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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