In my little world, things are picking up. I was kept quite busy in late November and December, filling in my time not devoted to clients by responding to a lot of queries from Venture Capitalists. “What do you think about this market? About this company? About this team?”  It appears that VCs are again starting to look for investment opportunities rather than reasons not to invest. I’m not sure whether this change is due to lowered valuations, improved public market conditions, more interesting business concepts, inherent VC DNA driving them to “do deals,” or that the VCs spouses are giving them an ultimatum to get out of the house because the kids have heard all their jokes, the car doesn’t need to be washed three times a week and the mailperson isn’t coming to the back door any more.  It’s probably a little bit of all these things.

Of these factors, the one I am confused about is the impact of the present state of the public markets on early-stage VC investing.   I can understand one aspect of this – the state of the market directly impacts the VCs ability to raise money for new funds – but I’m not quite sure why it would have a strong impact on their investment strategy in their existing funds.  I’ve heard the rationale – a weak public market reduces M&A and IPO activity.  And I believe it’s true in the moment.  But when you are an early stage investor, you are helping to create and nurture companies whose acquisition or IPO opportunity is years down the road.  And don’t we all know through bitter experience that market conditions today are not correlated to the conditions five, three, or even one and a half years from now?  So in theory, early stage VCs shouldn’t pay any attention to present market conditions.  There are two reasons why they do, however:

1. Present market conditions make it difficult to liquidate the investments they made over the past one to four years, which means they need to put more time and money into keeping those companies afloat (assuming they deserve to remain afloat).  This takes attention away from new investments.
    
2. We all have short memories and the investment period that is still in our memory window is the period from 1999 through mid-2001, where quick turn around liquidations – acquisitions of engineering teams and concepts, and IPOs based on business models and future revenue – were very common. 

From a VC perspective, the first reason above is very valid and needs to be managed.  The best VCs stay steady and true and invest at roughly the same rate through good times and bad.  These partnerships generally have a core set of people who’ve been in the game for some time and have seen several feast/famine cycles.  They recognize that innovation and the generation of break-through ideas is a process completely independent from the financial market cycles.  They also realize while end-user and service-provider spending do fluctuate somewhat based on macroeconomic conditions, there is still a huge amount of money spent each year, which can be shifted towards new products or services fairly rapidly if a clear and compelling value proposition surfaces. The best ideas can come at the worst of times.  And when that happens, the opportunity is huge because the company who executes on that idea can catch everyone off guard and therefore enjoy a period of market development and consolidation before a bunch of competitive “wanna-bes” get launched. 

The second reason above – the expectation of quick turn around on the investment - is an insidious concept that can creep unconsciously into the thinking of many who should know better.  I’ve seen this happen at Acuitive, where in our first few years, almost 100% of our clients that we took equity in executed a lucrative liquidation event.  Now we’re down to a hit rate of 50% or so and have to wait longer for those that do liquidate. That causes us to sometimes wish for the “good old days.”   But what we have to remember is that the times we are in now are like the normal times. The odd time was the crazy bubble time of 1999 through early 2001, where almost any idea backed by any team had a chance of success.  In normal times like today, good ideas executed by good teams sometimes succeed.  Often they don’t.  Bad ideas and bad teams almost always fail.  That’s why early stage start-ups work with people like Acuitive and venture capitalists and not bankers. 

So I think that all of us in the technology start-up world need to make a New Years resolution to go on a ‘wait-training'  regimen that consists of at least the following components:

• Wait for the right concepts and teams to come along before investing.
   
• Be patient with companies we are nurturing.  Don’t push them to go too far too fast. Allow them to develop real roots – products, customers, market presence, before expecting a liquidity event.  Remember heavyweight companies like Cisco and Microsoft, which operated for years as profitable private companies before going public.
   
• Encourage clients or portfolio companies to spend their money very wisely. Don’t assume that a liquidity event or even further funding is just around the corner.  Go as far as you can with what you’ve got in the bank.   Leverage external technology as much as possible. Focus R&D on the one or two things that truly make you different.  Don’t hire sales until there is something to sell.  Ramp up customers slowly and service them well.  Don’t hire a PR firm and launch a marketing program until manufacturing and the sales channel are in place to service the demand you might generate.
   
• Just survive, so that maybe in the future you’ll thrive.

What this means for Acuitive is that we’ll continue to grow slowly.  We added three people to the team in 2001 and look to do about that again in 2002.  We’ll also probably work with fewer clients, but more intensively with the core clients we do engage with.  To avoid being a cash drain, we’ll probably tweak the compensation mix in our agreements with these clients away from cash and more towards equity.   And then we’ll continue to work hard with the team to put them in a position to succeed, and then we’ll patiently wait for the fruits of that work to blossom.  In other words, more of the same. It seems to be working.

(volume 4, number 12)

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