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Finding opportunity in economic turmoil

Every day the headlines tell us our financial markets are in turmoil. What effect will all this bad news have on the venture capital industry? No one knows for sure. Events are happening almost too fast to process them. But here are some brief thoughts as to both the challenges and the opportunities for VCs in the current economic downturn.

First, the challenges.

In recent weeks, there have been well publicized reports of some VCs delivering harsh warnings to portfolio companies to cut costs and drastically reduce burn rates, plan for layoffs, spend each dollar as if it was their last and understand there is no assurance of future rounds of venture funding. One U.S. VC communicated this message to portfolio companies with slides of a death spiral, skull and crossbones and a pig being led to slaughter.

Prudence or Overreaction?

Whether all these dire reactions are a prudent response to a serious downturn, or an overreaction that could become a self-fulfilling prophecy, remain to be seen. Other VCs are at least wondering whether they need to hold, or will even be able to hold, in reserve substantially more than the 3x often held back for a portfolio company’s later rounds, as those VCs find themselves with growing numbers of later stage portfolio companies having no IPO and M&A prospects in sight—and requiring continuing large infusions of capital to grow or even survive.

Both early and later stage portfolio companies are now anticipating global markets with dwindling demand for their products. And most VCs may find themselves, at least in the near-term, shut out of fund-raising because LPs—as a result of the drastic drop in value of all the other asset classes in which they invest—find themselves over allocated in venture capital.

Further, the huge public pension LPs in states such as California—a state struggling to find money to pay its own bills—may become increasingly averse to investing in VC funds, especially in the face of the collapse of the IPO market and a growing reluctance of potential buyers to do acquisitions.

Lastly, angel investors, who have seen a significant portion of their personal wealth evaporate in the declining stock market, may be increasingly averse to providing future seed financing.

Glass Half Full

This may be the time to put the word ‘venture’ back into venture capital and for VCs to focus on investing in early stage companies, which may now be a better bet than later stage ones.”

Still, there are those, like myself, who see this as a time of opportunity for VCs. Warren Buffett believes the cycles of the securities markets are explained by two things: greed and fear. In times of greed, the market rises to unrealistic highs. In times of fear, it descends to unrealistic lows.

Buffett believes in investing heavily in times of fear, which is exactly what he’s now doing with his own vast personal fortune. In short, Buffett says we should be fearful in times of greed, and greedy in times of fear, especially when unemployment is rising, business is worsening and the headlines are scary.

In Buffett’s words, “So if you wait for the robins, spring will be over.”

What is the opportunity for venture capitalists? As the recession worsens, decreasing company valuations and lessening competition from other VCs for next-generation technologies may create attractive investment opportunities.

Some of the highest IRR in the past has been achieved through investments made in economic downturns. Further, in bad economic times, as layoffs increase, there can also be abundantly available talent not found in good times. A bad economy can be just the right time to start a new company.

In a declining economy, the imperative for cleantech could become even more compelling. As to health care, people continue to get sick—and they don’t stop needing IT.

Gut-Check Time

This may be the time to put the word “venture” back into venture capital and for VCs to focus on investing in early stage companies, which may now be a better bet than later stage ones. For example, by the time today’s early stage companies will have grown to later stage ones, the IPO and M&A markets may have returned.

And because the median M&A exit in the United States for venture-backed companies is now trending downward toward $55 million, early stage investment may offer VCs their best chance to achieve high-multiple returns on exit.

As the recession worsens, decreasing company valuations and lessening competition from other VCs for next-generation technologies may create attractive investment opportunities.”

There is nothing more important for the success of emerging technology companies than momentum, and acts such as premature layoffs may profoundly affect that momentum in ways from which a company may never recover. So, knee-jerk reactions in bad economies can be unwise.

In addition, VCs that forego investing in bad times may be impairing their future as they fail to capitalize on opportunities to invest in relatively low priced disruptive technologies that would enable them to achieve the ROI needed to secure LP funding in later years.

Technology is never more critical to the success of business than in a severe downturn—when companies need an edge—and it’s venture capital and the company-building skills of venture capitalists that can help provide it.

It is technology that drives an economy, and the resulting innovation that enables an economy to reinvent itself, and there has never been a more urgent need to make that happen and for VCs to do it through highly proactive, hands-on leadership with their portfolio companies.

Think Long Term

Over the past 35 years, I have seen other cycles—such as the market crash of 1987 and the bursting bubble of 2001. What is happening now is another cycle, though one that may be longer and deeper than we have seen before. But it, too, will pass. What VCs and their portfolio companies do in the next year or two may determine their market share for the next 10.

When needed in the past, VCs have summoned their great talent and skill to counsel their portfolio companies to think out of the box, and sometimes, even to reinvent themselves. In the months ahead, depending on how the economy unfolds, it is possible that VCs may need to apply this same talent and skill to themselves. Given the current circumstances, it won’t be easy, but I have no doubt they will succeed.

In the words of a wise person, these are not the times that build character; these are the times that reveal character. And to borrow from hockey legend Wayne Gretzky, it is now important to focus, not on where the hockey puck has been, but on where it is going.

Stephen A. Hurwitz is a partner in the law firm of Choate Hall & Stewart in Boston. He focuses his practice on business, corporate and securities law with an emphasis on venture capital and technology companies. He may be reached at hurwitz@choate.com.