Venture firms brace for cash crunch

Harold Bradley manages $2.1 billion for the Kansas City, Mo.-based Ewing Marion Kauffman Foundation. If you are a venture capitalist looking for a new limited partner, he's got something to tell you. "Don't stop in here," he says. "Don't try and sell me on a new fund, and good luck trying with everyone else."

Venture capital, as every VC is happy to tell you, operates on seven-to-ten-year cycles. Firms don't, for the most part, use debt to fund their companies. So in theory they should be shielded from the financial mess that has laid waste to some of the largest financial institutions in the world. But no one is getting out of this unscathed, and certainly not the gang that occupies Sand Hill Road in Silicon Valley.

The conversation among limited partners in VC funds these days is all about liquidity, Bradley says. Who's got it, and who doesn't. Hiding your money in illiquid venture capital funds looked pretty good six or 12 months ago. But if you are an endowment or pension fund with a huge exposure to a mega-buyout firm that is cratering, a hedge fund that is being wiped out or a venture fund that is on a seven-year runway to returns (in a market with no exits), what you want is cash now - not a one, three or five year wait to cash in.

So what does the financial crisis mean for VCs and for startups? For starters, if you are a second or third-tier venture firm trying to raise another fund, you can, as Bradley suggests, forget about it.

Before the market meltdown it might have been OK for a pension fund or university endowment to park money in an underperforming VC fund as a limited partner. But going forward, all bets are off.

Venture capital operates via commitments. A limited partner pledges a certain amount to a fund, and as the VC firm needs it, it makes capital calls to get that money to fund its portfolio companies. If you don't pony up when asked, you typically lose all your prior investment and are frozen out going forward. After the dotcom crash, capital calls came from VC firms and some limited partners simply said no - whether it was because they were wiped out in the Internet implosion, or they didn't want to throw good money after bad.

It could be worse this time around. "My expectation is that it will start first in some private equity funds, that there will be a substantial miss on a capital call, and we'll see it next in venture capital," says Paul Kedrosky, an investor and academic focused on the future of risk capital and writer of the business blog Infectious Greed. "No one is going to stiff Kleiner Perkins, but the second or third-tier guys will get stiffed all day long."

If you are a startup backed by a VC firm with loads of limited partners that are exposed to the Wall Street meltdown, or are mostly funded by angel investors without the deep pockets, now is when you start to worry and need to consider a future without that next round of funding.

"Any LP can be at risk," says Mark Tluszcz, co-founder and managing partner at one of the leading European venture firms, Mangrove Capital. "If there is a big LP, whether it is a bank or an insurance company, if they are facing serious financial issues they are going to cut back on their commitments."

Says Warren Weiss, a partner with Palo Alto-Calif.-based VC firm Foundation Capital: "If you are a company with a big cash burn, you are in for some pretty tough times. We're going to see more fire sales than mergers. You'll see a lot of companies in the $200-$400 million range that can't go public now, get acquired. The weak will get weeded out."

With hedge funds, buyout shops, even venture debt funds mostly on the sidelines, money is about to get really tight. The pressure will fall on VCs to decide which of their portfolio companies live and which die. Weiss believes liquidity is the key to navigating the next 12 t 18 months. "If you are a startup or a limited partner, it's no cash, no company," Weiss says.

Bryan LeBlanc, CFO of Portland, Ore.-based startup Jive Software, agrees. "If you are not cash-flow positive you are in a tough spot right now," says LeBlanc, whose company develops collaboration software for the workplace.

Jive is in relatively good shape, because it has significant revenue, was bootstrapped for the first six years, and only recently raised its first round of funding from Sequoia Capital. "To the extent you haven't figured out your business model yet you are in trouble, because it's going to be hard to get another round," LeBlanc says. "You aren't going to get a second life this time."

Brian Jacobs, a partner with San Mateo, Calif.-based Emergence Capital, is anticipating a shakeout. "There will be some realignment among firms and startups," he says, "but the bottom line is it just got a lot harder to make money in the venture capital business than a year ago - and maybe that is the way it should be."