VCs and Sheep: Separated At Birth?

This just in: VCs are sheep. In case you missed it, they all tend to look and act the same, although they smell much better. The VCs I mean. After being one of the flock for 14 years, I can speak to the herd mentality that drives the up and down cycles of the early stage investment community. The Wall Street Journal, citing Venture Source, reported that 57% of VC deals completed in the first quarter of 2009 were funded by existing investors, up from 44% a year earlier. That is 57% of a much smaller number of total financings that took place in the US (down 47% Y/Y) and Canada (down 25%Y/Y).

Why do VCs tend to invest in less new deals? Because, like sheep, they are skittish. Any loud noise, such as LPs yelling over conference speaker phones, tends to send them scurrying for the comfort of portfolio triage. After all, that’s what the first quarter of 2009 was. VCs looked at their portfolio and started to make decisions about who should get more money and who should die a miserable death. Here are a few of the fallen.

We have seen this movie before. In late 2000, early 2001, the same thing happened as the huge hangover of the dotcom/telecom party started. I have two columns that I wrote in March 2001 (they are over in my Archives) that talk about the same thing happening then as now. It is all part of the cycle of funding. The VCs will hunker down and only nibble at new deals for the first year or so, provided that they feel that the valuation is a good deal for them. At the first sign of recovery (VCs think exits, so a few IPOs or some more aggressive M&A), the funds will start flowing.

The people that fund the VCs are a little slower. LPs take time to adjust their allotments to venture funds and this typically happens annually. Net effect is that venture funds still get their “target” fund size even when it appears the world is melting around them. To wit, paidcontent.org tells us some funds like NEA and Trinity hit their targets, but other venerable firms like Draper Fisher Jurvetson are lowering their goals for the coming year. The LP lag in the funding cycle takes a couple of years to sort out… which is funny because just as the world starts looking good to invest, VC funds are at their dryest point of funding. This will definitely occur again in Canada this cycle as less and less money has been raised through other means, such as the labour sponsored funds.

So, the VC sheep and the LP sheep will conform and the cycle will continue. It might be a slower recovery this time, but it will recover. The best paid VCs seem to be those that break the sheep mold and run opposite the herd. They seem to have “dry powder” when other funds are scrambling to raise money or simply can’t do anything because their LPs are not answering the phone. It’s tough to avoid being a sheep because there is risk involved. But, it’s also tough being a sheep because your returns tend to stink. And then there are the baaaaaad puns.