Climate Update: Early Stage Investing

I've been collecting a lot of data about attitudes and behaviors towards early stage investing in today's tumultuous and uncertain market environment. Whether you happen to be an investor or an entrepreneur, an angel or a venture capitalist, you are going through a disciplined re-assessment of what you should be doing and how you should be doing it. One thing is for certain: few people are operating in the ways they did only a few short months ago. Aside from dozens of meetings with entrepreneurs and VCs, I attended a NextNY event last night that was all about how young companies should be coping with today's uncertainty. David Kidder of Clickable and Matt Blumberg of Return Path both had some sage advice, from the perspective of business builders that have been around since well before the bubble and crash and have been challenged to adapt to hard times.

Venture Capitalists: Uniformly more conservative, but many are still in business

As seems to be the case with many industries, I am seeing a barbell emerge in early stage investing. Many of the larger funds ($100 million+) I know and work with are pulling in their horns, focusing largely on current portfolio companies and reserving cash for supporting those that warrant additional investment. I recently had a deal where a term sheet was pulled by a premier VC; this is not something I could have imagined back in the summer. There is definitely a sense of hunkering down and being all over their management teams, asking for stepped-up financial reporting, cost cutting plans and hiring freezes. But in general, there doesn't appear to be much of an appetite to do new early stage deals. They are preparing for a nuclear winter where exits are few and far between, the IPO market is closed and times to exit could be extended from 3-5 years to 8-10 years and beyond.

Smaller funds, while certainly applying the same discipline to their existing portfolio companies, in general appear more sanguine about the opportunities that exist. They have fewer companies to deal with than larger funds, often have plenty of dry powder (both financially and managerially) to both support existing companies and to deploy in new deals and are seeing more deal flow than ever. So while they are clearly raising the bar for investment and competition for VC capital is intensifying, many view the current malaise as a chance to invest in great businesses at attractive prices, such that 7-10 years down the road they will look back and say: "Vintage 2008/09 deals were some of the best deals we've ever done."

All VCs, whether large or small, are saying that current cash should be husbanded, with the goal that it should be sufficient to support the business until cash flow breakeven. One of the big dilemmas is how to best support successful, growing early stage businesses that are not yet cash flow breakeven. My friend Fred just shared some interesting thoughts on the topic, citing Tom Evslin's post where he utters a common sensical but important line for people in freak-out mode to remember: "In the end you will succeed because of what you DO spend your money on." Surely time is right.

Though I've generally applied this concept to Wall Street it is certainly applicable to early stage companies: LIQUIDITY CREATES OPTIONALITY. That means having the chance to accelerate growth in the face of weakened competitors, to step up advertising and promotion when others can't afford such expenditures and to hire key talent at better prices to shorten release cycles or to sell more aggressively. The best VCs are helping their companies to balance the twin goals of liquidity preservation and growth, a balancing act that is not easy but essential for supporting the development of world-class businesses. VCs have got to be front-line risk managers. Risk managers aren't just for Wall Street any more.

Angels: Shaking out

The prevailing tone in the market is that angels who "dabble," e.g., aren't professional angels or "super angels" as I've referred to them in the past, are generally shell-shocked and backing away. They neither want to put capital in new deals nor likely have the stomach to participate in pay-to-play recapitalizations that will inevitably come about during 2009 as the cash crunch really takes its toll. We are in the early innings of what will be a very challenging time for companies funded in the past 1-3 years, those in need of capital that are not yet near cash flow breakeven but who have businesses worth supporting. Now I wasn't around in the 2001-2003 period doing early stage investing and don't have first-hand knowledge of the angel landscape that existed, but based upon conversations with Fred Wilson and others it seems that the super angel had not yet emerged.

Today, conversely, I know lots of people like me, refugees from big tech and big media with knowledge and cash or micro-cap funds (>$25 million) that are not only still in the game, but operating with much the same attitude as the smaller VCs discussed above. What this means for the entrepreneur is that it will surely be harder to put together those "friends and family" rounds, as the dad next door who was willing to toss in $50k in April is licking his wounds from his equity portfolio dropping by 30%. But while the competitive environment for capital has intensified the money is there, it just happens to be in fewer, more concentrated hands. And I'm not sure this capital was even available in the wake of the early 2000s downturn. So that is the good news.

Entrepreneurs: Be relevant, be focused, be a cash hog

David and Matt had some priceless lines last night that I will seek to recall, gems for the entrepreneur who is wondering how to best position their business both to the market and the investment community:

D. Kidder: Be in the jet stream; don't be at the edge. Get in the middle of "directional optimism."

What David was saying is to avoid being a feature, an add-on. Be right in the middle, be relevant. Be something that squarely addresses a client problem. Don't be afraid to go for it. Because if you don't, you will not succeed.

D. Kidder: Get your product into customers hands ASAP - NO SCIENCE PROJECTS - and with total transparency.

In essence, don't be afraid to look stupid, don't be afraid if it breaks. Be honest with a client as to where you are and what you are trying to accomplish. Take their feedback seriously. Rapidly iterate on the product. And get it back out in front of them. Use rapid iteration to FIND THAT CUSTOMER.

M. Blumberg: Overcommunicate with your team in times of turmoil. Whether the company is big or small, it doesn't matter. The leader needs to be a calming influence - and helps keep good employees in their seats.

Matt shared some stories of entrepreneurs he knows that did both very good and very bad jobs of communicating with their teams when times were tough. Those that did share a lot often found that team members came up with solutions better than the CEO, and were "pre-socialized," helping to allay a CEOs fear of having to fire people, cut salaries, etc.

D. Kidder: Listen to customers and data. They are the two keys.

While David acknowledged the value of his Board and other smart people in his orbit, at the end of the day the ultimate guideposts of progress are customer feedback and data around usage. Little else matters.

D. Kidder: Be and "AND" culture

In short, always be raising money until you never have to raise it again, and build product at the same time. Those who say raising money is a distraction to building product just don't get it. You have to do both AND do them well. It's all about the AND. 

The Key Take-aways

• Cash for start-ups is out there, but principally from the smaller VCs and super angels

• Fewer players actively doing early stage means greater competition for cash, so plans have to be sharp, relevant and highly cash efficient

• Cash is king, but you've got to spend cash to be king someday

• While the VC and economic weather is stormy and is likely to be so for quite some time, businesses are still being created, innovation is alive and well and businesses are getting funded. It is just that everybody is having a harder time. That's all.