Small Business

For Venture Capitalists, Paradise Lost


As co-founder and chairman of the influential Venture Law Group, Craig W. Johnson is a Silicon Valley heavyweight. The 80-attorney firm he helped start in 1993 has advised or aided the start of companies now worth tens of billions of dollars. They include successful outfits like Yahoo!, Hotmail, and Rosetta Inpharmatics. From his Sandhill Road perch, Johnson has closely observed the Internet bubble and the technology market's collapse, which savaged the venture-capital community.

BusinessWeek Online Technology Editor Alex Salkever spoke to him recently about the current state of VC markets in Silicon Valley and around the country. Following are edited excerpts of their conversation:

Q: So what's the next step for the VC community?

A: A big shakeout is already happening. I have in my mind the image of this Rube Goldberg-like machine in Silicon Valley that balances everything out. What happened over the past few years is all this money came in, and everything went out of equilibrium. Now, it's going to take a while for the system to settle back down again.

Companies have to readjust expectations. It's going to take five to seven or eight years to build a company -- instead of 12 to 18 months. Venture capitalists have to adjust expectations to account for the fact that they will get a lower rate of compounded return. The whole system is recalibrating itself.

Q: What happens to the money that VC funds raised in 2000, just before the bottom fell out?

A: There's no way VC funds can manage the money they've raised. They were opportunistic and said: "Gee, I can get a 2.5% management fee on $1 billion, just like I did for $200 million, and that money ends up in my pocket even if I'm sitting on it. That's kind of sweet." And they figured out a way to rationalize it. But in the cold light of day, most of the funds, if they're honest, are saying they can't manage this money.

Q: So what happens?

A: In addition to the fact that valuations are down significantly across the board, funds can't really invest more than $3 million to $4 million in the beginning of a company because they want to leave enough of its value in the hands of the entrepreneurs to make sure they stick around.

When you have to place and manage $1.5 billion, that's a big problem. If you have eight partners, then you can't come close to managing the investments required to disperse those funds. As a venture capitalist, you can't be on more than 10 company boards and still be effective. I've seen some VCs get on up to 15 or 20 boards, but frankly they're like a perpetual-motion machine at that level of commitment. And even at that level, you can't invest $1 billion productively. So what's happening is that everyone is readjusting.

Q: Is pressure building for VC funds to give money back to investors?

A: I'm on seven or eight advisory boards on different funds. Hearing it from the inside, I don't see a lot of pressure to give money back. What I do see is a few examples of individuals who made larger commitments than they should have to the funds. In the ebullience of the era, they said they would give $10 million to the fund. And now they can't honor that commitment and are trying to get out of it. What we're also seeing is Goldman Sachs and other firms that have put together special funds simply to buy out distressed individual limited-partner positions.

Q: Have the entrepreneurs snapped back to reality?

A: Not yet, but they're getting there quickly. It's kind of like someone has been existing in a paradise with warm skies, and suddenly they're deluged with freezing-cold water. I mean, how long does it take you to adjust to the fact that the water is cold?

The biggest problem of adjustment hasn't happened with first-time entrepreneurs. The biggest problem has occurred with companies that were sitting on large amounts of cash they had raised in the bubble period. In those instances, there were a number of CEOs struggling to adjust to the fact that maybe they should spend less and economize more. VCs are putting extreme pressure on CEOs to reduce burn rates [the pace at which a startup is running through cash on hand].

In some cases, they're getting quite a bit of resistance from the CEOs. It isn't until they run out of financing and realize how tough it is to raise incremental financing that the CEOs suddenly wake up to the fact that maybe they were spending too much. I know a number of companies in which venture companies had to fire the CEO because they couldn't get the CEO to readjust to the new metrics of the environment.

Q: How much of a contraction will the VC community see around the country?

A: My guess is you will have a 70% to 80% drop in total VC from the top of the peak, but many of these funds had been keeping the same number of partners and massively increasing the amount of money they were managing. I think I saw another statistic that says the number of professional venture capitalists in the country increased from 4,000 to 8,000 over the past couple of years. My guess is over the next two or three years, that number will probably come back down to the earlier levels or slightly below.

Q: You said company valuations are way down. How's that affecting the process?

A: What has happened is that companies are going back into the financing market, and even though they've made great progress, the first-round valuation of the company was much higher. They've set themselves up for getting hammered. So you have this strange phenomenon of a difficult or impossible financing round -- even when the business is doing well. We see that again and again. A company makes every milestone, and they still get a down round. That's hard because it taints a company.

Q: How are VC firms dealing with the trauma?

A: A lot are being forced to make some tough choices. Typically, a fund designates 50% of its funds for initial investments and 50% for follow-on investments to sustain companies later on.

What has happened is those funds are running out of reserves. What we're seeing now is that general partners are saying we've got five companies that need follow-up financing. But we are down to our last 10% of reserves. We can't support all of these companies. So we have to choose one or two. You have a lot of broken [VC funding] syndicates because some funds are saying we can't support all our children. It becomes kind of a Sophie's Choice situation. And it's about that brutal.


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