The Silver Lining

The venture capital ecosystem has reacted swiftly and decisively to the pending recession — an alacrity that bodes well for the long-term health of today’s startup companies. As Benchmark highlighted at the end of a recent memo to its portfolio companies, this is when the best companies get built.

Our current downturn is very different from the last one, which was like a slow motion train wreck. The NASDAQ peaked in April of 2000 and began a slow decline. Everyone hoped that it was just an inventory correction that would only last for a quarter or two. We were all in denial that the party was over. It was way too much fun while it lasted. After it was over, the ecosystem funded unviable businesses for far too long, keeping them on life support and thus diverting capital from new businesses that were better recalibrated for leaner times.

This time, the VC community has done the entire ecosystem a favor by quickly telling its portfolio companies to go to focus on the essentials, preserve cash and cut burn. Portfolio companies have responded quickly. Recent missives from leading funds like Sequoia, Kleiner Perkins, Benchmark and Foundation have provided excellent thought leadership and guidance for the ecosystem. Most companies are rightsizing headcount and redoing the 2009 budget and operating plan. This painful process will be done by year end.

Since the tech wreck, very early stage and seed stage companies have accepted the reality that unless one of the founders had previously built a successful VC backed company or had a brother-in-law at a VC firm, they need to be scrappy in building enough of solid foundation to become a viable candidate for venture funding. This has meant keeping one’s day job and working the business at night and on weekends, supplementing the cash flow with consulting assignments, licensing bits of the nascent technology to others or entering into creative partnerships with third parties to generate revenue, and raising bridge or seed financing from the founders, friends and family. Funding should remain available for these early stage companies, although it will be more difficult for companies to raise seed funding from angel investors who have seen their personal portfolios get hammered.

Between the lines of the various VC firms’ thought pieces is a signal to later stage companies that they will not be kept on life support with a subsequent round of funding unless they can demonstrate that they are viable businesses. Unless an existing portfolio company has preserved cash and made significant progress towards meeting its milestones and becoming a successful business, it should not expect to get another round of funding or, if it does get funded, should expect to get funded at a significant reduction in valuation. Early evidence of this trend is already apparent. A package of documents crossed my desk last week in a proposed down round financing with a pre-money valuation of about $500,000 after a Series D financing at about a $200 million post.

This may be good news for early stage companies because it likely indicates that funding for such companies will not evaporate as much as it did in the last downturn. This, time, expect the VC community to cull its portfolios more aggressively. Past experience indicates that companies that go through down round financings have a higher mortality rate than average, suggesting that capital may be better deployed in new businesses calibrated to a harsher economy than in marginal businesses that have gone through a painful restructuring. Aggressive culling may keep capital available for promising early stage companies and prevent the severe dip in new business funding that occurred in the last downturn.

The wild card in the ecosystem is capital calls. The extent to which limited partners may be unable or unwilling to meet future capital calls remains to be seen. That’s something to watch closely.

Down markets sharpen our focus on what is really important. Bottom line, if we are not building real, viable businesses that meet real needs in real markets, we’re delusional and should probably be doing something else. Having a viable business means that people will pay enough for your products or services with sufficient demand to sustain a cash flow positive business. Cash is always king, but in down markets, this is more evident and obvious to all.

The silver lining of any downturn is that you can spot the next wave if you look carefully enough. This downturn likely marks the end of the first wave of the cleantech/greentech/sustainable technology revolution. Disruptive technologies are adopted in two waves. The first wave is characterized by exuberance and overinvestment and is invariably followed by a crash. The second wave is always an order of magnitude larger than the first. It should be no different with clean, green and sustainable technology.

A more comprehensive way of doing business is needed to sustain the second wave. The massively interdependent nature of the global economy has outgrown laissez-faire policies towards unregulated markets, the invisible hand of Adam Smith and reliance on external and retroactively punitive regulations. If corporations want to avoid being stifled with regulations even more oppressive and crippling than Sarbanes Oxley, they will need to incorporate a conscience function that expands beyond the traditional fiduciary duty to shareholders, which ignores and often harms the commons, and respects all of a corporation’s stakeholders. As the wizards of Wall Street have recently proven to a world coping with the aftermath of credit default swaps, being smart doesn’t necessarily mean you’re wise.

The corporation is the most effective system of social cooperation ever invented. Models of upgraded and even more effective corporations are emerging for this new post-Industrial Age. Two weeks ago, I attended a very inspiring event in Austin called Catalyzing Conscious Capitalism where I met many of the leaders of a movement called conscious capitalism from companies like Whole Foods, REI, The Container Store and Joie de Vivre Hospitality. Many of these companies have already worked to instill a more comprehensive conscience mechanism to the corporation, as my last column discussed, providing good returns to investors while making holistic decisions that benefit all of their stakeholders. In future columns, I plan to interview some of the leaders of this emerging new business paradigm, which together with innovation may help lead us out of the current mess.

John Montgomery has practiced corporate law in Silicon Valley since 1984, and currently is a partner with Montgomery & Hansen LLP.