know of a venture group with better returns in the last five or 10 years. They’re doing the direct, honorable, straightforward thing, and we don’t have a problem with it,” says Hopf. “If this was a first-time fund from 1999, raised to take advantage of the market by three people in totally different fields, then my answer would be totally different.”

Investors in NEA agree. “Our working relationship with NEA has been just fine,” says one long-time investor in the firm. “They’re been able to get aggressive with their terms, but not overly aggressive. They’ve been there to answer questions. They clearly laid out the options and took into account the LPs’ interest.”

To be sure, these funds had to offer up more than their firm’s good name to close. NEA reduced its carry on the annex fund to 15% from its usual rate of 20% and will charge investors a flat management fee of $150,000. The annex fund is co-terminus with NEA VIII’s 12-year life cycle. Accel, conversely, eliminated the management fee altogether but will maintain a carried interest to mirror Accel VI. Enterprise took a similar tack: It will carry an 80%/20% split and has reduced its management fee. (Enterprise’s management fee is based on capital invested, not capital committed).

“These [annex] funds are an admission that they made a mistake,” said an annex fund investor. “It’s not surprising to know they got carried away with the euphoria of the times.”

Sink or Swim

When a company needs capital to move the business forward, or even just to survive, VCs are left with limited choices. If deemed a losing proposition in the long term, the business could be shut down. In this scenario, everyone loses, particularly the VCs and their limited partners, all of whom lose whatever capital they’ve already sunk into the business with no chance of capitalizing on even its intellectual property.

Alternatively, a venture firm behind a struggling company may look for new partners to re-fuel the company with commitments of time and equity. In a tight market, with but a handful of early-stage funds scouting new investment opportunities and the rest retrenching inside their existing portfolios, new investors are unlikely to jump into an already-troubled deal at an attractive valuation for existing investors. Even when they do jump in, new investors are likely to demand harsh terms from troubled companies that force existing investors to swallow the loss – higher liquidation preferences; full-ratchet, anti-dilution rights, and participating convertible preferred stock.

“When you’re looking high and low for that funding, typically those people that provide the money are in the driver’s seat,” says Ken Boger, a partner with the law firm of Kirkpatrick & Lockhart LLP. “They make you take a lower valuation, they’re senior in liquidation to you, they require you to convert preferred stock to common. When they come in at these terms – the right terms – they cut a harsh deal for existing investors.”

Thus, some of the LPs saying yes’ to annex funds feel like investing in the add-on vehicle is their best option.

Saving Face

GPs are navigating especially treacherous waters these days – keeping troubled companies afloat while cruising for new industry sectors that can be aligned with existing portfolios at a time where the public markets have recessed into low tide.

“Accel has been in business a long time and never had this problem before. I don’t believe we’ll have it again,” says Austin.

“If it works – trying to raise money to bail out companies that aren’t doing sufficiently well to stand on their own – if they’re successful in doing that, then it could positively affect rate of returns in the fund,” says Boger. “But if they raised additional capital from people invested in that fund and save companies that aren’t saved, they’re going to be dealing with very upset investors.”

Either way, it is a question that tinkers with a firm’s reputation. Although well-established firms may be able to return to LPs, speaking of their current problems as an aberration in the firm’s history, for newer firms, annex funds may seem like an act of desperation.

“Venture firms closely guard their reputation, and there’s been some discontinuity in the market in recent months,” says Harvard’s Lerner. “As an LP, I’d be less concerned because the venture business is unpredictable, and this is a thought-out way to manage that process.”

Meanwhile, NEA is closely monitoring the availability of follow-on capital for NEA IX, an $879.9 million fund raised in 1999 also heavily laden with Internet and software deals. Approximately 85% of that fund already has been committed. Accel, too, is maintaining a cautious outlook on its recent vintages.

“If I were a limited I would have an interest in any scenario that would bail out a troubled company,” says Boger.