EntrepreneursVenture Capital

Of venture capital and bubbles

By February 14, 2008 4 Comments

Bubble bursting

Following OpenCoffee this morning I met with Harry Holmwood for lunch.  Harry is a serial entrepreneur from the games industry and a veteran of the last bubble.  Amongst the topics we talked about was whether we are in another bubble today, what that might mean for the availability of financing now and in the future, and what that in turn implies for companies that are thinking of raising money.

In the last bubble a lot of companies raised large amounts of venture capital and built up big cost bases on the assumption that they would be able to raise more money in the future.  That assumption collapsed when the bubble burst and some of these companies either went under or had to endure painful restructurings and down rounds.

That is something that any company would want to avoid, yet at the same time raising venture capital to aggressively pursue a market opportunity can often be the right strategy.  This post is aimed at better understanding the trade-offs between the risk and reward of these options.

Most companies have a choice between a slow growth strategy which requires little or no investment (let’s call this the organic strategy) and a high growth strategy which requires significant third party investment (let’s call this the venture capital strategy).

The organic and venture capital strategies are equally good, they just have a different risk-reward trade off.  Organic is lower risk and lower reward, venture capital is higher risk and higher reward.  Which you choose will depend both on the circumstances of your company and your personal disposition and situation.  I repeat, neither one is inherently better than the other, they are just different.

The rest of this post is about understanding the impact of a changing financial climate on the venture capital strategy.  Specifically, the risk that you start on a VC track because you can, but then the financing climate becomes more difficult and you end up in trouble.

The first point to make is that great companies always get financed.  Valuations may move, but good companies always get money.  And if you don’t believe with all your soul that your company will be great then you should probably be careful about how much money you raise.

The second point is that good VCs are here for the long term and will stay with their companies irrespective of the economic cycle and wider macro-economic condition, provided always that the company retains its potential.

The third and final point is that with prudent management you can limit your exposure to downside even if the first two points don’t apply.  The key things here are knowing how much time you have left before your cash runs out, starting third party fundraising at least six to nine months before your drop dead date, getting firm statements from existing investors about the conditions under which they would or wouldn’t re-invest and if possible having a ‘cut back to profitability’ plan.

One of the more bubble-ish characteristics of the current financing climate in consumer internet is that I and others have been saying focus on building an audience first and monetisation second.  At first blush this seems to increase exposure to changes in the financing climate, but when you get into it things are not as bad as they might seem.  In the consumer internet sector once you strip out marketing expenses the operating costs of a company are often very low and as a result the ‘cut back to profitability’ plan may not be that painful.  Clearly Plan A is to have a large and fast growing community, but there are worse things than taking a period of time to consolidate an existing position before pushing on again.