What Happens When Venture Funds Dry Up?

Last Updated May 4, 2009 8:26 PM EDT

The recent announcement by cloud software vendor Workday that it has raised $74 million in venture capital notwithstanding, venture funding has slowed considerably over recent months and from the looks of things, VCs may be more likely to close up shop than fund new companies. While that means tech ventures had better find alternative ways of raising cash, that not might be such a bad thing, notes Giles McNamee, founder and general partner of Boston-based investment bank McNamee, Lawrence & Co.

According to McNamee, venture capital firms look to invest sums in the order of $25 million to $30 million in a first round, which is more than many start-ups need, particularly in a cloud computing world where they don't have to buy infrastructure. In return for that overabundance of riches, VCs exact onerous terms that leave founders with disproportionately little in the way of equity.

"People are waking up to the fact that smaller amounts make more sense -- there's less dilution -- and that they don't need to spend $10 million on marketing," McNamee told me.

Most funds are organized to operate for seven years, often with the option of extending the life of the fund for another three years; fund managers' earnings are based on the amound of capital they're managing rather than the success of their investments. "They're incented to be successful raising money from the limited partners, as opposed to being aligned with funding successful companies," McNamee said.

Rebecca Buckman at Forbes described the crisis VC firms are facing succinctly:
Venture firms raising ever-larger investment funds--which produce ever-larger fees, of course, and rich lifestyles for the VCs getting them--have simply backed too many crummy companies over the last 10 years.
So what comes next? According to McNamee, fledgling companies are raising capital through strategic investments made by larger companies in their space, as well as so-called angels -- wealthy individuals whose investments are typically in the single-digit millions. Those amounts are smaller than typical VCs would want to invest, but are often more than enough for a small software start-up. He pointed to Demandware, an e-commerce company that just raised $15 million, as an example of how this kind of funding is still flowing. Angel funding is "better for the company, investors are mostly successful CEOs that can help with advice -- it's a good process," he told me.

Another way to raise capital is through the public markets, but that source has dried up for small companies, especially since complying with the requirements of Sarbanes-Oxley can cost $2.5 million for a company with $10 million in revenues. Too rich, according to McNamee, who noted, "a five to ten million dollar IPO is not possible today."

McNamee expects the SEC or Congress to create a second, less stringent set of rules for smaller companies. I mentioned that loosening regulations, particularly where Wall Street is concerned, might be a tough sell in today's environment, but according to McNamee, "the biggest source of fundraising for Democrats is a combination of Wall Street and Silicon Valley, and those are all people for whom this is an important issue."

That said, it was also dear to former SEC Chariman Christopher Cox, but current SEC chief Mary Shapiro has given no indication that she's interested in creating this second regulatory tier.
  • Michael Hickins

    Michael Hickins has written about technology and business for BNET, InformationWeek, InternetNews.com, eWEEK -- where he was executive editor from 2007-2008 -- The Curator, Pseudo.com, Multex Investor, Reuters, and Conde Nast's WWD.com. Hickins is the author of The Actual Adventures of Michael Missing, a collection of short stories published by Alfred A. Knopf in 1991. He also published Blomqvist, a picaresque novel set in 11th century Europe, in 2006. Hickins remains passionately interested in the intersections of business, technology, politics and culture, and endures a life-long obsession with baseball. He is married with two children and lives in Manhattan.