Tough times for VCs means tough times for venture backed startups

by Healy Jones

Dow Jones’ Venturewire, a news service for VCs, today published an article titled “Darwinism Sets In At Claremont Creek.” This article described a venture capital firm dealing with the recent economic downturn, and how they are allocating their reserves to existing portfolio companies out of their older fund. The key take away from the article is that the fund will continue to fund their best investments but will stop backing their less-promising startups. In other words, some of their companies are not going to get additional funding from them.

That’s pretty bad news for some of their portfolio companies. The article talks a bit about how this is happening across the venture universe, and I believe that the journalist used the Claremont Creek fund as an example because they were very forthright on explaining their efforts/methods/thought process. Hats off to the investors at Claremont for being so honest about this. Startup CEOs can learn a lot from this example.

So that you understand a bit better what is going on here, we can go with the math presented in this article. Claremont Creek’s older fund was raised in 2005 and was $130 million in size. It has made $44 million in investments into 16 portfolio companies. (They are not making investments into new companies out of this fund; instead, new investments are made out of a new fund, a $175 million fund, that was recently raised.) The older fund should have reserved the remaining $86 million ($130 million - $44 million already invested) for these 16 companies. That’s about $5.4 million for each company. I’m willing to bet they did a robust job projecting the cash needs for these 16 portfolio companies, so let’s pretend that each portfolio company “needed” that $5.4 million to get to an exit/become profitable or whatever.

But now we have the evil economic downturn. Each portfolio company now needs 50% more cash from Claremont to get to exit (totally making this up, but it may be an OK projection). This could be for a variety of reasons, but the main ones might be that the companies are having issues finding new outside venture investors for their follow on financing rounds (this is happening to a lot of venture backed companies right now and is often only driven by the capital markets and NOT a function of how good the company is) and also, potentially, the portfolio companies are a bit more slow to get customers due to the downturn. So, each company now needs about $8 million to get to exit, not the $5.4.

That means that the venture fund in this example now needs $8 million times 16 portfolio companies, or $128 million - $42 million more than the firm thought it needed when it stopped making investments in new companies out of that fund. Yikes!

Regardless of how you cut the numbers from here, at least 4 companies are probably getting left out in the cold and will have to either dramatically cut their cash burn, find alternative sources of funding without a supportive VC or go out of business. And the major reason this is happening is not the portfolio company’s fault, it is the economy. Pretty depressing.

I know I sound like a broken record, but I’d like to suggest that your startup consider taking venture funding from more than one VC - syndicating - so that you have a better chance of avoiding this type of a situation. Two VCs are better than one in these types of situations.