Like any industry, venture capital goes through periods of expansion and contraction. When times are good, institutional money flows into VC firms big and small. For entrepreneurs in need of capital, it’s a win-win: not only is the cash they need relatively easy to come by, but it’s generally also easier to convince investors to be more patient and cooperative.
But what happens when times are bad?
As many entrepreneurs have witnessed since the 2008 financial crisis, a tough economy often causes institutional investors to tighten their purse strings and invest their money outside of VC funds. If they do invest in venture capital, it’s through larger, more established firms.
Naturally, that makes it more difficult for the smaller players. When demand exceeds supply, smaller VC firms often can’t raise subsequent funds and are forced to contract -- shedding partners, halting further investment, and simply waiting for current investments to exit.
Contraction like this causes to a Darwinian effect. The strong VCs survive and feast on the little guys, while the weaker funds falter and disappear. Unlike Darwinian evolution, however, this process rarely leaves the surviving population better off.
In fact, for entrepreneurs who are bound to -- and somewhat reliant on -- those lame duck investors, such turbulence can be incredibly harmful. It often leads to:
Disengagement When a venture firm is forced to contract, its partners may be less motivated to serve effectively on their portfolio companies’ boards, particularly in cases where they have been assigned to pick up the slack for former colleagues. This potentially lackadaisical attitude can drag down a company and its board.
Impatience. If a venture firm is unable to raise another fund and has shut down its operations, it’s likely that the firm’s investors will be more anxious than ever to see the returns on their investments. If their suddenly short-term vision and exit strategy does not align with your longer-term plans, it can cause numerous problems. For example, your VC may push for an earlier exit than you think the business is ready for. Or your VC may not want to support costly, long-term initiatives that hurt the company’s financial appeal to potential acquirers.
Obstinance. Even if follow-on rounds of financing make sense for the company and its exit strategy, dead weight investors may invoke their blocking rights and prevent the business from raising additional money. Their motivation for doing so is typically equity dilution, but it could also be due to a misalignment with the company’s long-term aspirations and vision.
The biggest problem with contraction in the industry, of course, is that VC firms don’t just shut down if they’re unable to raise a new fund. A VC might stop raising new funds and it might discontinue value-add services, but it never shuts its doors right away. That is because the firm must see its funds to completion, including seeing their existing portfolio companies through to their exits. As a result, until your business makes its exit or buys out those investors, you will have to deal with the problems they invariably present.
While you can’t predict what’s going to happen in the future, there are a few things you can do before you bring in investors to lessen the likelihood that a contracting industry could negatively impact your business.
1. Be picky about your VC partner. Before you take money from an investor, it’s critical to ensure that you and the VC are aligned around the company’s aspirations, and the timing and economics of an exit. Ultimately, if your business is a long-term build, it’s critical to make sure your VC firm is in it for the long haul, too.
2. Analyze the fund. The key questions to ask your VC include: When did you raise your fund? What’s the max you will invest in any one company? How much do you have in reserve for the portfolio and for our company specifically? What exits have you had in your previous funds and are your investors satisfied with the returns? You don’t want to end up with an investor whose fund is depleted when you need more capital.
3. Raise money when you don't need it. Counterintuitive? Yes, but the idea is to never run out of money and always plan for the worst. That way, if there's a contraction, your business will at least have access to the capital it needs to continue its long-term growth strategy.
4. Diversify your investment base. In other words, raise money from multiple investors. Admittedly, that causes complexity, but it also spreads out your sources of funding. So as you bring in new investors, you can ask struggling investors not to participate in follow-on rounds and save their capital for a rainy day.
The reality of a venture capital contraction-- and the subsequent Darwinian effect, unfortunately -- is that you can’t control when or if it happens. However, the data points to an industry that will likely keep contracting. The total universe of VC funds shrank by 31 percent between 2001 and 2011, and the number of funds that deployed capital between 2008 and 2012 decreased by 15 percent. While venutre capital funds are recovering as a whole, don’t expect to see the number of funds rise significantly from this point.
The good news is that the industry is consolidating into a smaller set of funds that are better positioned to survive future downturns. That will ultimately reduce companies’ risk of having a lame-duck VC as an investor. Plus, by taking the four precautions listed above -- and always ensuring that your investors and your board are on the same page -- you will mitigate the implications lame-duck investors can have, and make it much easier for your business to secure future rounds of funding.