As
Start-Ups Fail, Venture Investors Back Out in Droves Financing: The
stampede to put money into tech has reversed direction, with some
partners selling out at a loss. April 14, 2001 | JOSEPH MENN | TIMES
STAFF WRITER For the last three years, investors large and small have
been clamoring at the gates of American venture capital funds, begging
for a chance to put money into technology start-ups. The funds provided
early financing for such companies as Amazon.com Inc., Sun Microsystems
Inc. and America Online Inc. before their initial stock offerings,
turning millions of dollars into billions for an elite group of
university endowments, pension funds and individuals worth at least $1
million. Just as suddenly, the stampede to get in has reversed
direction. And some of the dot-com chief executives who made it into the
party, committing to invest millions over a decade or so, are trying to
back out of their obligations. "It's hard to imagine the speed with
which it has happened," said Jon Staenberg of Staenberg Venture
Partners, based in Seattle. He has fielded withdrawal inquiries from two
investors in his $100-million venture fund who now have cold feet. Both
are executives at companies whose market value tumbled by 90% or more.
An overall decline in venture financing this year was already expected,
since the amount put into start-ups soared 80% to a record $68.8 billion
last year, according to research firm VentureOne. Fund returns to
investors went negative in the fourth quarter of 2000 for the first time
in more than two years, research firm Venture Economics said this week.
It won't be hard for the top venture capital firms, such as Amazon
funder Kleiner Perkins Caufield & Byers, to raise cash. Those firms
have turned away hundreds of would-be limited partners in the past,
instead rewarding executives at companies they backed with permission to
invest. Many venture capital firms refuse to discuss the new
nervousness among their funders. "People are talking about it in hushed
tones, with great reluctance," Staenberg said. Those who will talk say
the pull-out isn't severe enough to impair the amount they invest in new
technologies, one of the major engines for economic growth in the last
decade. That's because individuals provide less than 20% of all venture
financing. But some are concerned that investments from big institutions
might decline for another reason: Many of them have financial plans
that call for allocating 5% or 10% of their assets to venture funds.
With those institutions' total portfolios shrinking along with the stock
market, that 5% or 10% works out to a lot less cash. On Friday, the
giant California Public Employees' Retirement System reported that it
lost 5.3% of its assets in February alone, wiping out $9 billion in
value. Barry Gonder, a senior investment officer at CalPERS, said it
seems unlikely that the system's total assets would slide so far that it
would have to cut back on future venture investments. "We're at about
5% [of total assets] today, and I can go as high as 8%," he said. "We'll
probably become more selective." The individual attempts to withdraw
are putting venture capital funds in a delicate position. If they
politely allow cash-crunched limited partners to back out, others who
simply dislike the firms' investment picks might try to follow suit.
"People get caught in the position of do they want to put good money
after bad?" said Brent Nicklas of private equity firm Lexington Partners
in New York. "I've never seen it quite as widespread." Venture capital
partnership agreements typically last seven to 10 years, and the
penalties for early withdrawal can be harsh. In some cases, if an
investor pulls out when the venture capital firm asks for a new round of
promised money, the partner can lose 50% of what it already put in. The
profits that the investor had earned to date also can be rolled over to
satisfy at least part of the obligation. If that's not enough to meet
the capital call, the venture capital firm can sue--an unpleasant step
in a business built largely on personal relationships. The least painful
way out for a desperate limited partner is to sell to another partner
or to dump an unwanted deal on the little-known but growing secondary
market, where a few firms specialize in buying limited partnership
interests. As tax bills come due, an increasing number of limited
partners are doing just that, unloading their holdings for less than 50
cents on the dollar. "We are seeing more sellers than we did six months
ago, but the quality has gone down," said Jerold Newman, president of
secondary buyer Willow Ridge Inc. in New York. Another buyer is
Nicklas' firm, which takes on soured investment deals worth as little as
$1 million--or as much as $1 billion--when a bank or other major
institution decides to sell off an entire portfolio. Many more calls
from individuals are coming into Lexington's Santa Clara office now than
six months ago, Nicklas said. "It's up, and I think it's going to
continue to increase through the end of this year," he said. "A lot of
last year's money came from new entrants into the market, including
high-net-worth individuals at companies that the VCs had backed." A
significant complication for those trying to sell off their investments
is the difficulty in figuring out how much their stakes are worth.
Venture funds often wait until two months after the end of a quarter
before estimating how much their portfolio of public and private
holdings is worth. Those trying to sell now are using valuation
statements from December, before much of the stock slump. The funds also
often use numbers designed to make their returns look the best,
according to Stephen Lisson of InsiderVC.com. It's common for them to
mark up the value of private companies as stocks in similar firms rise,
then decline to mark them down again until forced to do so by an event
such as a takeover or a bankruptcy. And these days, it's impossible to
tell which companies are going to be around in a year. "Valuations are
somewhat irrelevant if the company is going to run out of money,"
Nicklas said. With struggling firms more likely to return to the hand
that fed them for another round of financing, it's up to the venture
capital firms to decide whether their offspring live or die. "How do you
predict or handicap or bet on what the venture guys are going to do?
When you sit down with them, they tell you that even they don't know,"
Nicklas said. As Start-Ups Fail, Venture Investors Back Out in Droves -
Los Angeles Times
http://articles.latimes.com/print/2001/apr/14/business/fi-50936
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