Last week, with Excel’s help, we looked at the “simple” computation of a VC fund’s rate of return. This week: Reserves, a most important sets of numbers.
As a rule, for every dollar initially invested in a company, we immediately set aside an additional $2 or even $3 as a reserve for future rounds, future injections of capital. Entrepreneurs often tell us they’ll only need one round, this round of financing before reaching the cash-flow positive nirvana. I know, when an entrepreneur, I did it (to) myself, several times… We don’t argue, we smile, nod and enter the appropriate reserve amount in a spreadsheet.
Next, we try to forecast the additional rounds: one round in 15 months, perhaps, and another one 18 months later.
As we do this for every company in our portfolio, the spreadsheet tells us how much capital we’ve invested so far and, as companies develop and need more capital, how much will be required and when.
Then, the hard work starts.
Try getting one of us VCs on the phone on Monday mornings: across the entire Valley, we’re all in ritual Partnership Meetings. Where I currently work, none of us golfs, this shortens the meeting and allows us to jump right into the portfolio review.
Not every company requires a lengthy discussion but, as you can well imagine, with the youngest companies in our care, the early days are noisy and messy. We don’t live in a well-groomed space of quarterly earnings, guidance to Wall Street and GAAP numbers. We exist in a chaotic world of prototypes that don’t work, schedules that are never met, cash flying off faster than expected, temperamental techies, marketers equating their manhood with their budget, to say nothing of distracted co-investors.
You’re entitled to think I exaggerate, I do, but only a bit. In any given portfolio company, we don’t have all these problems at the same time. But, at any given time, we have one (or more) of these “challenges”, as we’re supposed to call them in California. And, lest you think I’m unfairly critical of our co-investors, we, too, get distracted, sidetracked as well. Our own set of problems rarely coincides with our colleagues’ worlds of troubles.
No complaints, it’s our world, and it is too interesting, too rich in unusual people, new technologies, innovative business ideas, too much fun for us to get more than briefly rattled when we’re knocked down, one more time, from our “I’ve seen it all” perch.
Our “shift happened” discussions range from “Why did Big Company Z renege on its promise to license X?” to “When do we really ship?” and, “When will our mad scientist entrepreneur need another round?”.
All other concerns recede when we begin to see the bottom of the cash register; that’s why we put what we call a 2X or 3X reserve behind our initial investment.
A pause here to review the Professional Investor Theorem: a pro’s job is to invest as much, as many times, for as long as required for the situation to become clear.
This quantity, clear, is a two-state variable, it can only assume two values: dead or cash-flow positive. As a corollary, when we stop investing, our decision means the situation has become clear, at least to us. If the company isn’t cash-flow positive it means we think it’s dead. Our inaction says we think our investment is worth nothing. As a result, we shouldn’t mind if we get “washed-out”. The latter phrase means our percentage ownership of the company gets reduced to almost nothing under the terms imposed by more courageous (or deluded) investors. They put new money and we don’t. Helped by our inaction (and the company’s weakened position, it’s running out of cash), these investors can, and should, dictate terms favoring their interest. Put up or shut up.
This leads to the worst possible scenario for a pro: believing in a company’s future but no longer having the funds to support it – and to protect the existing ownership share.
Hence the importance of reserves: they’re vital to the protection of our ownership. Actually, the ownership isn’t ours but our own investors’, our Limited Partners’ stakes in what we call “our portfolio companies”. Still, I think we’re entitled to call them ours, not just as a shorthand but mainly because we know whose failure it’ll be if things blow up: ours.
So, week in and week out, we look at each company, we fire up the Reserves spreadsheet and ponder. Do we have enough reserves for this one? When do we need to kick the CEO’s rear end, I meant to say “gently invite the CEO” to start raising a new round? Which new investors should we try and bring into the new round? Are we going to get forced into an insider round because the company hasn’t made enough progress to attract new investors? (We hate these insider rounds, I’ll explain in a future column.)
Today’s economy makes the Reserves questions even more urgent than usual. Product development snafus or not, last year’s operating plans are out the window, revenue will not materialize as soon or as high as planned. Our companies will need more money than expected and our fund hasn’t grown in size.
Another pause here to discuss Capital Calls. When we assemble a $200M fund, our investors, our LPs don’t wire the whole amount on day one. The fund size is the total of our LPs’ commitments, keep that word in mind. To start operating we only need a small fraction of the total amount, say 10%. (We’re not bankers, what would we do with $200M sitting in a money-market account?) We start investing and, whenever we need more money for new investments and new rounds, we make Capital Calls; we email and call our LPs telling them to please kindly wire a few more millions into our account. They oblige, often within hours, this is America, we’re dealing with pros and they’ve been receiving regular progress reports.
Unless they, our LPs, run into their own cash crises. The financial meltdown has pushed yet another unthinkable into reality: huge institutions such as state pension funds, to say nothing of Wall Street giants, can’t make capital calls. This strands VC firms and, in turn, strands start-ups. Welshing on their contractual commitments exposes LPs to consequences ranging from forfeiting their position, rare, to being forced to sell it to another, better equipped investor. A “secondary” market used to exist for such transactions, it worked well after the crash of the Internet Bubble; that meltdown was a cash-rich recession. Not today: there isn’t an active secondary market to pick up the pieces after LPs run out of cash. In the extreme, the inability to find a substitute investor could push LPs into forfeiting, losing their interest in the fund. This is the theory. In practice, some LPs are too big to fleece.
Calpers is the retirement fund for Calfornia’s public employees. The largest fund in the country, Calpers invests a small amount (5% or less) of its fund in “riskier” asset classes (a term of art) such as venture funds. By June 2006, Calpers had a fund value of $212B (billions), a year later it rose to $250B (a net return of 19%!). Calpers lost 5%, down to $237B in June 2008; the number will be significantly lower come next June. Another huge institution, Harvard’s own endowment fund ($37B), was down 22% in 2008, with worse numbers expected for 2009. If you’re a semi-rational venture firm, do you force Harvard or Calpers into forfeiting their position? Hypothetically, as Counsel suggests I say, big LPs would call their VC firms ahead of capital calls with a suggestion: Let’s forestall potentially awkward situations, don’t make capital calls. All very discreet, no public unpleasantness. The right thing to do, we’re optimists, we all believe we have a future: Look, OpenTable went public this week…
Back to the weekly dissection of the Reserves spreadsheet. Not only do we have to think of our own companies, which ones are likely to survive but will require more cash than planned, which ones should “donate” their reserves to the survivors as we decide to leave them to their own devices. But also, with the LP liquidity crisis cascading into some VC firms having less cash than expected (or paraded), we have to brace for trouble with co-investors. If one of them runs out of cash, how do we find a substitute, and is it really a good idea to wash this firm out? We might have to do business with them in a not-too-distant (and bright…) tomorrow.
Isn’t this fun? —JLG
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