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BWSmallBiz -- Venture Capital October 9, 2009, 1:21PM EST

Left in the Lurch

Startups are finding that in hard times not all of their backers hang around. Here's what to do if they don't

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Illustration by Jonathan Barkat

By Eileen Gunn

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SynapSense team: VC partner Beninga, CEO Van Deventer, and retired VC partner Phillips Martin Klimek

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Ray Vella/BW

Hubert Engelbrechten became CEO of Fremont (Calif.)-based semiconductor manufacturer GTronix in 2005, when the company was barely out of startup mode. He helped it raise $40 million in venture capital, including a $10 million round led by Palo Alto (Calif.)-based Jafco Ventures. Jafco partner Aaron Cheatham had been instrumental in persuading the firm to invest, believing the company had truly innovative technology and that it could do well in the Asian marketplace, where Jafco has strong connections. With that round of funding, Cheatham took a seat on GTronix' board and became a close adviser to the company. But in the fall of 2008, Cheatham dropped a bombshell: Jafco had become disenchanted with the mature, capital-intensive semiconductor industry, and Cheatham himself would be leaving the firm. That left Engelbrechten with an empty board seat and a financial backer having second thoughts, just as he was starting to raise his fourth round of financing—crucial to getting GTronix through the recession.

While you might think the compensation structure of venture firms would tie their principals to the firm pretty much for life, such exits are becoming more common. In 2008, nearly 16% of principals left their venture capital firms, according to the National Venture Capital Assn., and those remaining had about 10% less money per partner to manage. A survey by Deloitte Touche Tohmatsu earlier this year found that 41% of firms plan to invest less, while 21% are changing the sectors they invest in. As a result, Mark Heesen, president of the NVCA, says: "I expect that you'll continue to see a decline both in the number of VC professionals and the number of VC firms in 2009."

There are other, more ominous factors at work as well. Each partner at a firm is responsible for bringing in new deals and for helping his or her companies grow. The firm takes a share of the profits when the company is sold or goes public, with the person who "discovered" the company often garnering a slightly larger share. A partner whose companies aren't doing well cuts into his colleagues' profits and hurts the firm's track record. Now, with more economic pressure on VCs and their portfolio companies, firms are quicker to cut loose a colleague who brings in problematic deals. Partners are fleeing to other firms or other kinds of work if it becomes apparent their firm won't be able to raise its next fund and will have to wind down. And VC firms raised only $1.7 billion in the second quarter of 2009—the smallest amount since 2003. "Quite a few of my clients have been told that a firm is no longer investing in their sector, so the partners who focus on it are leaving," says Josh Nathanson, a partner with Cleveland recruiter ON Search Partners, which specializes in startups.

For entrepreneurs, such unexpected exits raise unnerving questions about the possibility of a new board member, access to the venture firm's network, and the willingness of the VCs to commit to follow-on financing. In the case of GTronix, Cheatham would be handing over his board seat to another Jafco partner, one who might be less familiar with the industry and the company and far less vested in its success.

While the relationship between an entrepreneur and his or her investors can be fraught during the best of times, CEOs at this crossroads need not sit by idly—and nervously—awaiting their fate. Here's how to manage a difficult situation and prevent it from undermining your business.

SIGNS OF A TURNOVER

If you're getting nervous about your board, stay alert for some common signals that turnover is coming. If your VC firm isn't making new investments in your sector, the partners may be cooling on it—and on the particular partner whose specialty it is. "If the VC on your board isn't making new investments, or if a lot of his investments aren't doing well," he's most likely headed for the door, says Michael Braun, CEO of San Jose (Calif.) software company Intacct, who has been involved in the tech industry for 38 years as an entrepreneur and a VC. "If he doesn't want to update his partners about you without excessive preparation, that could signal he's no longer very powerful at the firm," says Braun.

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