Up Rounds Down, Down Rounds Up

So, first the good news. The latest quarterly survey of venture capital firms by law firm Fenwick & West shows that up rounds for portfolio companies exceeded down rounds by 54% to 33% in the fourth quarter. That means that even in this poor economy, stong companies are seeing valuations rise and collecting larger funding rounds.

Now, the bad news. That ratio represents the lowest amount by which up rounds exceeded down rounds since the third quarter of 2004, according to Barry Kramer, a lawyer at Fenwick and co-author of the study. Perhaps more ominously, he says, down rounds increased each month through the quarter, and for December 2008, 45% of all financings were down rounds.

Not all industries fared equally. A breakdown of 4Q08 financings by industry shows that Web 2.0 and digital media was by far the strongest sector. Given that most companies in that sector struggle to raise follow-on funding, this result begged the question: Were up rounds due to the fact that only a small portion of ultra-high performers got funded? The short answer: Yes.

”People are focused on funding their most promising companies, so it skews the results a bit,” says Kramer. That’s created a flight to quality, in which VCs make sure their top companies are funded, or perhaps overfunded, to weather rough times.

The situation for follow-on funding may be somewhat worse that the data indicates because it doesn’t take account of the bridge loans and warrants. In a difficult fund-raising climate, bridge loans can be used in lieu of follow-on rounds, or as an alternative to a down round.

Warrants are another component that Kramer says are being deployed increasingly in fund-raising rounds. Generally, they allow an investor in a new round the right to purchase additional shares in a company later at the same price. In effect, it’s a bit of a perk – enabling investors to get future shares at a discount should the company perform well – but doesn’t show up as depressing the price of the current round.

Complete results of the surveys are at www.fenwick.com/vctrends.htm.